IRS LB&I Directive provides tax opportunity for insurance companies

Credit-related impairment under 43R may be deductible

An Internal Revenue Service (IRS) Large Business & International (LB&I) Directive, issued July 30, 2012, provides insurance companies the opportunity to take a partial worthlessness deduction under Internal Revenue Code section 166(a)(2). The partial worthlessness deduction would be for the amount of the Statement of Statutory Accounting Principle No. 43R (SSAP No. 43R) credit-related impairment charge-offs of eligible securities reported on the insurance company’s Annual Statement. The provisions of the Directive can be applied no earlier than the insurance company’s 2009 taxable year and no later than the insurance company’s 2012 taxable year.

Background

IRC section 166(a)(2) provides that when a debt is recoverable only in part, the debt may be allowed as a deduction in an amount not in excess of the part charged off within the taxable year.

State law generally requires insurance companies to file Annual Statements with insurance regulatory authorities using the accounting principles set forth in the National Association of Insurance Commissioners (NAIC) Accounting Practices and Procedures Manual. SSAP No. 43R provides accounting rules that must be followed when loan-backed and other structured securities are impaired and subject to charge-off, for all reporting periods ending on or after September 30, 2009.

Guidance

Under this Directive, LB&I examiners should not challenge an insurance company’s partial worthlessness deduction under section 166(a)(2) for eligible securities, if the insurance company complies with the following:

  • First year adjustment
    The insurance company’s partial worthlessness deduction under section 166(a)(2) for eligible securities is the same amount as the insurance company’s SSAP No. 43R credit-related impairment charge-offs, for the same securities as reported on its Annual Statement. The insurance company must reduce or increase its deduction by a positive or negative adjustment in the first year it applies the Directive (the Adjustment Year).

    The positive or negative adjustment is determined on December 31 of the Adjustment Year. The tax basis of the eligible securities may not be less than the post-charge-off statutory carrying value of the same securities under SSAP No. 43R, as adjusted for any non-credit related impairment.
  • SSAP No. 43R credit-related charge-off conformity
    For taxable years beginning after the Adjustment Year, the insurance company’s partial worthlessness deduction under section 166(a)(2) for eligible securities is the same amount as the insurance company’s SSAP No. 43R credit-related impairment charge-offs, for the same securities reported on its Annual Statement.

    If an insurance company complies with the first year adjustment and uses the SSAP No. 43R credit-related impairment charge-off amount for all eligible securities that are partially worthless, LB&I examiners should not challenge the partial worthlessness deduction as reported on the insurance company’s federal income tax returns for all open tax years ending before the Adjustment Year.

Implementation

For insurance companies that are not currently under IRS examination, the provisions of the Directive can be implemented by filing amended federal income tax returns for prior open tax years or by applying the Directive for the insurance company’s 2012 taxable year. A statement must be attached to the federal income tax return for the Adjustment Year stating the insurance company is implementing the provisions of the Directive beginning in the Adjustment Year. For taxpayers filing a consolidated federal income tax return, a separate statement should be attached for each insurance company included in the consolidated filing.

Insurance companies currently under examination may consult with the LB&I examiners to determine whether to change the amount of the company’s partial worthlessness deduction for eligible securities for the tax year(s) under examination to be consistent with the Directive, or to file amended federal income tax returns.

Certification

Upon examination by the IRS, an insurance company that used its SSAP No. 43R credit-related impairment charge-offs of eligible securities reported on its Annual Statement as the amount of a partial worthlessness deduction under section 166(a)(2), must complete and sign an LB&I Directive on Section 166 Partial Worthlessness Deduction Certification Statement (Certification Statement). The Certification Statement must be signed by an authorized individual of the company and must be provided to the LB&I examiner within 30 days of a request for the statement. A separate Certification Statement may be requested for each taxable year under audit, as well as for each insurance company filing as part of a consolidated group.

Recordkeeping

An insurance company implementing the provisions of the Directive should retain the underlying documentation reconciling the SSAP No. 43R credit-related impairment charge-offs for eligible securities reported on its Annual Statement with the section 166(a)(2) partial worthlessness deduction claimed for the same eligible securities. If an insurance company fails to properly and timely submit the requested documentation permitting the LB&I examiner to reconcile the insurance company’s statutory accounting impairment with its federal income tax deduction for eligible securities, the Directive may be deemed not to apply to the insurance company, and regular audit procedures will apply.