IRS Issues Guidance on the Separate Account Dividends Received Deduction

The Insurance Branch in IRS Chief Counsel’s National Office recently issued a Chief Counsel Advice (CCA) memorandum regarding the Dividends Received Deduction (DRD) in the separate account partnership fund context. The CCA provides guidance on a partnership structure that some life insurance companies have adopted for separate accounts in lieu of the more typical Registered Investment Company (RIC) structure. Under the partnership structure, some of the funds in which the separate accounts are invested are taxed as partnerships (instead of RICs) and the life insurance company is a partner. A few Large Business & International division (LB&I) examiners have raised issues regarding the mechanical application of the company’s share/proration calculation as it applies to the partnership structure.

By way of background, the term “proration” generally refers to an allocation of a company’s net investment income between the “company’s share” and the “policyholders’ share.” It is based on a fraction that is applied to determine how much of the company’s net investment income is credited to policyholders, and how much is not. In this context, the result is applied to the separate account DRD to disallow a portion (representing the policyholders’ share) in order to prevent the company from obtaining a double benefit by funding reserve deductions with dividends that have been deducted.

The LB&I examiners, in general, have asserted that in calculating this fraction to be applied to the separate account DRD, the pass-through partnership taxation rules should be disregarded and the proration formula should be calculated as if the partnerships were RIC-like entities. The National Office provided the CCA to an LB&I team in response to a request for advice on three related issues the team raised in an audit of a life insurance company.

In particular, the National Office concluded that the taxpayer under audit by the LB&I team

1. properly determined its gross investment income under section 812(d) without reduction for the investment expenses of the partnership in which the taxpayer invested;

2. properly included in “amount retained” under Treas. Reg. § 1.801-8 the partnership investment fees it paid to an affiliate; and

3. was not precluded from deducting those fees by the section 811(c)(3) prohibition on double deductions.

SEPARATE ACCOUNT DRD BACKGROUND

Some general background might help readers who are not familiar with the separate account DRD understand the CCA’s conclusions. Internal Revenue Code section 805(a)(4)(A)3 allows a life insurance company a DRD under sections 243 and 245, but the company must reduce the tax benefit from the deduction under the proration formula (which also applies to tax-exempt interest). In general, the reduction is intended to prevent the company from receiving a double benefit by deducting a portion of the dividends received and also receiving a deduction for reserve increases funded by the dividends. The reduction is accomplished by allocating, or prorating, net investment income between certain deductible amounts, which generally consist of investment earnings deemed to be credited to policy or contract obligations (the policyholder’s share) and amounts not credited (the company’s share).