On February 4, the IRS issued a new revenue ruling – Rev. Rul. 2014-7 – that indicates that the IRS no longer plans to issue formal guidance concerning the treatment of the dividends-received deduction (DRD) with respect to the earnings of a life insurance company’s separate account. Notably, the impact of Rev. Rul. 2014-7 is consistent with the Obama Administration’s proposals to limit the availability of the separate account DRD through legislation.
Sutherland Observation: The most recent legislative proposal from the Obama Administration, which is described in the General Explanations of the Administration’s Fiscal Year 2014 Revenue Proposals, would expand the limitations on the DRD that generally apply to other corporate taxpayers to life insurance company separate account dividends. That limitation would apply in the same proportion as the mean of reserves bears to the mean of total assets of the separate account. Thus, under the Administration’s proposal, dividends received by a separate account likely would be entitled to only a very small, if any, DRD.
We offer some background on the separate account DRD issue and the circumstances surrounding the issuance of Rev. Rul. 2014-7 below.
In the case of a life insurance company, the DRD is permitted only with regard to the “company’s share” of dividends received, reflecting the fact that some portion of the company’s dividend income is used to fund tax-deductible reserves for its obligations to policyholders. Likewise, the net increase or net decrease in reserves is computed by reducing the ending balance of the reserve items by the policyholders’ share of tax-exempt interest. The regime for computing the company’s share and policyholders’ share of net investment income generally is referred to as “proration.”
A life insurance company’s separate account assets, liabilities, and income are segregated from those of the company’s general account in order to support variable life insurance and variable annuity contracts. As relevant to the determination of the separate account DRD, the company’s share and policyholders’ share of net investment income are computed for the company’s general account and separately for each separate account. In view of the nuances associated with these computations, the separate account DRD has been the subject of ongoing controversy in IRS audits of life insurance companies.
Prelude to, and Likely Effect of, Rev. Rul. 2014-7
In Rev. Rul. 2007-54, 2007-2 C.B. 604, the IRS addressed the DRD for dividends received on assets held in a life insurance company’s separate account in a manner that diverged from the treatment of the separate account DRD under Treasury regulations that carried over from prior law. In view of the concerns raised with respect to Rev. Rul. 2007-54, the IRS issued Rev. Rul. 2007-61, 2007-2 C.B. 799, which suspended Rev. Rul. 2007-54 and stated that the separate account DRD issue would be addressed through the issuance of Treasury regulations.
Rev. Rul. 2014-7, which addresses the treatment of reserves for a variable annuity contract under IRC § 807, concludes by modifying and superseding Rev. Rul. 2007-54 and obsoleting Rev. Rul. 2007-61. Thus, in view of these effects, Rev. Rul. 2014-7 indicates that the IRS no longer plans to issue formal guidance concerning the treatment of the separate account DRD.
We anticipate that the Obama Administration will continue to push its proposal concerning the calculation of the separate account DRD in its budget proposals for fiscal year 2015, which are scheduled to be released in early March. We intend to report on those budget proposals when they become available.