IRS Attempts to Avoid Income/Deduction Mismatch for Deferred and Uncollected Premiums

In CCA 200504030 (Oct. 15, 2004), the IRS Chief Counsel adopted the position that a change in computing life insurance reserves to remove net deferred and uncollected premiums (D&U premiums) is a change in method of accounting rather than a change in basis of computing life insurance reserves. This conclusion had significant economic and practical consequences to the taxpayer in the CCA. If the correction for D&U premiums is considered to be a change in method of accounting, IRC §446(e) provides that securing the Commissioner’s consent is a condition to the change. The consent requirement applies even though the failure to back out D&U premiums is erroneous. Another consequence of characterizing the D&U premium change as a change in method of accounting is that IRC §481 requires an adjustment to prevent a double deduction or a double inclusion of income that otherwise would result from the change. A change to reduce reserves for D&U premiums will result in a double deduction for reserves in an amount equal to the opening balance of D&U premiums for the year of the change. Therefore, an unfavorable IRC §481 adjustment, increasing taxable income in an amount equal to such opening balance of D&U premiums, will be required, and such amount at best will be spread over four years. Rev. Proc. 97-27, 1997-1 C.B. 680, modified by Rev. Proc. 2002-19, 2002-1 C.B. 696. On the other hand, if the D&U premium change qualifies as a change in basis of computing reserves from an erroneous reserve method to the reserve method authorized by the Code, no permission from the IRS is needed and the adverse adjustment to eliminate the double deduction arising from the change is spread over 10 years under IRC §807(f ). Rev. Rul. 94-74, 1994-2 C.B. 157. Therefore, in these circumstances, there is a significant advantage if IRC §807(f ) applies and a 10-year spread is allowable.

At first blush, it may appear that the IRS Chief Counsel is wrong; the reduction in reserves for D&U premiums seems to be a change in basis of computing reserves to which IRC §807(f ) applies. However, it is not that simple. The requirement in the statute for reducing reserves for D&U premiums is found in IRC §811(c)(1), which provides that no reserve can be established for any item unless the gross amount of premiums attributable to the item is required to be included in life insurance gross income. Because IRC §811(a) adopts an accrual method of accounting for premiums, and D&U premiums usually are not accrued, they are not required to be included in life insurance gross income. Therefore, D&U premiums should be excluded from both premiums and, as a result, also excluded from reserves. A correction in timing for reporting premium income is a change in method of accounting requiring the consent of the Commissioner under IRC §446(e). So, the issue becomes: Is the reserve correction for D&U premiums a change in method of accounting because it is driven in the first instance by the treatment of an income item?Or, is the D&U premium income and the resulting reserve effects treated as two separate items subject to different change rules?