4.42.3  Examination Methods and Techniques

4.42.3.1  (05-29-2002)
Overview

  1. This chapter discusses the examination methods and techniques applicable to insurance companies.

4.42.3.1.1  (05-29-2002)
Comparison of Income Shown on Form 1120–L with the Annual Statement

  1. This comparison is one of the most important tasks you will perform in your preliminary review. Experienced insurance company examiners have found this phase of the audit will, as a general rule, produce many of the leads to be followed-up in the examination of the books and records. This comparison is referred to throughout the guidelines.

4.42.3.2  (05-29-2002)
Life Insurance Company Gross Income – IRC section 803

  1. Gross Income includes all items that relate to corporations generally as well as those unique to life insurance companies.

  2. In connection with our preliminary review, we should reconcile (to extent possible) the income reported on the return against page 4 of the Annual Statement (Summary of Operations). Any unusual items noted or the failure of the reconciliation to balance, should be given a priority position in the audit plan.

  3. The Life Insurance Company Gross Income includes:

    1. Gross premiums and other considerations received on insurance and annuity contracts less return premiums and premiums and other considerations arising out of indemnity reinsurance. IRC section 803(a)(1). Gross premiums and other considerations include (advance premiums, deposits, fees, assessments, considerations received for assuming liabilities under contracts not issued by the corporation, and the amount of policyholder dividends reimbursable to the taxpayer by a reinsurer in respect of reinsured policies). See IRC section 803(b)(1). Return premiums include amounts rebated or refunded due to policy cancellations or due to incorrectly computed premiums, but do not include amounts returned to policyholders when such amounts are not fixed in the contract but instead depend on the corporations experience or the management’s discretion.

    2. Net decrease in reserves – If there is a decrease in the reserves, the amount of decrease is reported as current income. See Schedule F, Form 1120–L, line 8 – If the amount is negative, it is entered as a positive number as current year income.

    3. Ten percent of certain decreases in reserves – If the amount of any item referred to in IRC section 807(c) decreases as a result of a change in basis used to determine that item, ten percent of the decrease must be included in life insurance company gross income for each of the ten succeeding tax years. See IRC section 807(f)(1).

    4. 3–1/3 percent of year end balance of reserves under IRC section 807(e)(7)(B) – For tax years beginning on or after September 30, 1990, and before September 30, 1996.

    5. Investment Income — The amount from Schedule B, Form 1120–L, line 8, plus interest received on securities acquisition loans (ESOP).

    6. Net Capital Gains — Schedule D, Form 1120–L, line 12

    7. Other Income — Includes any other taxable income not included above. The taxpayer should list the types and amounts of income on an attached schedule.

4.42.3.2.1  (05-29-2002)
Premiums Income – IRC section 803(a)(1)

  1. Gross Premiums – IRC section 803(a)(1)(A). The amount of gross premiums includes consideration for supplementary contracts with life contingencies, consideration for contracts without life contingencies, policyholders’ dividends, advance premiums and deposits.

    1. Premium income begins with the amounts reflected on lines 1, 2, and 3 of the Summary of Operations, page 4 of the Annual Statement.

    2. The premium and annuity considerations in the Summary of Operations are detailed in Exhibit 1, Part 1 of the Annual Statement.

    3. The amounts shown in Exhibit 1 are amounts specified in the policy and annuity contracts, the payments of which are required to make the respective contract effective in the first place and for their continuance in force thereafter.

    4. The amounts of accident and health premiums reflected in Exhibit 1 are taken from Schedule H, Accident and Health Exhibit of the Annual Statement.

    5. In some cases a company may submit a separate Convention Annual Statement used by Casualty Insurance Companies to report its accident and health business in lieu of completing Schedule H of the Annual Statement.

    6. Notation should also be made to ensure that premiums paid in advance and premium deposit funds are considered income in the year received for income tax purposes; and whether retrospective rate credits and experience rating refund should be reclassified as policyholder dividends instead of a return of premiums.

    7. Also considered premium income are the "phantom premiums" from the Excess Interest–Schedule E, line 2 and Premium Adjustments – Schedule E, line 3, of the 1120–L Any policyholder dividends that increase any benefits payable under the contract (including cash values), or reduces premium otherwise required, the amount of that policyholder dividend is treated as paid to the policyholder and returned by the policyholder to the company as a premium. This premium portion is the so called "phantom premium" .

    8. When you are auditing a large life insurance company, it may not be possible to reconcile amounts required to be reported on the return from information contained on the Annual Statement, because of the difference in the manner of accounting for Annual Statement purposes and tax purposes. Therefore, in your preliminary review, notation should be made to accomplish such reconciliation.

    9. Note in accordance with the Committee Reports’ interpretation of IRC section 811(c)(1), no portion of the deferred and uncollected premiums is includible in taxable income under the accrual method until received.

  2. Less: Premium Return – IRC section 803(a)(1)(B).

    1. Return premiums generally are limited to amounts rebated or refunded due to policy cancellations or to erroneously computed premiums.

    2. Premiums and other consideration arising out of indemnity reinsurance.

4.42.3.2.2  (05-29-2002)
Net Decrease in Reserves – IRC section 807(a)

  1. The net decrease in reserves after adjustment under IRC section 807(a) is taken into account as gross income.

  2. Items to be considered in computing the net decrease in reserves are those specified in IRC section 807(c), life insurance reserves [as defined in IRC section 816(b)] and unearned premiums and unpaid losses included in the total reserves under IRC section 816(c)(2).

  3. Rev. Rul. 65–33, C.B. 1965–2, 263, requires unpaid losses to be taken into account only in computing the deduction for "Death Benefits etc." This has been amplified by Rev. Rul. 67–129, 1967–1, C.B. 170.

  4. The unearned premiums for accident and health policies will be shown on Exhibit 9 and Schedule H of the Annual Statement. In accordance with IRC section 846, the Unearned Premium is reduced by 20 percent after application of the Deferred Acquisition Cost provisions under IRC section 848.

  5. The amounts (discounted at the appropriate rate of interest) necessary to satisfy the obligations under insurance and annuity contracts, but only if such obligations do not involve (at the time with respect to which the computation is made) life, accident, or health contingencies.

  6. Dividend accumulations, and other amounts, held at interest in connection with insurance and annuity contracts (including contracts supplementary thereto). These are shown separately in Exhibit 10 of the Annual Statement.

  7. Premiums received in advance, and liabilities for premium deposit funds. Reserves for premiums received in advance and liabilities for premium deposit funds are generally reconcilable with the amounts on lines 9 and 10, respectively, page 3 of the Annual Statement. These amounts are required to be discounted in accordance with IRC section 846, (20 Percent Reduction on Change in Advance Premiums, after the application of the Deferred Acquisition Cost provisions).

  8. Reasonable special contingency reserves under contracts of group term life insurance or group health and accident insurance. These funds which are maintained for the provision of insurance on retired lives, for premium stabilization, or for a combination, thereof, usually are reflected on page 3 of the Annual Statement as a separate miscellaneous liability.

  9. The "decrease in reserves" , included as an income item would represent an excess of the January 1 items appearing in the paragraph (2) above over the December 31 items reduced by the policyholders’ share of tax-exempt interest, plus any excess described in IRC section 809(a)(2) for the taxable year.

