Tax Litigation Update: Second Circuit Decision Limits Deductibility of Life Insurance Dividends

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A decision by the United StatesCourt of Appeals for the Second Circuit earlier this month strictly interpreted deductibility I.R.C. § 808(c) as it relates to the deductibility of policyholder dividends paid by life insurance companies. Generally,  I.R.C. § 808(c) permits life insurance companies to deduct amounts “paid or accrued during the taxable year.” In the case, New York Life Insurance Company of America v. United States, the Second Circuit denied New York Life’s attempt to deduct dividend payments in one year that, in the opinion of the Second Circuit, were not paid or accrued until the following year. A copy of the decision is available here.

Background

At issue in the case were two primary types of dividend payments. The first, referred to by the Second Circuit as “Annual Dividends on January Policies,” were paid to policyholders annually, in an amount equal to the policyholder’s proportionate interest in the company’s annual surplus. These dividends were payable on the anniversary date of the policyholder’s purchase of the policy, but only if the policyholder had paid the preceding 12 monthly premium payments and only if the policy was in force (i.e., the policyholder had not cashed out or surrendered the policy) prior to the anniversary date.

New York Life developed a practice whereby it would credit the policyholder with the annual dividend shortly before, but not exactly on, the date on which the payment was actually made. In most circumstances, both the credit date and the payment date were in the same year. For certain January policies, however, the credit date fell in year 1 while the payment date fell in year 2. In such circumstances, New York Life deducted the payment when the credit was made (year 1) rather than waiting to deduct the payment in the following year, when it was actually made. The Internal Revenue Service (IRS) asserted that these credited payments were not deductible until the year they were actually paid, and thus New York Life was taking advantage of the deduction a year earlier than permissible.

The second type of dividend at issue was referred to by the Court as a “Termination Dividend.” Termination Dividends were paid automatically upon termination of a given policy, for instance upon death of the policyholder, or maturation or surrender of the policy. Depending on the circumstances, a policyholder would either receive an annual dividend, a Termination Dividend, or both. In the event the termination event took place before the annual dividend was credited, the policyholder would only receive the termination dividend. If the termination event took place after the credit date, the policyholder received both. If no termination event took place, the policyholder received only the annual dividend. Deductions for Termination Dividends were taken based on New York Life’s projection, made each December, as to the amount of the Annual and Termination Dividends that would be paid on each policy, with the deduction taken for the lesser of the two. Like the “Annual Dividends for January Policies,” this practice resulted in deductions for Termination Dividends being taken in the year prior to actual payment.

Six taxable years (1990-1995) were at issue in the case. After examination, the IRS denied nearly 100 million dollars in deductions attributable to the dividend practices described above. New York Life paid the liability and sued for a refund. The U.S. District Court for the Southern District of New York dismissed New York Life’s complaint for failure to state a claim, holding that based on the facts set forth in New York’s Life complaint, New York Life was entitled to no relief. New York Life’s appeal of that order precipitated the Second Circuit’s opinion.

Second Circuit Opinion

The Second Circuit analyzed the deductibility of each dividend payment under the “All Events” test, codified at Treas. Reg. § 1.461-1(a)(2)(i). This test is used in determining the timing of deductions for accrual basis taxpayers and contains three elements:

  1. All the events have occurred that establish liability;
  2. The amount of the liability can be determined with reasonable accuracy; and
  3. Economic performance has occurred with respect to the liability.

All three elements must be met for a payment to become deductible by an accrual basis taxpayer. The Second Circuit held that both of the at-issue dividends failed the first element of the test and were thus not currently deductible.

Annual Dividends on January Policies

Regarding the “Annual Dividends on January Policies,” the Court held that at the time the payments were credited to the policyholders certain events still needed to occur before New York Life’s liability on the dividend became fixed and inescapable, not contingent upon some future event. Specifically, the Court held that even where the policyholder had fully paid the previous 12 months of premiums, it was still uncertain whether the policy would be in force on the payment date. Even if the possibility was slight, there still remained the chance that the policyholder would choose to cash in the policy prior to the dividend payment date, and thus the second requirement necessary for a policyholder to receive an annual dividend payment would not be met. Significantly, the Court held that even a “statistical certainty” that a policyholder would keep her policy in force as of the dividend payment date was insufficient to satisfy the first element of the All Events test.

