Recent Case Demostrates Timing Matters When Claiming Deductions
August 2013On August 1, 2013, the Court of Appeals for the Second Circuit affirmed a district court decision in the case of New York Life Insurance Company v. United States ("New York Life").  The District Court had agreed with the government that New York Life had prematurely accrued certain policyholder dividends. The case is significant because it offers insights into the details of the application of the "all events” test, which is the well-known and widely applied U.S. tax accounting rule for determining the proper year for the deduction of a liability.
New York Life is a mutual life insurance company organized under the laws of New York State. The company annually paid "policyholder dividends" to the holders of certain insurance policies. These dividends were payable out of the company's surplus, and they were deductible by the company in the year that they were “paid or accrued” for purposes of computing the company's federal income tax liability.
The timing of the deduction of two types of policyholder dividends was at issue in the case: (i) the “Annual Dividend for January Policies,” and (ii) the “Termination Dividend." The case addresses policies with an anniversary date in January. In order to be eligible for an Annual Dividend, a policyholder’s policy had to be in force on the policy's anniversary date and all premiums due as of the anniversary date must have been paid.
A Termination Dividend could be paid by New York Life upon the termination of an eligible policy by death of the insured, maturity of the policy or its surrender by the holder. New York law permits mutual insurance companies to pay such dividends; however, New York Life had no contractual obligation to pay a Termination Dividend.
During the years at issue (1990 through 1995), New York Life's internal policy was to credit policyholder accounts in December for certain Annual Dividends and Termination Dividends that the company intended to pay in January of the following year. If a terminating event occurred before a credit to the policy with an Annual Dividend, the company would pay only the Termination Dividend in January. However, if the terminating event occurred after the company had credited the policy with the Annual Dividend, the company would pay both the Annual Dividend and the Termination Dividend. If no terminating event occurred, then the company would pay only the Annual Dividend in January.
The deduction for policyholder dividends is allowed by section 808 of the Internal Revenue Code, a provision specific to insurance companies. The deduction is allowed for policyholder dividends "paid or accrued" during the taxable year. Whether a deduction of a liability is properly accrued is determined under the Code’s general tax accounting rules -- in this case, the regulations issued under section 446. This regulation contains the all events test for determining when a liability may be deducted:
A liability is incurred, and generally is taken account for federal income tax purposes, in the taxable year in which all events have occurred that established the effect of the liability, the amount of the liability can be determined with reasonable accuracy, and economic performance has occurred with respect to the liability.
The Court of Appeals for the Second Circuit agreed with the District Court that New York Life had not satisfied the first part of the all events test (“all events have occurred that establish . . . the liability”) with respect to policyholder dividends that it had accrued in December and paid in January of the following year. With respect to the Annual Dividend for January Policies, the Circuit Court found that it was not sufficient that the policyholder had paid in December the last premium necessary to keep the policy in force through the policy’s January anniversary date. The court reasoned that the policyholder still could decide to surrender the policy in January, in which case the annual dividend would not be payable. Moreover, New York Life did not guarantee that it would pay the Annual Dividend in such cases.
New York Life argued that a policyholder's decision to not terminate a policy in January was not an "event," under the all events test, because under prior case law an event had been defined as "ordinarily something which marks a change in the status quo." The Circuit Court rejected that argument saying that under the policy a significant decision had been committed to the policyholders (even though, as a practical matter, most policyholders do not terminate a policy before the anniversary date after having paid the final premium for the year).
With respect to Termination Dividends the Circuit Court found that New York Life had no contractual obligation to pay a Termination Dividend, and it had no legal obligation to pay the dividend under New York law. New York Life countered that the regulation stating the all events test also provides that the term “liability” is “not limited to items for which a legal obligation to pay exists at the time of payment." The court dismissed the relevance of this argument, noting that the regulation refers to "time of payment," while the issue in the case was whether the liability had been properly accrued in the earlier year.
New York Life also argued that the liability for the Termination Dividend accrued in the prior year because its board of directors had met annually in November and approved payment of the Termination Dividend in the following year. The Circuit Court concluded that "without some pre-existing obligation, a board's resolution cannot convert a voluntary expense into an accrued liability for federal income tax purposes." Finally, New York Life argued that the board resolution created an implied contract to pay the Termination Dividend. The court concluded that it saw no basis for finding an implied contractual obligation based on the board resolution.KEYWORD: Tax Accounting
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