4.42.3.2.3  (05-29-2002))
Ten Percent Decrease in Reserves – IRC section 807(f)(1)(B)(ii)

  1. Page 1, line 3 of Form 1120–L accounts for the decrease in the tax reserves as a result of change in the computation of the tax reserves. The decrease is amortized into income over ten years using the straight line method beginning the year after the change.

  2. The examiner can reconcile the amount to be amortized into income over the ten-year period by examining the prior year’s Annual Statement, Exhibit 8A—Change in Bases of Valuation During The Year—Any "reserve weakening" will be reflected in this exhibit as a negative amount. Any "reserve weakening" will require the approval of the home state Insurance Department.

4.42.3.2.4  (05-29-2002)
3-1/3 Percent of Year End Balance of Reserves Under IRC section 807(e)(7)(B)

  1. The 1990 Act is Congress’ attempt to match tax deductions with taxable income. The 20 percent reduction of the tax reserves is required to be put into income over 6 years. This amount is to be found on page 1, line 4 of Form 1120–L has a 6 year lifespan, (1991–1996). Effective with the first taxable year beginning on or after September 30, 1990, the 20 percent reduction in the life insurance company reserve is to be included in gross income at the rate of 3 –1/3% percent each year for 6 years (20% / 6 years = 3 –1/3%).

  2. The life insurance company will include gross income of the 1990 closing balance of the unearned premium reserve and the premiums received in advance on insurance contracts not described in IRC section 816(b)(1)(B) of the Internal Revenue Code. To compute the amount of the reserve for which 20 percent is to apply, the examiner using the 1990 Annual Statement adds the amounts found in Exhibit 9, line 1, columns 2, 3, 4, 7, 8, and 9 plus the amounts found in Exhibit 1, lines 4 and 14, Columns 8, 9, and 10.

4.42.3.2.5  (05-29-2002)
Investment Income

  1. Investment Income, line 5 of Form 1120–L. The amount entered on this line is taken from Schedule B, line 8 plus interest received on securities acquisition loans as defined in IRC section 133(b). Text 3.7 and the its subparagraphs completely explain the reconciliation of Schedule B to the Annual Statement. In 1997, Form 1120–L, line 4, represents Investment Income.

4.42.3.2.6  (05-29-2002)
Net Capital Gain

  1. Net capital gain is reported on line 6 of Form 1120–L. The amount being reported does not directly come from the Annual Statement but from Schedule D (Form 1120) of the tax return. Text 3.8 of this handbook explains the capital gains and losses which is directly reconcilable to the Annual Statement. For 1997, Form 1120–L reports net Capital Gain on line 5.

4.42.3.2.7  (05-29-2002)
Other Amounts

  1. Other Income is reported on line 7 of Form 1120–L. This item is not reconcilable to the Annual Statement. Thus, the examiner should secure the taxpayer’s workpapers to determine what items are included in this line.

  2. Some of the income included in this line is the ordinary income from the recapture of depreciation (IRC section 1245) of business equipment (reported on Form 4797), the mutual company "true up" of income from the recomputation of the differential earnings and miscellaneous income not reported elsewhere.

4.42.3.3  (05-29-2002)
Life Insurance Company Deductions

  1. The deductions section of Form 1120–L includes a number of amounts which should be reconciled to the deductions reflected in the Summary of Operations which appears on page 4 of the Annual Statement. These deductions include those items which are deductible by general corporations plus several deductions which are peculiar to life insurance companies. IRC section 805 provides for the allowance of these deductions.

4.42.3.3.1  (05-29-2002)
Death Benefits

  1. Death benefits, etc. includes all claims and benefits accrued and losses incurred during the year on insurance, annuity, and supplementary contracts.

  2. Items to be considered are amounts incurred for death benefits, matured endowments, annuity benefits, disability benefits, surrender benefits, group conversion, benefits under accident and health policies, and payments on supplementary contracts with or without life contingencies on the Annual Statement.

  3. For Annual Statement purposes amounts incurred for death benefits, etc. are shown on lines 8 through 16A of the Summary of Operations.

  4. Detail in support of incurred benefits for life insurance contracts is reflected in Exhibit 11 of the Annual Statement. Exhibit 11 is therefore the source of detail for the amounts on line 8, death benefits; line 10, annuity benefits; and line 11, disability benefits and benefits under accident and health policies, of the Summary of Operations on page 4 of the Annual Statement. Additional detail for Exhibit 11 incurred benefits for accident and health contracts is reflected in Schedule H of the Annual Statement.

  5. Detail in support of line 11A; coupons, guaranteed annual pure endowments and similar benefits; of the Summary of Operations is reflected in Annual Statement, Exhibit 7.

  6. Detail in support of line 12 through line 16A of the Summary of Operations is reflected in Annual Statement, Exhibit 12.

  7. Incurred benefits take into account reinsurance recoverable and unpaid claim liabilities including incurred but unreported (IBNR) claims.

  8. In your preliminary review you should bear in mind that loss accruals for Annual Statement purposes may be different than amounts required to be taken into account for tax purposes. To illustrate:

    1. Unpaid losses on life insurance contracts, including IBNR, are deductible as death benefits on Form 1120–L. These unpaid losses are included in the increase in reserves lines on the Summary of Operations, therefore, reclassification is required to include this amount in death benefits on the Form 1120–L.

    2. Unpaid losses (other than losses on life insurance contracts) included on Form 1120–L must be discounted under the provisions of IRC section 846. These discounted unpaid losses are included, in part, in the deduction for death benefits on the Form 1120–L. The increase or decrease in the amount of discount from the previous year is therefore an adjustment to the Annual Statement amounts in determining the death benefits included on the Form 1120–L.

    3. IBNR claim liabilities may represent unreasonable estimates. These may be acceptable by State Insurance Commissioners who are primarily concerned with the adequacy of the reserve for protection of policyholders. A reasonable estimate for tax purposes may require a recomputation based on the past experience of the company. If this recomputation is made by the taxpayer, the Annual Statement amounts must be adjusted in arriving at the death benefits deduction included on the Form 1120–L.

    4. The Annual Statement incurred losses include amounts for resisted claims. The inclusion of resisted claims can be seen by tracing the resisted claim amounts from the detail of the Annual Statement to the Summary of Operations. On Exhibit 11, Part 1 resisted claims are included in the computation of net policy and contract claims liability at the end of the year. This year-end liability is then included in the computation of incurred losses on Exhibit 11, Part 2 with the net incurred losses being carried to several lines on the Summary of Operations. Further detail of the resisted claims can be found in Schedule F of the Annual Statement. While there are resisted losses that may be resisted due to suicide or misrepresentation in the application, historically a certain portion of the resisted losses are eventually paid. Therefore, an allocation based on a historical development would generally be allowable and would be shown by the taxpayer as an adjustment to the death benefits on the Form 1120–L to the extent of the change from the resisted losses at the prior year end. "Resisted Losses" relating to casualty type contracts are by definition part of "losses incurred" and as such are among the deductions allowed life insurance companies. There is no provision in the Annual Statement for resisted claims on accident and health contracts. Therefore, no adjustment to the Annual Statement incurred losses on accident and health contracts is required in the computation of death benefits on the Form 1120–L.

    5. Interest paid, as opposed to credited to the reserves, on supplementary contracts without life contingencies, policy and contract funds, dividend accumulations, and advance premium deposits are includible as death benefits on Form 1120–L. An adjustment will be required on the Form 11201 to reclassify these amounts to death benefits.

