Subchapter L: Statutory Reserves Do Not Always Have To Be Set Forth in the Annual Statement

Deductible federally prescribed reserves are capped by statutory reserves. To qualify as statutory reserves for this purpose, I.R.C. § 807(d)(6) provides that the reserves must be “set forth” in the annual statement. Is there ever an instance where tax reserves should not be capped even though they exceed statutory reserves that are reported in the annual statement? Yes, when statutory reserves are weakened.

A simple example illustrates how reserve weakening results in this tax reserve anomaly. Suppose a life insurer issues contracts that include a disability waiver-of-premium benefit for an additional charge. Tax reserves for this type of benefit are equal to the reserves taken into account on the annual statement because they are held for qualified supplemental benefits under I.R.C. § 807(e)(3). Now suppose the company changes its basis of computing its statutory reserves for this benefit and the result is lower statutory (and therefore tax) reserves. In such case I.R.C. § 807(f) comes into play. I.R.C. § 807(f) defers until the succeeding taxable year the tax recognition of the decreased reserves resulting from the reserve weakening for contracts issued before the taxable year. For those contracts, tax reserves are computed on the old method for the year of change, and reserves computed on the new method are used for the years thereafter. The difference between the closing reserves computed on the old basis and the closing reserves computed on the new basis for the year of change is spread over ten years beginning in the year following the year the change in basis of computing reserves occurs. Going back to the qualified supplemental benefits example, the effect of I.R.C. § 807(f) is that the year-of-change tax reserves are computed for previously-issued contracts as if no change in statutory reserves occurred. But wait. Should we cap tax reserves for the year of change by the lower amount of statutory reserves actually “set forth” for that year in the annual statement? The answer is “no.”

The technical statutory language under current law that leads to this result is found in I.R.C. § 807(f) itself. The requirement to compute reserves using the “old basis” for the year of change refers to the entire reserve “item” described in I.R.C. § 807(c), which by its terms includes application of the statutory reserves cap.