Insurance Co. Can't Currently Deduct Dividends In Year Credited To Policyholders' Accounts

New York Life Insurance Co. v. U.S., (DC NY 04/19/2011) 107 AFTR 2d ¶2011-806

A district court has held that an accrual-method life insurance company can't claim Code Sec. 808(c) deductions in the year that dividends are credited to its policyholders' accounts, but not actually paid until the following year. The court determined that, since the company's liability to pay the dividends remained contingent at the time they were credited to the policy, it failed to satisfy Reg. §1.461-1(a)(2) 's all events test.

Background. Under Code Sec. 808(c), a life insurance company can claim deductions for policyholder dividends paid or accrued during the taxable year. Code Sec. 808(a) broadly defines a policyholder dividend as “any dividend or similar distribution to policyholders in their capacity as such.”

Under Code Sec. 461(a), a deduction or credit must be taken for the tax year that is the proper tax year under the taxpayer's method of accounting used to compute its taxable income. Reg. §1.461-1(a)(2)(i) provides that under an accrual method of accounting, a liability is incurred, and is generally taken into account for tax purposes, in the tax year in which: (1) all the events have occurred that establish the fact of the liability; (2) the amount of the liability can be determined with reasonable accuracy; and (3) economic performance has occurred with respect to the liability (the “all events test”).

Facts. New York Life Insurance Co. (“NY Life”) is an accrual-method life insurance company. Under New York insurance law, it is required to annually distribute a portion of its surplus earnings to policy owners. This “annual dividend” is payable on the anniversary of a policy if the policy remains in force on that date and all premiums due have been paid. From '90 to '95, NY Life credited a policyholder's account with the annual dividend on the later of: (i) 30 days before the policy's anniversary; or (ii) the date on which all premiums due have been received.

NY Life typically credited a policyholder's account up to 30 days before the policy anniversary, but didn't pay the annual dividend until the policy's anniversary. As a result, policies with anniversaries in January were credited and paid in different taxable years.

In addition to the annual dividend, New York law allowed NY Life to distribute a portion of its surplus earnings as a one-time “termination dividend” to policyholders when a policy terminated by death, maturity or surrender. Depending on whether a policy terminated in any given year, NY Life would expect to pay on each policy an annual dividend, a termination dividend, or both. Each December, NY Life estimated the minimum amount (i.e., the smaller of the two dividends) to be paid on each policy in the following year.

In '90 through '95, NY Life claimed Code Sec. 808(c) deductions for: (1) January annual dividends that were credited to policyholders in December of each year, but weren't actually paid until January of the following year; and (2) the smaller of the annual dividend and the termination dividend that it expected to pay on each policy in the first 8.5 months of years '91 through '96. IRS disallowed these deductions and limited them to policyholder dividends actually paid during the taxable year. NY Life paid the tax deficiencies and interest and filed refund claims for '90 through '95. It also claimed a credit carryback to '88.

Supreme Court precedent controls. The district court determined that NY Life wasn't entitled to currently deduct policyholder dividends in the year that they were credited but not paid. In so holding, it decided that NY Life's liability to pay the dividends at the time they were credited was conditioned on the policy remaining in force on its anniversary date.

The court looked to Supreme Court caselaw to distinguish between fixed and contingent liabilities for purposes of the all events test, including U.S. v. Hughes Properties, Inc., (S Ct 1986) 58 AFTR 2d 86-5062, which held that a casino's liability that was fixed in amount under state law accrued even though payment wouldn't happen until later. However, in U.S. v. General Dynamics Corp., (S Ct 1987) 59 AFTR 2d 87-899, the Supreme Court held that an employer couldn't currently deduct its liability to reimburse employees for medical care that was received in the final quarter of the tax year, but for which employees had not yet submitted claims, because the claims were the “last link” to fix the employer's liability for purposes of the all events test.

The district court concluded that NY Life's situation was more akin to General Dynamics, and that reaching the policy's anniversary date was the “last link” in fixing NY Life's liability. Because NY Life was only obligated to pay if and when the policy remained in force on its anniversary, it was considered contingent before that date. The court rejected NY Life's argument that crediting the dividend fixed its liability, finding that its past practice of actually paying these amounts didn't render them “fixed” under the all events test.

Similarly, NY Life's argument that it was entitled to deduct the smaller of the annual or termination dividend was also rejected. The court found that, as of December 31 of each year at issue, NY Life's liability to pay a termination dividend was contingent on the policy actually terminating.

References: For when expenses are deductible by accrual taxpayers, see FTC 2d/FIN ¶G-2620; United States Tax Reporter ¶4614.15; TaxDesk ¶442,000; TG ¶6216.