4.42.3.3.2  (05-29-2002)
Net Increase in Reserves

  1. On Form 1120–L, a deduction is allowed for the net increase in reserves. If the computation results in a net decrease in reserves, the decrease is included in the income section of Form 1120–L (text 3.2.2 above). Beginning in 1984 life insurance companies are required to compute their deduction of increase in reserves, or income item for the decrease in reserves, on Form 1120–L using a basis which results in the deduction often being substantially different from the increase in reserve amounts reflected on line 17, (Increase in aggregate reserves for life and accident and health policies and contracts); line 17A, (Increase in liability for premium and other deposit funds; and line 18), (Increase in reserve for supplementary contracts without life contingencies and for dividend and coupon accumulations), of the Summary of Operations which appears on page 4 of the Annual Statement. For purposes of reconciling the amount of increase in reserves on Form 1120–L to the amounts on the Annual Statement, it is advisable to substitute the tax basis increase in reserves for the amounts on the Summary of Operations until further examination steps are taken.

  2. A thorough understanding of the IRC provisions concerning the computation of the deduction for increase in reserves is necessary to complete a detailed reconciliation of the increase in reserves amounts on Form 1120–L to the Annual Statement. Further information concerning increase in reserves is contained in Examination Techniques for Specific Areas and Potential Adjustments (252.6 below).

  3. Form 1120–L contains a detailed schedule, Schedule F, which provides the totals for each of the six types of reserves specified in IRC section 807(c) for both the beginning of the tax year and the end of the tax year. This schedule can be reconciled to the reserve amounts found in the Annual Statements for the prior year and the current year. It is important to reconcile beginning and ending reserve amounts instead of attempting to reconcile to the net increase in reserves deducted on Form 1120–L since the net increase in reserves has been adjusted, in Form 1120–L, Schedule F, for the policyholder share of tax exempt interest and any excess differential earnings amount.

    1. Life insurance reserves [IRC section 807(c)(1)] can be reconciled to Exhibit 8 of the Annual Statement. Life insurance reserves, under IRC definitions, found elsewhere in the Annual Statement (non-cancelable accident and health reserves from Exhibit 9 for example) must be added to the Exhibit 8 total to arrive at IRC section 807(c)(1) reserves. IRC section 807(d)(3)(C) requires that an adjustment be made to eliminate the deficiency reserves, which are referred to in Exhibit 8 as "excess of valuation net premiums over corresponding gross premiums on respective policies …" Any reserve established which is attributable to deferred and uncollected premiums in arriving at the reserves on Form 1120–L must be eliminated from the computation of the increase in reserves deduction. A substantial adjustment will normally exist to change from the Annual Statement life insurance reserves to those determined under the federally prescribed reserve calculation methods.

    2. Unearned premiums and unpaid losses [IRC section 807(c)(2)] can be reconciled to Exhibit 9 of the Annual Statement. Schedule H of the Annual Statement provides additional information in support of the amounts entered in Exhibit 9. The Exhibit 9 total is first reduced by any reserves included in life insurance reserves [text 3.3.2, paragraph (3)(a) above]. As with life insurance reserves, an adjustment will be required to change from the Annual Statement reserves to those determined under the federally prescribed reserve calculation methods. IRC section 807(e)(7) requires that both the beginning and ending balance in the reserves for unearned premiums be reduced by 20 percent for tax purposes. Both the beginning and ending balances of unpaid losses, except for unpaid losses on life insurance contracts, be discounted under the rules provided in IRC section 846. Additional adjustments may be made in arriving at the amount entered on Form 1120–L.

    3. Reserves for supplementary contracts, discounted at the appropriate rate of interest, [IRC section 807(c)(3)] are found in Part A of Exhibit 10 of the Annual Statement. This total is often entered on Form 1120–L with no adjustment being required unless a change is required in the interest rate required for discounting.

    4. Reserves for dividend accumulations and other amounts [IRC section 807(c)(4)] are generally found in Part A of Exhibit 10 of the Annual Statement. Adjustments may be made in arriving at the amount entered on Form 1120–L.

    5. Reserves for advance premiums [IRC section 807(c)(5)] will normally include the amounts reflected on line 9, premiums and annuity considerations received in advance, and line 10, liability for premium and other deposit funds, of page 3, Liabilities, Surplus and Other Funds, of the Annual Statement. The amount on line 9 of page 3 can be traced to Exhibit 1, Part 1 of the Annual Statement. The amount on line 10 of page 3 can be traced to Exhibit 10 of the Annual Statement. IRC section 807(e)(7) requires that both the beginning and ending balance in the reserves for non-life advance premiums be reduced by 20 percent for tax purposes. Additional adjustments may be made in arriving at the amount entered on Form 1120–L.

    6. Special contingency reserves [IRC section 807(c)(6)] may be found in various locations in the Annual Statement to include entry as a write-in for deductions on the Summary of Operations. In addition, the taxpayer will often include items which are included on page 3, Liabilities, Surplus and Other Funds, which are not deducted on the Summary of Operations.

4.42.3.3.3  (05-29-2002)
Ten Percent of Any Increase in Reserves Under IRC section 807(f)(1)(B)

  1. If the provisions of IRC section 807(f) are applicable to a change in basis for computing any reserve item either in the current year or in any of the previous 11 years, 10 percent of this increase is allowable as a deduction or conversely 10 percent of the decrease is includible as income in each of the 10 years subsequent to the year of change. This item is solely an adjustment for income tax purposes and therefore will not appear on the Annual Statement. A reconciling adjustment must be made for this item to reconcile Form 1120–L to the Annual Statement.

4.42.3.3.4  (05-29-2002)
Deductible Policyholder Dividends

  1. For Form 1120–L deductible policyholder dividend amounts include, by IRC definition, any amount paid or credited to a policyholder where the amount is not fixed in the contract but depends on the experience or discretion of the company, excess interest, premium adjustments, and experience-related refunds.

  2. Exhibit 7, column 1 and column 2, of the Annual Statement reflect the total of the dividends to policyholders. This total includes the increase in the provision for annual dividend and coupon policies and the provision for deferred dividend policies. These two provision items normally represent an estimate of policyholder dividends and coupons which may be payable in the following year. Therefore, the accrual requirement of the IRC have probably not been met and the increase in the provisions may not be included in the deduction for policyholder dividends.

  3. The total of dividends to policyholders on Exhibit 7 of the Annual Statement must be reduced by any increase in the provisions referred to in paragraph (2) above and increased by excess interest, premium adjustments, and experience-rated refunds to determine the amount included in the deduction on Form 1120–L.

  4. If the company has made excess interest payments to policyholders, the excess interest will probably be included with interest on policy or contract funds on the Annual Statement Summary of Operations. The excess interest should be reclassified to be included in policyholder dividends on Form 1120–L.

  5. Premium adjustments and experience-rated refunds may be included as a reduction to premium income on the Annual Statement. These amounts should be reclassified to be included in policyholder dividends on Form 1120–L.

  6. Dividends which increase policy benefits, increase surrender value, or serve to reduce the premium the policyholder must pay are to be treated as policyholder dividends and are to be added to premium income as if the policyholder had returned the dividend to the insurance company as a premium. These adjustments effectively increase income and deductions by the same amount but due to the effect on other computations on the return [paragraph (9) below] the proper classification of policyholder dividends is important.

  7. Mutual life insurance companies must reduce the deduction for policyholder dividends on Form 1120–L by the differential earnings amount which is computed on Schedule C of Form 1120–L. To reconcile the amount of deductible policyholder dividends on Form 1120–L, for a mutual company, the differential earnings amount must be subtracted from policyholder dividends reflected on the Annual Statement.

