Revenue Code 815: The Phase III Tax and Surplus Accounts

The taxation of life insurance companies is governed by specialized rules reflecting the long-term nature of their obligations. Unlike other corporations, the way these insurers recognize income and handle payments to owners has historically been subject to a distinct framework. This structure was designed to account for the financial responsibility these companies have to the individuals they insure.

The Two Surplus Accounts

Under a system established by the Life Insurance Company Income Tax Act of 1959, stock life insurance companies were required to maintain two specific memorandum accounts to track their earnings. These accounts, created under Internal Revenue Code Section 815, dictated the tax treatment of money distributed to shareholders. They were not physical bank accounts but rather ledgers for tax accounting purposes that segregated earnings based on their tax status.

The first of these was the Shareholders Surplus Account (SSA). This account consisted of the company’s profits that had already been subjected to corporate income tax. Its balance would be increased by the life insurance company’s taxable income for the year, along with certain other items like specific tax-exempt interest and net capital gains.

The second account was the Policyholders Surplus Account (PSA). The PSA was designed to hold certain underwriting and investment income that had not yet been taxed at the corporate level. A primary source for this account was 50% of the amount by which the company’s gain from operations exceeded its taxable investment income. The tax on this income was deferred until it was distributed to shareholders.

Ordering of Distributions to Shareholders

The tax code established a strict hierarchy for distributions made from a life insurance company to its shareholders. The character of the distribution, and therefore its tax implications, was determined entirely by which account it was deemed to come from based on this mandated progression.

Under these rules, any distribution to shareholders was treated as being paid first from the Shareholders Surplus Account (SSA). The company would reduce its SSA balance by the amount of the distribution until the account was fully depleted. Because the funds in the SSA had already been taxed at the corporate level, these distributions did not create a new tax liability for the insurance company itself.

Only after the Shareholders Surplus Account balance was reduced to zero would any further distributions be considered to have come from the Policyholders Surplus Account (PSA). This meant a company could not choose to pay a distribution from its PSA if it still had a positive balance in its SSA. This rigid ordering was a central control mechanism in the three-phase taxation system, directly linking distribution decisions to significant tax outcomes.

Tax Consequences of Distributions

The primary tax consequence of this system was triggered when a distribution was sourced from the Policyholders Surplus Account (PSA). While distributions from the Shareholders Surplus Account were tax-neutral for the company, a distribution from the PSA had immediate tax ramifications.

When a distribution was made from the PSA, it triggered what was commonly known as the “Phase III tax.” This was not a separate tax rate but rather a mechanism that ended the deferral on the income held in that account. The amount of the distribution from the PSA was required to be subtracted from the account and added directly to the life insurance company’s taxable income for that year. This inclusion in taxable income subjected the funds to the prevailing corporate income tax rate. The Phase III tax effectively served as the backstop to the system, guaranteeing that profits could not be passed to owners without first being subject to corporate tax.

Modern Treatment of Account Balances

The tax framework governing these surplus accounts has undergone significant changes. The Tax Reform Act of 1984 was the first major step, effectively freezing the Policyholders Surplus Account (PSA) by repealing the three-phase system of taxation for life insurance companies. While this legislation stopped new additions to the PSA, it did not eliminate the existing balances or the Phase III tax on distributions from them.

The most definitive change came with the Tax Cuts and Jobs Act (TCJA) of 2017, which fully repealed the surplus account rules. This act eliminated the Phase III tax regime for tax years beginning after December 31, 2017.

Under a transition rule in the TCJA, life insurance companies with a remaining PSA balance as of the end of 2017 were required to pay tax on that balance. The law mandates that these companies must include one-eighth of the frozen PSA balance in their taxable income for each of the eight tax years from 2018 through 2025.