New York Life had set forth two primary arguments in support of its deduction of the “Annual Dividend for January Policies.” First, it argued that an interpretation § 808(c) requiring a taxpayer to wait until the year of payment to deduct the dividend amount renders the “accrued” part of the phrase “paid or accrued” in § 808(c) superfluous. In rejecting this argument, the Court reasoned that, in the context of § 808(c), “accrued” refers to amounts which are guaranteed ahead of payment; they have not been paid yet but there was no way for the payor to escape the obligation to pay in the future. That certainty of obligation was not present with New York Life’s annual dividends and thus could not be said to have accrued.

Second, New York Life argued that a policyholder’s decision to keep or give up her policy was not an “event” for purposes of the All Events test, and thus that decision did not have to be made to satisfy the first element of the All Events test.

This argument was based on a prior Second Circuit decision that defined “event” under the All Events test as “something that marks a change in the status quo.” Burnham v. Comm’r, 878 F.2d 86 (2d. Cir. 1989). According to New York Life, the current status of existing policies (i.e. being in force) constituted the status quo and thus the policyholder’s decision to simply leave the policy alone and let it remain in force through the anniversary date was not an “event” for purposes of the test.

Somewhat unpersuasively, the Second Circuit distinguished the phrase “continuation of the status quo” as used in Burnham from its application to New York Life on the basis that, in Burnham, “the fact of the liability” was conclusively established, while New York Life’s liability was still predicated on the policy being in force on the anniversary date.

Further, the payment in Burnham was not predicated on any choice to be made by the payee, whereas New York Life’s liability depended on the policyholder’s choice to keep the policy in force or cash out. These distinctions were sufficient to distinguish the concept of “maintaining the status quo” as used in Burnham such that a decision by a New York Life policyholder to not surrender the policy, even if that decision was completely passive, was an event that would change the status quo of the relationship between New York Life and the policyholder.

Termination Dividends

The rationale behind denying the deductions taken for Termination Dividends was more straightforward. Essentially, the Court held that New York Life did not have an obligation to pay a dividend upon policy termination and therefore could not deduct the dividend amount until it was paid. The individual policies did not contain an obligation to pay a termination dividend (other than a “post-mortem dividend”), nor did applicable state law. Further, board resolutions made in November to pay the following year’s dividends, even irrevocable resolutions, were insufficient to create a contractual obligation to pay the dividends. The Court distinguished similar cases that held board resolutions were sufficient to create contractual liability on the basis that, in those cases, the payee was notified of the forthcoming payment thereby creating an implied contract between the corporation and the payee.

Disagreement With Federal Court of Claims

Although it attempted to distinguish the two cases, the Second Circuit’s decision appears to conflict with a recent decision of the Federal Court of Claims, Massachusetts Mutual Life Ins. Co. v. United States, 103 Fed. Cl. 111 (2012). In that case, the Court of Claims upheld a deduction taken by a life insurer on dividends paid to policyholders under circumstances extremely similar to those present in the New York Lifecase. Specifically, the insurer was permitted to deduct dividend payments prior to actual payment when the sole requirement for the policy to be considered “in force,” thus entitling its holder to a dividend, was for all premiums to have been paid through the policy anniversary date.

In a footnote, the Court attempted to distinguish its opinion from the Court of Claims’ opinion based on the fact that New York Life required, in addition to up to date premium payments, that the policyholder not surrender her policy prior to the anniversary date.

This attempt to distinguish the cases seems, at best, questionable. The policy in the Mass Mutual case could easily be read to imply a requirement that the policyholder not surrender its policy prior to the anniversary date. Otherwise, Mass Mutual would be obligated to pay dividends on policies that no longer existed. More realistically, the Second Circuit’s opinion should be read as being in conflict with the Court of Claims’ opinion, which could have several pertinent ramifications. Most importantly, similarly situated taxpayers, beyond those within the Second Circuit’s jurisdiction, will likely be more inclined to file refund complaints in the Court of Claims than in a Federal District Court within the Second Circuit.

More generally, if the Second Circuit’s strict interpretation of the Code’s timing provisions is found persuasive in other jurisdictions, accrual basis taxpayers, not just dividend-paying life insurers, may be forced to review and modify their current deduction practices.