  8. If the differential earnings amount exceeds the total of policyholder dividends, the excess reduces the deduction for increase in reserves (text 3.3.2, paragraph (3) above].

  9. Policyholder dividends affect the computation of the company/policyholder share percentage and ultimately the extent to which the increase in reserves deduction is reduced by a portion of the tax-exempt interest earned by the company (text 3.3.2, paragraph (3) above]. Policyholder dividends also affect the computation of the computation of the differential earnings amount for mutual life insurance companies.

4.42.3.3.5  (05-29-2002)
Consideration Paid for Assumption by Another Person of Liabilities

  1. The deduction allowable under IRC section 805(a)(6) is shown on line 13 of Form 1120–L. This deduction represents the consideration attributable to the assumption of block reinsurance by another insurer. The consideration arises where a taxpayer makes payment to another company for assuming all of the taxpayer’s risks in a block of policies.

  2. This reinsurance is not the usual type. It occurs when all or part of the business of a life insurance company is taken over by another company under an arrangement whereby the reinsurer becomes solely liable to the policyholders.

  3. The transaction is usually evidenced by a blanket contract which designates the individual risks by identifying them as members of the group, and which lists the assets to be transferred, values mutually agreed to, and liabilities to be assumed.

  4. In any case where all of the life business of a company, or of any block thereof, is transferred to another company or transferred from another company, the number of policies and amount of insurance involved are included in the Exhibit of Life Insurance of the Annual Statement. A footnote will indicate the amounts for each block of insurance ceded or assumed.

  5. If an entry is found on this line of Form 1120–L, a request should be made to the taxpayer for assistance in reconciling the amount to the Annual Statement in most cases.

  6. Additional information concerning reinsurance topics can be found in Chapter 5, text 5.1.

4.42.3.3.6  (05-29-2002)
Dividends Reimbursable by Taxpayer

  1. This Form 1120–L deduction is for policyholder dividends the taxpayer must reimburse to another insurance company which have been paid or accrued on policies which the taxpayer has assumed under a reinsurance contract.

  2. The assuming company is allowed a deduction on this line of Form 1120–L instead of including the reimbursed amount in the line for policyholder dividends.

  3. If an entry is found on line 14 of Form 1120–L, a request should be made to the taxpayer for assistance in reconciling the amount to the Annual Statement in most cases.

  4. Additional information concerning reinsurance topics can be found in Chapter 5, text 5.2.

4.42.3.3.7  (05-29-2002)
Interest, Less Tax-Exempt Interest Expense

  1. This Form 1120–L deduction is for interest allowable under IRC section 163, with no deduction allowable for any reserve item of the taxpayer. The normal IRC section 163 requirements apply to this deduction.

  2. The amounts entered on line 15a of Form 1120–L will normally be found as a deduction in arriving at net investment income in Exhibit 2 of the Annual Statement. The deduction will normally appear as a write-in item at the bottom of Exhibit 2. The deductions reflected in Exhibit 2 of the Annual Statement are allowable as deductions in several different items on Form 1120–L and are discussed in more detail in text 3.3.9.

  3. In addition, if the taxpayer has interest expense on encumbrances related to its home office building, the rental income for the company’s occupancy of it own buildings reflected in net investment income, Exhibit 2 of the Annual Statement, will be reduced by the amount of the interest and will be disclosed in the footnotes to Exhibit 2. Further explanation of the reconciliation of investment income is found in text 3.7.

  4. Additional interest expense may be included in General Expenses, Exhibit 5 of the Annual Statement and may be reclassified to be included in this Form 1120–L line.

  5. Exhibit 12, Reconciliation of Ledger Assets, of the Annual Statement will contain an entry for interest actually paid on borrowed money. This entry can be used as additional information to complete the reconciliation of interest expense on Form 1120–L.

  6. Interest paid or accrued on indebtedness incurred or continued to purchase or carry obligations which are tax-exempt reduces the deduction for interest expense.

4.42.3.3.8  (05-29-2002)
Deductible Policy Acquisition Expense

  1. Beginning with any taxable year which includes September 30, 1990, life insurance companies are required to capitalize an amount representing policy acquisition expenses under IRC section 848. The company is then allowed a deduction for amortization of these policy acquisition expenses over either a 60-month or 120-month period. This item is solely an adjustment for income tax purposes and therefore will not appear on the Annual Statement.

  2. Prior to 1993, the Form 1120–L did not include a separate line for the deduction of policy acquisition expenses. The adjustments to capitalize and amortize policy acquisition expenses were made as a part of the calculation of Other Deductions.

  3. For the 1993 return, a separate schedule, Schedule G, has been included in the return for the calculation of the capitalization and amortization of policy acquisition expenses. The use of this schedule results in Other Deductions being integrated with the adjustments for policy acquisition expenses. Using this schedule, the taxpayer will probably have no entry in the Other Deductions line of the Form 1120–L but instead will include the amounts detailed above in the Form 1120–L line for deductible policy acquisition expenses.

  4. For years subsequent to 1993, the calculation of deductible policy acquisition expenses may be separated from Other Deductions for purposes of tax return presentation.

  5. Although the Form 1120–L presentation varies, a reconciling item for the capitalization and amortization of policy acquisition expenses will be required. Sufficient information should be provided on the tax return, either in the required attachment for the computation of Other Deductions or on the return schedule for policy acquisition expenses, to determine the proper reconciling items.

4.42.3.3.9  (05-29-2002)
Other Deductions

  1. The total of the allowable deductions for all other expenses which have not already been provided for is entered on this Form 1120–L line 18.

  2. The Form 1120–L instructions require that a schedule be attached to the return to provide detail of the items included in this amount. This schedule will be useful in completing the reconciliation of Other Deductions.

  3. Annual Statement items included in Other Deductions are: commissions; general expenses; taxes, licenses and fees; depreciation on real estate and other invested assets; and, write-ins for other investment deductions.

  4. Commissions incurred are shown on two separate lines of the summary of operations, page 4, of the Annual Statement. Exhibit 1, Part 2, of the Annual Statement provides additional detail of the commissions.

  5. Exhibit 5, General Expenses, of the Annual Statement provides detail of a number of expense items. Note that Exhibit 5 reflects expenses on an incurred basis with adjustments at the bottom of the exhibit to convert to a paid basis.

    1. The total of column 1, column 2, and column 3 of Exhibit 5 is carried to the Annual Statement Summary of Operations as a separate line for general insurance expenses. The total of column 4 of Exhibit 5 is carried to Exhibit 2 as a deduction in arriving at Annual Statement net investment income. Net investment income is then carried to the summary of operations as an income item. The total of all four columns of Annual Statement Exhibit 5 should be included in Other Deductions on the return.

    2. Schedule A of the Annual Statement provides additional detail of real estate expenses included in Exhibit 5 and real estate taxes included in Exhibit 6. This detail is presented on an individual property basis.

  6. Exhibit 5, General Expenses, of the Annual Statement contains several items which require adjustment in determining the correct deduction on Form 1120–L.

    1. Capital expenditures, such as improvements and betterments to rental property, costs of securing mortgages, finders fees, etc. are normally shown as expenses in Exhibit 5. The Exhibit 5 expenses must be reduced by the capital expenditures and increased by the allowable depreciation in determining Other Deductions on the return.

