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Field Directive on Examination of IRC § 847

January 13, 2006

MEMORANDUM FOR INDUSTRY DIRECTORS, LMSB
 DIRECTORS, FIELD OPERATIONS
 DIRECTOR, FIELD SPECIALISTS
 DIRECTOR, PREFILING AND TECHNICAL GUIDANCE
 DIRECTOR, OGDEN SERVICE CENTER

FROM: Paul D. DeNard /s/ Paul D. DeNard
Industry Director
Financial Services

SUBJECT: Field Directive on Examination of IRC § 847

INTRODUCTION
This memorandum’s purpose is to provide field direction on the background, identification, examination, and reconciliation of I.R.C. § 847 accounts which are maintained in the Ogden Campus.

BACKGROUND
Before the Tax Reform Act of 1986 (TRA86), property and casualty insurance companies generally were allowed to deduct the full amount of their unpaid customer claims in calculating the insurer’s taxable income.  Congressional concern that these insurers were overstating their current deductions for future loss payments resulted in a TRA '86 change to require discounting of unpaid losses.  I.R.C. § 832 requires that taxpayers discount their deductions for insurance loss reserves, and now, before a deduction for loss reserves can be claimed, the unpaid losses must be discounted under I.R.C. § 846.  This discounting is necessary to account for the time value of money.

The deduction for unpaid losses under I.R.C. § 846 is now limited to the amount of discounted unpaid losses, and represents the sum of the discounted unpaid losses separately computed, with respect to unpaid losses, in each line of business, attributable to each accident year.  The amount is computed by using the amount of the undiscounted unpaid losses, the applicable interest rate, and the applicable loss payment pattern per I.R.C. § 846(a)(2).

Under I.R.C. § 847, for taxable years beginning after December 31, 1987,an insurance company required to discount unpaid losses may elect to take a deduction, not to exceed the excess of the undiscounted unpaid losses over the related discounted unpaid losses at the end of the year.  In other words, a deduction equal to the amount of the discount.  By claiming a deduction for discounted losses in accordance with I.R.C. § 846, and the additional deduction for the amount of the discount under I.R.C. § 847, the taxpayer in essence is deducting its full, undiscounted, reserve for losses.  In order to be eligible to take the deduction under I.R.C. § 847, the taxpayer must make special estimated tax payments (SETP).

The amount of the I.R.C. § 847 deduction in the first year is to be added to a "special loss discount account" per I.R.C. § 847(3).  For each year thereafter, an amount equal to the amount allowed as a deduction for that taxable year is to be added to the special loss discount account. I.R.C. § 847(4).  In subsequent years as losses are paid and the related discount declines, a corresponding amount is to be subtracted from the special loss discount account and included in the company's gross income. I.R.C. § 847(5)(A) and (B).  To the extent that any amount added to the special loss discount account is not subtracted from the account before the 15th year following the year for which the amount was added, the amount will be subtracted from the account and included in gross income in the 15th year. I.R.C. § 847(5).

Any additional tax liability resulting from the inclusion of the amounts from the "special loss discount account" in gross income is offset by previously made SETP.  If after the payment is applied there is an adjustment reducing the amount of the additional tax, in lieu of any credit or refund for such reduction, a "special estimated tax payment" will be treated as made in an amount equal to the amount otherwise allowable as a credit or refund.  To the extent the SETP are not used to offset additional taxes during the 15 years following the year for which the payment was made (which may occur if the company incurs net operating losses in those years), the unused amount will be treated as a regular estimated tax payment in the 16th year after the year for which a "special estimated tax payment was made". I.R.C. § 847(2).  Accordingly, the SETP may be applied to pay income taxes due in the 16th year, or the amount may be refunded to the company.   The first 15 year period expires in 2004.

Reporting Discussion
Taxpayers use Form 8816 to report the “special loss discount account” and SETP.  In each subsequent year, a Form 8816 must be filed, whether or not previously deducted income is reported, for each accident year for which a deduction is claimed until all the income is brought back in.  This may take up to 15 years.  Each subsidiary electing I.R.C. § 847 in a consolidated return must file its own Form 8816.  On Form 8816, each accident year is reported separately.  The later filed Forms 8816 reference the initial accident year.  A taxpayer would likely have multiple accident years, each one building on the initial year.  See the instructions for Form 8816.
 
Guidelines
The SETP accounts are maintained in the Accounting Control Operation of Submission Processing at the Ogden Campus.  In as much as the provision has been in effect since 1988, errors may have occurred in accounting for the I.R.C. § 847 election that should be corrected.  The most common errors noted to date are:

  1. taxpayers not maintaining adequate workpapers to properly account for prior year deductions
  2. taxpayer payments for the special estimated tax not properly transferred from master file accounts to the SETP ledger account
  3. SETP balances not properly transferred to new accounts when a subsidiary electing I.R.C. § 847 transfers out of a consolidated group or joins a new consolidated group
  4. examination reports adjusting unpaid losses not properly reflecting changes to the I.R.C. § 847deduction/income

The following guidelines serve as recommendations to examiners for the audit of insurance company returns that have elected to take an I.R.C. § 847 deduction.

