Subchapter L: Life Insurance CompaniesPosted October 6th, 2010
Why is this Topic Important to Wealth Managers? Presents an introduction into the taxation of U.S. life insurance companies. Provides insight for wealth managers considering advanced planning techniques involving the use of life insurance companies.
Congress has determined, generally, that insurance companies by issuing insurance contracts are serving the public good. Moreover, Congress has determined that the tax accounting applicable to corporations does not adequately align to the operations of the insurance industry. Thus, to distinguish insurance companies, Congress created a special chapter of the Internal Revenue Code (subchapter “L”) applicable only for them. Subchapter L is divided into Section 801 to 848 of which 801 to 818 address the taxation of lile insurance companies.
By example, because of the nature of the life insurance business, in that liabilities carry long into the future, Congress has afforded special deductions to this class. To avoid potential reserve deficiencies by recognizing income (and therefore incurring a present tax liability) when premiums are collected, Congress essentially allows underwriting gains to occur once the insurance liability obligations have expired.
Let’s take a look at the Code specifically to see how these mechanics actually work. First and foremost, pursuant to IRC Sec. 801 a life insurance company is taxed at the same rates as other corporations. These rates can be found in IRC § 11.
A life insurance company means under IRC § 816(a), “ an insurance company which is engaged in the business of issuing life insurance and annuity contracts”, generally, as well as accident or health contracts, so long as, the company’s “life insurance reserves, plus unearned premiums” on “noncancellable” policies, “comprise more than 50 percent of its total reserves.”
In other words, life insurance company means any company with “more than half of the business of which during the taxable year is the issuing of insurance or annuity contracts or the reinsuring of risks underwritten by insurance companies.” IRC § 816 (a).
IRC § 816 (b)(1) defines for the purposes of the previous Subsection (a), life insurance reserves’ to mean, “amounts which are computed or estimated on the basis of recognized mortality…and assumed rates of interest, and which are set aside to mature or liquidate, either by payment or reinsurance, future unaccrued claims arising from life insurance, annuity, and noncancellable accident and health insurance contracts” based on current contingencies.
Another way of stating the above – amounts that are calculated based on mortality tables and are reserved for payment of future obligations – would be considered in other terms, essentially, liabilities for payment of death benefits. For calculation purposes to see if life reserves are more than half of total reserves, total reserves must be defined. Total reserves means “life insurance reserves, unearned premiums, and unpaid losses…, and all other insurance reserves required by law.” IRC Sec. 816 (c).
We now know when a company is taxed as a life insurance company, and the rates at what it is taxed at, but do not yet know the taxable base. In order to determine this, one must consider the taxable income of the insurance company. Insurance company taxable income is defined in § 801(b) to mean, “life insurance gross income, reduced by life insurance deductions.”
This basic formula needs then to be expanded to define life insurance gross income and life insurance deductions. Section 803 states that life insurance gross income is the premiums less return of premiums as well as decreases in insurance reserves. The latter category is recognition of gross income of premiums used (notwithstanding the deduction for cost) at the time the insurance payment is actually made to the insured’s beneficiary.
Section 805 lists the deductions allowed to an insurance company. This list includes, “all claims and benefit accrued” in relation to death benefits. As well as, the net increase in insurance reserves to pay future obligations (which includes premium reserves and unearned premiums [IRC 807]). Additionally, increases in cash values of polices are deductible under § 805. Furthermore, under § 806 there are supplementary deductions for taxable underwriting income for small insurance companies of 60% of income up to $3,000,000 with certain phase-out provisions after that amount.
In sum, the life insurance company recognizes premiums as gross income but deducts premium reserves and unearned premiums associated to the long-term liabilities carried as future payment obligations this year.
Tomorrow’s blogticle will discuss taxation of foreign insurance companies.
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