    2. On the Annual Statement the rental value of the home office building is included as rent expense in Exhibit 5 with a corresponding amount included as rental income on Exhibit 2 of the Annual Statement. Both the income and expense items related to home office rent are to be reversed in preparation of the tax return. The amount included in the Annual Statement for home office rent is reflected in a footnote to Annual Statement Exhibit 2 (Exhibit 3 in earlier years).

    3. Often the cost and/or depreciation of furniture and equipment and computer software is included in General Expenses on Exhibit 5. Normally the depreciation method used on the Annual Statement differs from the methods required on the tax return. The Exhibit 5 expenses must be reduced by expenditures which are properly capitalized and increased by the allowable tax depreciation in determining Other Deductions on the return.

    4. Depreciation on Exhibit 5 of the Annual Statement may contain write-downs and other charges not allowable for tax purposes. If these amounts are included in Exhibit 5, appropriate adjustments must be made to exclude them on the tax return.

    5. Miscellaneous Losses on Exhibit 5 of the Annual Statement may contain losses which are not allowable for income tax purposes. Appropriate adjustments should be made to reduce the amount included in Other Deductions on the tax return.

    6. Some companies charge qualified pension plan past service costs to "Contributions for Benefit Plans" in Exhibit 5 of the Annual Statement. In computing the allowable Other Deductions on the tax return, appropriate adjustments should be made to reduce this amount.

    7. The deduction for contributions to fund its own life and retirement plans should be adjusted to exclude any amounts for expenses and profits in determining the amount to be included in Other Deductions on the tax return.

    8. IRC section 274 provides several limitations on the amount of the allowable deduction for entertainment, gifts, travel and meals. A reconciling adjustment must be made to the expenses reported on the Annual Statement in determining the amounts to be included on the tax return for this type of expense.

  7. Exhibit 6, Taxes, Licenses and Fees, of the Annual Statement reflects expenses in a manner similar the method in Exhibit 5 as stated above.

    Note:

    Federal income taxes are not included in Exhibit 6 but are entered as a separate line item on page 4, Summary of Operations, of the Annual Statement.

  8. The Annual Statement Summary of Operations, page 4, includes a separate item for "Increase in Loading on and Cost of Collection in Excess of Loading on Deferred and Uncollected Premiums." This item is not to be included in Other Deductions on the tax return.

  9. IRC section 805(b)(2) provides special rules for the limitation on the amount of contributions which are allowed to be included in Other Deductions on the tax return for a life insurance company. This limitation may result in an adjustment being required to reconcile Other Deductions to the Annual Statement.

  10. The presentation of Other Deductions in relation to policy acquisition expenses (text 3.3.8) on the Form 1120–L varies depending on the return year.

    1. Prior to 1993, the Form 1120–L did not include a separate line for the deduction of policy acquisition expenses. The adjustments to capitalize and amortize policy acquisition expenses were made as a part of the calculation of Other Deductions.

    2. For the 1993 return, a separate schedule, Schedule G, has been included in the return for the calculation of the capitalization and amortization of policy acquisition expenses. The use of this schedule results in Other Deductions being integrated with the adjustments for policy acquisition expenses. Using this schedule, the taxpayer will probably have no entry in the Other Deductions line of the Form 1120–L but instead will include the amounts detailed above in the Form 1120–L line for deductible policy acquisition expenses.

    3. For years subsequent to 1993, the calculation of deductible policy acquisition expenses may be separated from Other Deductions for purposes of tax return presentation.

    4. Although the Form 1120–L presentation varies, the reconciling items for Other Deductions detailed above will be required whether the Other Deductions are on a separate line of the tax return or are integrated into the calculation of deductible policy acquisition expenses.

4.42.3.3.10  (05-29-2002)
Dividend Received Deduction

  1. The provisions of IRC sections 243, 244, and 245 [as modified by IRC section 805(a)(4)] apply to life insurance companies. A schedule is included in Form 1120–L to mathematically determine the allowable dividend received deduction. This item is solely an adjustment for income tax purposes and therefore will not appear on the Annual Statement. A reconciling adjustment must be made for this item to reconcile Form 1120–L to the Annual Statement.

4.42.3.3.11  (05-29-2002)
Operations Loss Deduction

  1. If a life insurance company has an operations loss carryover from a prior year or an operations loss carryback from a subsequent year, the provisions of IRC section 810 are applicable to the computation of the allowable operations loss deduction. This item is solely an adjustment for income tax purposes and therefore will not appear on the Annual Statement. A reconciling adjustment must be made for this item to reconcile Form 1120–L to the Annual Statement.

4.42.3.4  (05-29-2002)
Life Insurance Company Taxable Income (LICTI)

  1. IRC section 801(b) defines Life Insurance Company Taxable Income (LICTI) as the difference between life insurance gross income and life insurance deductions. (IRC sections 803, 805, 806 and 810) Life insurance gross income is discussed in text 3.2 of this handbook and its subparagraphs, while the life insurance deductions are discussed in text 3.3 and its subparagraphs and the small life insurance company deduction is discussed in text 3.4.3.

4.42.3.4.1  (05-29-2002)
General Discussion

  1. A life insurance company must use an accrual method of accounting, or a method of permitted under regulations that combines an accrual method with another recognized method. The method of accounting required for State regulatory purposes will apply only if it is not inconsistent with the Federal tax accounting rules. See IRC section 811 for the rules on method of accounting.

  2. A life insurance company’s taxable income is assembled in a single phase calculation and reported on Page 1 of Form 1120–L. The first seven lines on the return contain the gross income information of a life insurance company. Lines 9 through 20 contain the tax deductions of a life insurance company.

  3. The total tax for the life insurance company is computed in Schedule K, Form 1120–L and entered on line 28 of the return.

4.42.3.4.2  (05-29-2002)
Gain or Loss from Operations

  1. The starting point of any life insurance company examination is the company’s Annual Statement. The examiner can obtain from the summary of operations (page 4) of the Annual Statement the life insurance company’s net gain or loss.

  2. The taxpayer in its reconciliation of the Annual Statement to the tax return begins with the net gain or loss from operations, page 4, line 29 of the Annual Statement.

  3. LICTI is computed by additions and subtractions to the amount from Page 4 of the Annual Statement.

4.42.3.4.3  (05-29-2002)
Small Life Insurance Company Deduction Schedule H, Form 1120–L

  1. A small life insurance company deduction is allowed to a life insurance company if it meets two tests dealing with the size of the company. These two tests are the asset test and the income test.

    1. A company must have assets of less than $500 million at the end of the taxable year.

    2. The tentative LICTI of the company must be less than $15 million.

  2. The deduction is equal to 60 percent of the first $3 million of tentative LICTI, reduced by 15 percent of the tentative LICTI in excess of $3 million until a company reaches the maximum tentative LICTI of $15 million. The maximum small life insurance company deduction is $1,800,000.

  3. Both the income and assets of a company must be determined at the controlled group level.

    1. For the income test, tentative LICTI would only include life insurance companies that are members of the controlled group

    2. For the asset test, the controlled group includes all companies, whether or not they are a life insurance companies.

  4. The term controlled group means any controlled group of corporations as defined in IRC section 1563(a). It doesn’t matter whether or not they filed a consolidated return. A foreign corporation may be a member of a controlled group.