  • Secure a copy of the § 847 control card from the Revenue Accounting Team at the Ogden Campus.
  • Determine whether the account balance reconciles with the taxpayer's records. 
  • If there is a discrepancy between the Service balance and taxpayer records, obtain transcripts for all tax years beginning with the election of I.R.C. § 847 by the taxpayer.
  • Trace SETP payments from the master file transcript to the ledger account   (§ 847 control card) and determine that the payments have been posted to the account for the correct year and amount.
  • Reconcile the ledger account to Forms 8816 on a company by company basis, not on a consolidated basis.  If this has not been done on a prior audit, it will be time consuming and therefore must be started early in the audit process.  It is important to involve the taxpayer in this reconciliation.  It will save you time. 
  • Reconcile the amount reported for the additional deduction to the taxpayer’s discount workpapers from the Form 8816 and request an explanation of any discrepancies.
  • Obtain copies of all prior RAR's from the time of the taxpayer’s first election of I.R.C. § 847, which affect the 847 balance. 
  • Recalculate the additional deduction and SETP payments for any changes made to the unpaid losses and loss adjustment expenses during the audit and prior audits.
  • Determine if the taxpayer calculated the SETP payment correctly. 
  • Determine if the taxpayer calculated its Alternative Minimum Tax correctly.  SETP payments may not be used to reduce the amount of Alternative Minimum Tax (AMT).
  • If adjustments need to be made to the ledger account on an agreed case due to examination adjustments, indicate the amount of the adjustment on the “Adjustment to Prepayment Credits” line of Form 4549, include an explanation in the “Other Information” section of Form 4549, and notify the Revenue Accounting Team at the Ogden Campus.  A suggested memo format is located on the P&C Insurance Technical Advisor web-site for this notification purpose.

 

Technical Issues
NOL Carrybacks.
  The effect of a NOL carryback into a year involving an I.R.C.  § 847 election depends on whether (1) there in a new election in which a deduction has been claimed and a SETP made or (2) the reversal of a prior election and previously paid SETP is applied to pay tax on the I.R.C. § 847 income. 

  1. If the NOL carryback is deducted in a year in which an I.R.C. § 847 deduction has been claimed, the amount of tax benefit for the deduction must be recomputed and new limitations set.  If the I.R.C. § 847 deduction is reduced, a corresponding amount of previously paid SETP is refunded to the taxpayer.
  2. If the NOL carryback is deducted in a year in which income is recognized from the reversal of the special loss discount account, no refund is made to the taxpayer.  Rather in keeping with I.R.C. § 847(2), the corresponding SETP is moved back to the SETP ledger account.   The SETP payment is then used to pay tax when the NOL is absorbed.  This treatment is necessary to maintain the revenue neutrality of the I.R.C. § 847 provisions. 

To illustrate the second situation, assume a taxpayer makes an I.R.C. § 847 election for the 1993 tax year, deducts $200, and makes a SETP of $70 to account for the regular tax on the deduction.  In tax year 2000, the special loss discount account reverses, the taxpayer recognizes the $200 in income, and applies the $70 SETP to pay the tax on the I.R.C. § 847 income.  Then, in 2002 the taxpayer incurs a large NOL.  The NOL is carried back to 2000, eliminates all of the year 2000 and 2001 income and is fully absorbed in 2003.   The $70 SETP applied in tax year 2000 will be returned to the general ledger account when the tax year 2002 NOL is carried back.  The NOL deduction available for 2003 will be $200 less when computed taking I.R.C. §847 into account than the NOL deduction computed without regard to I.R.C. § 847.  The SETP of $70 is then available to pay the tax on the I.R.C. § 847 amount.  If the $70 had been refunded for the 2000 tax year, the taxpayer electing I.R.C. §847 would receive a greater benefit than a taxpayer not making the election because the electing taxpayer, in essence, has received a refund of taxes due in 1993.

Sale of subsidiary stock when I.R.C. § 338(h) (10) election is made.  The remaining balance in a subsidiary’s special loss discount account must be recognized into income on an I.R.C. § 338(h) (10) election and any excess remaining in the SETP account after application to pay the tax on the recognized special loss discount account income is voided.  This is the position set out in FSA 200051011 (August 28, 2000) and Proposed Reg. § 1.338-11.

Sale or distribution of insurance subsidiary stock.  An insurance subsidiary that leaves a consolidated group but is not deemed or actually liquidated is entitled to the balance of the SETP account relating to its special loss discount account.  This question was the subject of ILM 200222039 (January 22, 2002).

Joint Committee Reporting.  There has been a question as to whether a refund of SETP account amounts requires a report to the Joint Committee.  It is believed that a Joint Committee report is not required on SETP refunds.  SETP are only refunded when characterized as an estimated tax payment—either a “special estimated tax payment” refunded due to audit adjustments that affect the I.R.C. § 847 deduction, NOL carrybacks that reduce the I.R.C. § 847 deduction, or refunds of unused SETP in the 16th year that convert to regular estimated tax payments due to unreversed amounts in the special loss discount account.  Joint Committee reporting requirements do not require the reporting of refunds of estimated tax payments.

Interest Payable on SETP Refunds.  When is interest payable of refunds of SETP and based on what date?  As stated above, refunds of SETP account amounts are made when the loss of the tax benefit of the I.R.C. § 847 deduction occurs.  As such, interest is payable to the same extent and timing as if the SETP was an actual tax payment.  See ILM 200118001.

This LMSB directive is not an official pronouncement of the law or the Service's position and cannot be used, cited, or relied upon as such.

Contact
If you have any questions, please contact Mary B. Sordi, Technical Advisor, Property and Casualty Insurance, PFTG Group 4, at 302-286-1587 or email at Mary.Sordi@irs.gov.

cc: LMSB Commissioner and Deputy Commissioner
      LMSB Director, Performance, Quality and Innovation
 
 

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