Examination of Dividends Received Deduction on Separate Accounts of Life Insurance Companies


LMSB Control No: LMSB-4-0510-015
                                                                                           Impacted IRM 4.42.4

May 20, 2010





Walter L. Harris /s/ Walter L. Harris
Industry Director
Financial Services


Examination of Dividends Received Deduction on Separate Accounts of Life Insurance Companies


In an effort to effectively utilize resources, this Industry Director Directive (IDD) supersedes prior direction to the field regarding the examination of the dividends received deduction (DRD) incurred in connection with separate accounts of life insurance companies (see IDD issued April 22, 2008 (LMSB Control No.: LMSB-04-0308-010) and Issue Alert issued July 15, 2009).

Life insurance companies get a tax deduction for their increase in reserves.  Correct determination of the amount of dividends subject to the DRD ensures that a life insurance company does not realize an excess benefit by deducting part of investment earnings credited to policyholders that have already been deducted through increases in reserves.

This IDD reflects a management decision to balance current resources and workload priorities.  This IDD is not an official pronouncement of law, and cannot be used, cited, or relied upon as such.

In general, under sections 243 through 246 of the Internal Revenue Code, a corporation is allowed a deduction for all or a specified portion of dividends received from other corporations.  The same DRD rules apply to a life insurance company, as modified by section 805(a)(4)(A)(ii) to limit the DRD to the company’s share of investment income.  The policyholders’ share of investment income is not eligible for the DRD.

Section 812 includes a formula for allocating investment income between the company and the policyholders for purposes of the DRD.  This formula is commonly referred to as a proration.  The company and policyholder shares must be calculated independently for the general and separate accounts.

A separate account is sponsored by a life insurance company and, in substance, is an investment funding mechanism.  Assets held in separate accounts are legally segregated for the benefit of particular policyholders.  A general account represents all assets of the insurer that are available to satisfy its overall obligations.  It does not include any separate account assets.

Section 812(a)(1) defines the company’s share for purposes of the DRD as the percentage obtained by dividing the company’s share of net investment income for the taxable year by the net investment income for the taxable year.  Section 812(b)(1) provides that the company’s share of net investment income equals the excess, if any, of net investment income for the taxable year over the sum of policy interest and gross investment income’s proportionate share of policyholder dividends for the taxable year.  According to section 812(b)(2), policy interest includes (among other things) required interest.  With respect to calculating the company’s share of a separate account’s net investment income, Treas. Reg. § 1.801-8(e) sets forth a formula to be used in computing required interest at “another appropriate rate.”  See TAM 200038008 (Jun. 13, 2000) and TAM 200339049 (Aug. 20, 2002).

Rev. Rul. 2007-54, 2007-38 IRB 604, released on August 16, 2007, was also intended to address, at least in part, the calculation of an insurance company’s DRD.  However, Rev. Rul. 2007-54 was subsequently suspended by Rev. Rul. 2007-61, 2007-42 IRB 799.  In suspending Rev. Rul. 2007-54, Rev. Rul. 2007-61 stated that the Treasury Department and the IRS intended to address in regulations the issues considered in the suspended revenue ruling and, until such time, the issues should be analyzed as though Rev. Rul. 2007-54 had not been issued. 

Risk Analysis:

The DRD issue of life insurance companies is not a mandatory examination item, but should be considered in the auditors’ Risk Analysis.  If the Risk Analysis indicates that this issue is material, it should be developed.

Agents should consider raising the DRD issue if a life insurance company uses a method, or changed its method, for computing a company’s share of investment income that is inconsistent with section 812 and Treas. Reg. § 1.801-8(e) (as illustrated by TAM 200038008 and TAM 200339049) and that causes a material increase in the company’s share of investment income with a corresponding material increase in the dividend received deduction on the tax return. 

Examiners should obtain a multi-year comparison of the DRD calculation and determine if the company has changed its method of calculating the DRD.  For example, if over several years there is a significantly higher company share of net investment income, an Information Document Request (IDR) should be issued requesting identification of the reasons for the change.
Audit Techniques:

In order to determine whether to audit the DRD issue, examiners should consider the following questions and/or issue IDRs as appropriate.

- Has there been a change in the life insurance company’s method of computing the life insurance company’s share of the dividends received deduction? If so, agents should request additional information that would clarify the nature of a change, such as a comprehensive explanation of the life insurance company’s method of computing the DRD before and after the change together with detailed computations on a separate account basis. 

- The examiner should review the computations and determine whether the facts represented in the life insurance company’s computation methodology are consistent with the company’s reporting for other purposes (i.e. financial reporting, state law purposes).  For example, examiners may request a life insurance company’s original separate account application for separate account treatment submitted to the Office of the Commissioner of Insurance to verify that the taxpayer’s treatment of a separate account is consistent with the definition under state law.

The Field should ensure appropriate communication and collaboration with Local Counsel.  Local Counsel should coordinate, when necessary, with Diane Helfgott, LMSB Life Insurance Industry Counsel.  The assistance of LMSB Life Insurance actuaries may be beneficial.

Please contact LMSB Technical Advisor Senior Manager Earnest Griffin at          (713) 209-4309

cc: Commissioner, LMSB
     Deputy Commissioner, LMSB
     Deputy Commissioner, International
     Division Counsel, LMSB
     Commissioner, SBSE
     Chief, Appeals
     Director, Planning, Quality, Analysis and Support