4.42.3.5  (05-29-2002)
Total Taxable Income

  1. After having determined life insurance company taxable income on Form 1120–L, two additional items, limitation on noninsurance losses and amount subtracted from policyholder surplus account, are added to arrive at total taxable income. These two additional items are peculiar to life insurance companies and are not found on the life insurance company Annual Statement, they are solely additional adjustments required on the tax return and are supported by specific schedules included in Form 1120–L.

4.42.3.5.1  (05-29-2002)
Limitation on Noninsurance Losses

  1. IRC section 806(b)(3) places a limit on the amount of losses from noninsurance business activities which may be included in the determination of total taxable income by a life insurance company. A separate schedule, Schedule I, on Form 1120–L provides for the calculation of the amount of noninsurance losses which exceed the limitation.

  2. The IRC section 806(b)(3) limitation imposes a restriction on the deduction of noninsurance losses similar to that which is provided for consolidated life insurance and non-life insurance entities.

  3. The total noninsurance losses are included in the computation of LICTI with the excess noninsurance losses, as determined on Schedule I, entered on Form 1120–L as an increase in the determination of total taxable income.

  4. This item is solely an adjustment for income tax purposes and therefore will not appear on the Annual Statement. A reconciling adjustment must be made for this item to reconcile Form 1120–L to the Annual Statement.

4.42.3.5.2  (05-29-2002)
Amount Subtracted from Policyholder Surplus Account

  1. Prior to January 1, 1984, the Internal Revenue Code allowed a stock life insurance company to accumulate a specified portion of its income in the policyholders surplus account without being subject to current taxation. The Tax Reform Act of 1984 eliminated this provision thereby eliminating any further additions to the policyholders surplus account. Furthermore, the Tax Reform Act of 1984 requires stock life insurance companies to continue to account for and report the December 31, 1983 policyholders surplus account balance, as adjusted by subsequent distributions, as this balance ultimately will be subject to taxation upon distribution.

  2. Any distribution, direct or indirect, to the shareholders of a stock life insurance company is considered to be made first from the shareholders surplus account, representing earnings and profits which have been subject to taxation including earnings subsequent to December 31, 1983. Distributions which exceed the available amounts in the shareholders surplus account are then considered to be made from the balance in the policyholders surplus account, which has not been previously taxed.

  3. The amount includible in total taxable income for subtractions from the policyholders surplus account is solely an adjustment for income tax purposes and therefore will not appear on the Annual Statement. A reconciling adjustment must be made for this item to reconcile Form 1120–L to the Annual Statement.

4.42.3.6  (05-29-2002)
Total Assets and Total Insurance Liabilities

  1. Total assets [IRC section 806(a)(3)(C)] and total insurance liabilities (IRC section 842(b)(2)(B)(i)) are part of the Form 1120–L, Schedule L, Parts I and II. Schedule L, Part II is totally reconciled to the assets and liabilities of the Annual Statement, Pages 2 and 3.

4.42.3.6.1  (05-29-2002)
Total Assets [IRC section 806(a)(3)(C)]

  1. Total assets [IRC section 806(a)(3)(C)] is part of the Form 1120–L, Schedule L, Parts I.

  2. Total assets [IRC section 806(a)(3)(C)] current value is required for the determination of the small life insurance company deduction. Under the Tax Reform Act of 1984, a life insurance company qualifies for the small life insurance company deduction if its assets are less than $500,000,000. The term "assets" means all assets of the company including the nonadmitted assets for Annual Statement purposes and the identifiable intangible assets. For purposes of section 806, a single company takes related company assets into account in calculating total assets.

  3. The total assets cannot be totally reconciled to the Annual Statement, but the examiners starting point is the net admitted assets per the Annual Statement, Exhibit 13, column 4. Various tax adjustments are required to be made to the net admitted assets in order to determine the proper total assets for the small life insurance company deduction.

4.42.3.6.2  (05-29-2002)
Real Property and Stocks

  1. Real property and stock shall be valued at fair market value according to the Code. In accordance with the regulations, the fair market value or adjusted basis is not reduced by any encumbrances. Fair market value need only to be a reasonable approximation and an annual appraisal is not required.

  2. In accordance with Rev. Rul. 67–243 (CB 1967–2, 236) unimproved land held for the company’s future building site must be included in the total assets.

  3. The fair market value of stocks need only be a reasonable valuation method. The market values shown in Schedule D, Part 2 of the Annual Statement are in accordance with the recommendations of the Committee on Valuation of Securities of the NAIC. They are listed in an annual publication "Valuation of Securities." These values usually reflect the market values with the exception of preferred stock in subsidiaries and other insurance companies. According to Rev. Rul. 74–503, (CB 1974–2, 117) the fair market value of treasury stock is to be excluded from total assets.

4.42.3.6.3  (05-29-2002)
Partnership Interests

  1. IRC section 806(a)(3)(D) contains the special rule for determining the life insurance company’s valuation for its interest in a partnership or trust. The valuation is determined by the company’s proportional share of the assets held by the partnership or trust without regard to the liabilities of such partnership or trust.

4.42.3.6.4  (05-29-2002)
Other Assets

  1. All other assets such as money, bonds, mortgage loans, policy loans, collateral loans, premium notes, interest and other income due and accrued, amounts recoverable from reinsurers, accident and health premiums due and unpaid, premiums deferred and uncollected, agent’s debit balances, advances to agents, and etc. are includible. Also includible are such items as unamortized finder’s fees, accrued interest on policy loans, unamortized bonuses paid for assumption reinsurance, the company’s share in a reinsurance pool and unlisted assets.

  2. The examiner should review the unlisted assets shown in Schedule X of the Annual Statement to determine whether or not any of these assets should be included in Other Assets.

  3. The valuation of these assets should be the adjusted basis, the same adjusted basis used to determine gain or loss on a sale or other disposition, [IRC section 806(a)(3)(C)(ii)].

4.42.3.7  (05-29-2002)
Schedule B, Gross Investment Income, Form 1120-L, IRC section 812(d)

  1. You will note that lines 1 to 7 reflect investment income, line 8. Line 8 of this schedule is then carried over to Page 1 of Form 1120–L, line 4.

  2. Interest income under line 1 of Schedule B of the return is reflected in the Annual Statement, Exhibit 2 —Net Investment Income.

  3. The detail supporting some of the interest items reported in Exhibit 2 is shown in the following schedules of the Annual Statement:

    1. The detail of the amounts shown on line 1 of Exhibit 2 (interest on bonds) is contained in Schedule D, Parts 1, 3, 4 and 5 of the Annual Statement. By analyzing these parts of Schedule D, it may be possible to determine the correctness of the fully exempt and partially exempt bond interest as reported. Schedule D —Summary, which gives a breakdown on bonds owned at the end of the year by country, may also be used for this purpose. It is important to remember that the accrual of "market discount" on bonds is not required for taxable years beginning after December 31,1962. If the company has been accruing market discount, permission is required to change to the nonaccrual method. See Rev. Rul. 73–60, (C.B. 1973–1, 332) as clarified by Rev. Rul. 78–150, OB. 1978–1, 214.

    2. The detail support for interest on bank deposits Exhibit 2, line 7, is reflected in Schedule E of the Annual Statement.

    3. No supporting schedules are provided in the Annual Statement for: interest on mortgage loans, interest on premium notes, policy loans and liens, or interest on collateral loans shown under lines, 3, 5 and 6, respectively, of Exhibit 2. The company will provide the necessary details on request.

