What Are the General Deductions Under Section 805?
Understand the distinct tax methodology for life insurance companies, including the calculation and application of deductions to arrive at taxable income.
For a business to be classified as a life insurance company for tax purposes, more than half of its operations must involve issuing life insurance and annuity contracts, or reinsuring risks from other insurance companies. Additionally, over 50% of its total reserves must be composed of life insurance reserves. This business model, centered on long-term obligations and the management of substantial investment portfolios, necessitates a specialized approach to calculating taxable income. This article focuses on the general deductions available to these companies under the Internal Revenue Code (IRC), which are used to determine their tax liability.
Allowable General Deductions
The framework for life insurance company taxation allows for several specific deductions, outlined primarily in IRC Section 805. These deductions are subtracted from life insurance gross income to arrive at the company’s taxable income. Each deduction reflects a component of the company’s financial operations, from paying out policyholder benefits to managing its business activities.
A primary deduction is for claims and benefits accrued during the year. This includes all death benefits, annuity payments, and other policy-related payouts that the company is obligated to pay. It represents a direct cost of doing business.
Life insurance companies are also permitted to deduct the net increase in certain reserves. These reserves, mandated by state law, are funds set aside to meet future obligations to policyholders. As the company’s future liabilities grow, it must increase its reserves, and this increase is recognized as a deduction for tax purposes.
Other deductions, such as for policyholder dividends, the dividends-received deduction, and net operating losses, are also permitted but are subject to special rules discussed in later sections. Finally, life insurance companies can take deductions for charitable contributions, subject to a limit of 10% of their taxable income with certain adjustments. They are also permitted to claim other general business deductions that are available to all corporations under the tax code, provided they are not otherwise limited by the specific rules for life insurers.
Special Rules and Limitations
The general deductions available to life insurance companies are subject to a series of special rules and limitations that alter their final amounts. The dividends-received deduction (DRD) is subject to a specific limitation for life insurance companies. The deduction is prorated between the company’s share of net investment income and the policyholders’ share.
The Tax Cuts and Jobs Act of 2017 (TCJA) simplified this by establishing a set company share of 70% for calculating the DRD. This means the company can only apply the DRD percentage to its 70% share of the eligible dividends. For instance, the general DRD for dividends from a less-than-20%-owned corporation is 50%, so a life insurer’s effective deduction is 35% (50% of its 70% share).
The treatment of tax-exempt income, such as interest from municipal bonds, also indirectly impacts deductions. A portion of the company’s tax-exempt income is allocated to the policyholders’ share of income, which reduces the amount the company must add to its deductible reserves. This effectively reduces the tax benefit of holding tax-exempt assets.
Understanding the Net Operating Loss Deduction
For many years, life insurance companies utilized a specific deduction known as the operations loss deduction (OLD) to account for years when their deductions exceeded their income. Prior to its repeal, the OLD rules allowed a company to carry a loss from operations back three years and forward 15 years. The Tax Cuts and Jobs Act of 2017 repealed the special OLD rules for losses arising in tax years beginning after December 31, 2017.
Following the TCJA, life insurance companies are now subject to the standard NOL rules found in IRC Section 172. Under the new rules, net operating losses can no longer be carried back to prior tax years. Instead, they can be carried forward indefinitely to offset future taxable income. However, the NOL deduction in any single year is limited to 80% of the company’s taxable income for that year.
Determining the Policyholder Dividends Deduction
The deduction for policyholder dividends is an important component of tax calculations for many life insurance companies. Policyholder dividends are amounts paid or accrued to policyholders that represent a distribution of the company’s surplus earnings or a return of excess premiums paid. The tax code allows a deduction for the full amount of policyholder dividends paid or accrued during the taxable year.
Role in Calculating Taxable Income
The various deductions allowed under Section 805, after being adjusted by all applicable special rules and limitations, play a direct role in the final calculation of a company’s tax liability. The goal is to arrive at the Life Insurance Company Taxable Income (LICTI), which is the base amount subject to the corporate income tax rate.
The formula for LICTI begins with life insurance gross income, which includes premiums and net decreases in reserves. From this amount, the company subtracts the total of its allowable general deductions. The result of this subtraction is the company’s LICTI. This final figure is then multiplied by the 21% corporate tax rate to determine the company’s federal income tax for the year. The final tax obligation is reported on Form 1120-L, the U.S. Life Insurance Company Income Tax Return.