Subchapter L: Can You Believe It? Deductible Tax Reserves Might Be Greater For Life Insurance Contracts That Flunk IRC Section 7702 Than For Those That Do Not

In my column in the last issue of TAXING TIMES, I pointed out that, despite contrary authority in Rev. Rul. 91-17, the Internal Revenue Code imposes no withholding and reporting obligations on the issuer of a failed contract that does not satisfy the definition of a life insurance contract under I.R.C. § 7702 even though the inside build-up on the contract in an amount specified in I.R.C. § 7702(g) is currently taxable to the policyholder. This column will now turn to the taxation of the issuer with respect to a failed contract. It may seem counterintuitive, but it is possible for a life insurance company to have a more favorable tax result if a contract flunks I.R.C. § 7702, i.e., it may get a higher tax reserve deduction than if the contract qualified.

Statutory reserves for life insurance contracts generally are required to be recomputed for tax purposes. The re-computation of life insurance reserves under I.R.C. § 807(d) involves a three-step approach. An actuarial reserve is first computed on a contract-by-contract basis, and second, this reserve is compared to the net surrender value of the contract. The larger amount is the tax reserve, except—the third step—in no event can the amount of the tax reserve exceed the amount of the statutory reserves. “Statutory reserves” for this purpose generally refers to the aggregate amount of reserves for the contract which are set forth in the company's annual statement.