  4. Gross taxable dividends, (Schedule A, line 15, col. a) summarized on line 2, Schedule B of the return are reflected in Exhibit 2, line 2 of the Annual Statement. The detail of dividend income can be found in Schedule D, Parts 2, 3, 4 and 5 of the Annual Statement. Accrued dividends are not recognized as taxable income in the year of accrual.

  5. Where the company’s Annual Statement discloses holdings of common stocks in public utility companies, it is suggested that these be checked against the dividend section of Capital Adjustment Service to determine if any part of the dividends are nontaxable.

  6. When the Annual Statement discloses ownership of stocks of public utility companies, these holdings should be checked to determine if the ownership is less than or greater than 20 percent for the dividend received deduction.

  7. Rental income on line 3, Schedule B, of the return is reflected in Exhibit 2, line 4 of the Annual Statement. The detail pertaining to this income is found in Schedule A, Parts 1 and 2 of the Annual Statement.

    1. Note that the company is required to include the rental value of the space occupied by it in its own buildings. (Shown as a footnote to Exhibit 2). A deduction for the same amount of this rent is taken on line 1, Exhibit 5 of the Annual Statement. However, both the income and deduction are to be deleted in the preparation of the tax return.

    2. Since the Annual Statement requires that interest on real estate encumbrances be deducted from rental income, care should be taken that this item is added back for tax purposes.

  8. Royalty income, line 4, Schedule B of the tax return may be combined with real estate income or listed separately in Exhibit 2 of the Annual Statement as having been received from an unlisted asset.

    1. Information contained in the Annual Statement relative to this income will enable the agent to pinpoint areas for further audit consideration.

    2. The details of rental and royalty income can be verified in the real estate section of the company’s investment department.

  9. Income from lease terminations, prepayment penalties, commitment fees, etc., reported on line 5, Schedule B of the return are usually reflected in Exhibits 2 and 3 of the Annual Statement. Details pertaining to this income will be found in the real estate and mortgage departments of the insurance company.

  10. The excess of net short-term capital gain over net long-term capital loss is shown on line 6 of Schedule B of the return. The capital gains and losses shown on Schedule D (Form 1120–L) attached to the return are reflected in Exhibit 3 of the Annual Statement and explained in Schedule D, Parts 4 and 5 of the Annual Statement. Ordinarily, there will be an adjustment to the gains and losses on bonds between the Annual Statement and the return since the accrual of "market discount" for tax purposes is no longer required for years beginning after December 31, 1962. Any net gains representing "market discounts" recognized by the life insurance company on any bonds held to maturity which were issued before July 19, 1984 and acquired by the company on or before September 25, 1995, are subject to a special tax rate of 31.6 percent.

  11. There is no provision in the Annual Statement for "gross income from a trade or business other than insurance business" . Any gross income from this source required to be reported on line 7, Schedule B of the return and deductions applicable to this activity will be reported and taken along with "Other Deductions" on Page 1, line 17 of the return. The net amount will probably be entered on line 6 of the Summary of Operations which appears on page 4 of the Annual Statement or on line 8 of Exhibit 2. An insurance company must take into account separately its distributive share of any partnership item which if separately taken into account by the company would result in an income tax liability for that company different from that which would result if that company did not take the item separately. Treas. Regs. 1.702–1(a)(8)(ii).

  12. To insure that the correct gross investment income is being reported, the agent should reconcile line 8, Schedule B of the return to Exhibit 2, line 10, col. 7 of the Annual Statement. The reconciliation will be made up of reclassifications, such as gross rent on home office, interest on real estate and etc., and real differences, such as tax-exempt interest on bonds and mortgage loans, market discounts, accrued dividends, income from easements, etc.

  13. Real estate expenses deducted as "Other Deductions" , Page 1, line 19 of Form 1120–L. Expenses are reported on line 9.1, of Exhibit 5, while real estate taxes are reported on line 1, of Exhibit 6 of the Annual Statement.

    1. Ordinarily, the entire amount of real estate expenses and taxes on both rented as well as self-occupied properties are reported in the investment expense column of Exhibit 5 and 6 of the Annual Statement.

    2. Details of the real estate expense, taxes, and depreciation for specific properties are reported in Schedule A, Parts 1 and 2 of the Annual Statement.

  14. Capital expenditures, such as improvements and betterments to rental property, costs of securing mortgages, finders fees, etc. are often shown as expenses in Exhibit 5 of the Annual Statement.

    1. This method of reporting is permitted and often required by the NAIC.

    2. Consequently, during the course of your examination, you must determine if such expenditures should be capitalized or deducted as "Other Deductions" , page 1, line 18 of the return.

  15. In addition to the above, you must make sure that the expenses meet the requirements of IRC section 805(a)(8).

4.42.3.7.1  (05-29-2002)
Gross Rents

  1. Rental income on line 3, Schedule B, of the return is reflected in Exhibit 2, line 4 of the Annual Statement. The detail pertaining to this income is found in Schedule A, Parts 1 and 2 of the Annual Statement. In addition, rents received in advance are includible in gross income under the "claim of right" doctrine in the year received [Treas. Reg. 1.61–8(b)].

    1. Security deposits to be applied to the last month’s rent, according to the rental agreement, are treated as advance rent and includible in gross income.

    2. Note that the company is required to include the rental value of the space occupied by it in its own buildings. (Shown as a footnote to Exhibit 2). A deduction for the same amount of this rent is taken on line 1, Exhibit 5 of the Annual Statement. However, both the income and deduction are to be deleted in the preparation of the tax return.

    3. Since the Annual Statement requires that interest on real estate encumbrances be deducted from rental income, care should be taken that this item is added back for tax purposes.

    4. Payments for the use of real estate, PAYMENTS FOR AN EASEMENT OF RIGHT-OF-WAY is treated as rents and includible in gross income.

4.42.3.7.2  (05-29-2002)
Gross Royalties

  1. Royalties described in the Treas, Reg. 1.61–8 are includible in gross income. Royalties may be received from books, stories, plays, copyrights, trademarks, formulas, patents and from leases of mineral or oil-bearing lands.

  2. Royalty income, line 4, Schedule B of the return may be combined with real estate income or listed separately in Exhibit 2, line 8, of the Annual Statement as income attributable to "Other Invested Assets."

    1. Information contained in the Annual Statement relative to this income will enable the agent to pinpoint areas for further audit consideration.

    2. The details of rental and royalty income can be verified in the real estate section of the company’s investment department.

4.42.3.7.3  (05-29-2002)
Leases, Terminations, etc.

  1. Income from lease terminations, prepayment penalties, commitment fees, etc., reported on line 5, Schedule B of the return are usually reflected in Exhibits 2 and 3 of the Annual Statement. Details pertaining to this income will be found in the real estate and mortgage departments of the insurance company.

    1. Prepayment penalties and acceleration fees received in connection with mortgage loans made to CORPORATIONS after December 31, 1954, come under the provisions of IRC section 1232(a), and therefore are capital gains.

    2. Hedging transactions will be reported on this line as ordinary income and losses. Hedging transactions are to be treated as ordinary transactions rather than a capital transactions.

4.42.3.7.4  (05-29-2002)
Excess of Net Short-Term Capital Gains Over Net Long-Term Capital Losses – Schedule D, Line 11 (Form 1120)

  1. The excess of net short-term capital gains over net long-term capital losses is shown on line 6 of Schedule B of the return. This is summarized in Part Ill of the Schedule D. The capital gains and losses shown on Schedule D, (Form 1120) attached to the return are reflected in Exhibit 3 of the Annual Statement and explained in Schedule D, Parts 4 and 5 of the Annual Statement. Ordinarily, there will be an adjustment to the gain or loss on bonds between the Annual Statement and the return since the accrual of "market discount" for tax purposes is no longer required for years beginning after December 31, 1962.

  2. In 1992, Schedule D provisions were made for setting out and reporting "gains or (losses) from like-kind exchanges from Form 8824. Short-term gains or losses are reported on line 3 of Schedule D."

4.42.3.7.5  (05-29-2002)
Gross Income from Trade or Business Other Than Insurance

  1. The tax significance of this item is that "non-insurance business" income is not eligible for the Small Company Deduction in accordance with IRC section 812(d)(3).

  2. Gross "non-insurance business" income could result from the insurance company being a partner in a non-insurance business partnership. The net income from such a partnership would be reported in the Annual Statement Schedule BA, Part 1, column 12.

    1. The gross income would be reported as gross investment income in Schedule B, line 7.

    2. The gross deductions would be reported as "Other Deductions" , Page 1, line 18.

4.42.3.7.6  (05-29-2002)
Investment Income

  1. Investment Income is the total of lines 1 thru 7. This amount is entered on line 8, Schedule B and on Page 1, line 5, Form 1120–L.

4.42.3.7.7  (05-29-2002)
Tax-Exempt Interest

  1. Tax-exempt interest income in accordance with IRC section 103 comes from obligations of a state, a territory, a possession of the United States, the District of Columbia, or any political subdivision thereof.

    1. The tax-exempt interest income comes from the bonds in the Annual Statement Schedule D. The bonds are classified as "State, Territories, and Possessions," "Political Subdivisions," and "Special Revenue and Assessment Obligations."

    2. Interest from ESOP loans is not considered tax-exempt interest income from securities, even though the interest is 50 percent tax free if the security qualifies.

    One could verify that the bonds produce tax-exempt interest under tax law by referring to the Moody’s Municipal Bond Manual or CCH Capital Change Reports.


    In Rev. Rul. 87–116, (C.B. 1987–2,44) the IRS ruled that interest on bonds issued by a political subdivision does not qualify as tax-exempt if the bonds were not approved by the voters and are not a valid obligation of the political subdivision under state law.

4.42.3.7.8  (05-29-2002)
Investment Income Plus Tax-Exempt Interest

  1. Investment income plus tax-exempt interest income is the addition of lines 8 and 9 of Schedule B, Form 1120–L.

4.42.3.7.9  (05-29-2002)
100 Percent Qualifying Dividends – Schedule B, Line

  1. In accordance with IRC section 812(e), dividends from certain subsidiaries are not included in gross investment income. The term 100 percent dividend means any dividend if the percentage used for the purpose of determining the dividend received deduction (DRD) allowable under IRC sections 243, 244, and 245(b) is 100 percent.

  2. The term 100 percent dividend does not include any distribution by a corporation to the extent that the distribution is out of tax-exempt interest or out of dividends which are not classified as 100 percent dividends.

  3. The term 100 percent dividend does not include any dividend from a foreign corporation as described in IRC section 805(a)(4)(E).

  4. The actual recognition of an increase in undistributed equity in a subsidiary or affiliated company is not a dividend included in taxable gross investment income or the calculation of the dividend received deduction even though under statutory accounting a life insurance company is allowed to report such increases as dividends.

4.42.3.7.10  (05-29-2002)
Gross Investment Income

  1. Gross investment income is determined in Schedule B, line 13, by subtracting the 100 percent qualifying dividends, (Schedule B, line 12), from the total of investment income, (Schedule B, line 8), and the tax-exempt interest, (Schedule B, line 9). The amount determined is also entered on Schedule F, line 9.

4.42.3.8  (05-29-2002)
Schedule D (Form 1120) –Gains and Losses from Sales or Exchanges of Property

  1. Prior to 1959, capital gains of life insurance companies were not included in income or taxable. Under the Life Insurance Company Income Tax of 1959, the treatment of capital gains and losses for life insurance companies was changed materially.

  2. Starting with year 1959, net short-term capital gains in excess of net long-term capital losses were included in gross investment income.

  3. For the years 1959 through 1961, long-term capital gains in excess of short-term capital losses were taxed at a rate of 25 percent. For years after 1961, long-term capital gains were includible in taxable investment income and in gain or (loss) from operations, and were subject to alternative tax treatment, when applicable.

  4. A net capital loss cannot be deducted. However, beginning in 1970 net capital losses could be carried back to each of the preceding three years and forward to the five succeeding years as offsets in accordance with IRC section 1212. For years prior to 1970, only a carryforward was available. Capital loss carrybacks are offset first against short-term capital gains, and then against long-term capital gains.

  5. Currently, life insurance companies are subject to the same general provisions of the Code relating to capital gains and losses available to any other type of corporation, except that the capital gains and losses for a life insurance company are modified by IRC section 818(c) as follows:

    1. Capital gains and losses will result from the sale or exchange of a capital asset as defined in IRC section 1221: sales and taxable exchanges of investment assets; worthlessness of stock or securities; IRC section 1231 gains -IRC section 818(b) excludes from IRC section 1231 treatment non-insurance related assets. For example, a loss on the sale of an apartment building would be a capital loss. IRC section 1231 treatment is allocable to the sale of real and personal property used in carrying on an insurance business; and gains from disposition of IRC sections 1245 and 1250 property. Note that the recaptured depreciation on investment property should be reported on Page 1, line 7 other income on the 1120–L return.

    2. Holding period for the distinction between long-term and short-term capital gains and losses is currently one year. Short-term capital gains and losses pertains to assets held one year or less. Long-term capital gains and losses pertains to assets held more than one year.

  6. In the audit of net capital gains, Page 1, line 5 Form 1120–L, Schedule A, Part 2 of the Annual Statement, shows an itemization of all real estate sold during the year. Schedule D, Part 4 of the Annual Statement, shows all the bonds and stocks sold, redeemed, or otherwise disposed of during the current year.

    1. These schedules should be the starting point for the capital gains audit.

    2. Since all basic data such as brokerage statements, etc., are available, verification will then follow the same auditing techniques used for the Schedule D of any tax return.

  7. In order not to tax life insurance companies on the appreciation in value which took place before January 1,1959, IRC section 818(c)(1), currently in effect, limits the amount of gain that is to be recognized on the sale or other disposition of certain property held by the company on December 31, 1958.

    1. The taxable gain on the sale or other disposition of such property is the amount by which the gain exceeds the difference between the fair market value on December 31, 1958 and the adjusted basis for determining gain as of that date.

    2. The use of the December 31, 1958 fair market value cannot create a recognized loss.

    3. Recognized losses are computed by using the adjusted basis regardless of the December 31, 1958 value.

    4. This relief provision of IRC section 818(c)(1) applies only if the taxpayer has been a life insurance company at all times on and after December 31, 1958, until the asset is sold.

    Example:

    On December 31, 1958 a life insurance company owned 1,000 shares of ABC stock with an adjusted basis of $30,000 and market value of $100,000. This stock sold in 1993 for $110,000 and the adjusted basis remained unchanged.
    The realized gain is $80,000. $70,000 of the gain is not taxed since it represents appreciation in value at December 31, 1958. The balance, $10,000, is recognized as long-term capital gain.


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