CRS REPORTS ON POLICYHOLDER DIVIDENDS AND SECTION 809.

                              95-678 E

The life insurance industry is sharply divided into a stockholder-owned segment and a policyholder-owned, "mutual" segment. Since the segments compete with one another for business, it is important that the tax system treat them equally, but defining taxable income for the differently organized companies has proven extraordinarily difficult.

In the past, several different systems were tried, usually taxing stockholder-owned and mutual companies on different bases. Since 1984, taxable income has been defined the same for stock and mutual companies, but with special restrictions on mutual companies' deductions for policyholder dividends. A restriction on this deduction is considered necessary for equal taxation of the industry segments because dividends to stockholders are not deductible.

Currently, the restrictions on mutual companies' policyholder dividend deductions, which are contained in section 809 of the Internal Revenue Code (IRC), are under criticism from almost everyone, but there is no consensus on how they should be reformed. They are criticized by the mutual companies because the formula used causes a mutual company's taxes to depend on industry averages rather than its own performance. They are criticized by the stock companies because the mutuals are not paying as large a share of the industry's total taxes as anticipated. And they are criticized by the Treasury Department because the industry's total tax bill has been lower than expected.

Suggested alternatives to section 809 range from simple repeal (allowing full deductibility of dividends) to disallowing a set percentage of the deduction. None of the proposals, however, are based on measuring and taxing the actual economic income of the companies. This is due in part to the treatment of the policyholders, who are generally not taxed on income generated on their behalf by both mutual and stock companies, and in part to the use of reserve accounting by the companies, which shelters most of their income from taxation. It is possible that the problem of equal taxation of the industry segments can only be solved in the context of complete reform of the current system of taxing life insurance companies and products.

                              CONTENTS

From 1913 to 1921, no attempt to differentiate the two segments was made and the tax was imposed on net income as defined for regulatory accounting purposes, which gave an advantage to mutual companies. From 1921 to the late 1950s, the tax imposed was essentially an excise tax on investment income not credited to policyholders, which was a heavier tax on the mutual segment. (For most of this period, the mutual segment was much larger and more dominant.) From 1959 to 1981, there was a very complex three-tier system that taxed the stockholder-owned and mutual companies differently, the stock companies mostly on part of their operating profits and the mutual companies mostly on their investment earnings. Since 1982, taxable income has been defined the same for stock and mutual companies, but with special restrictions on mutual companies' deductions. Currently, the restrictions on mutual companies, which are contained in section 809 of the Internal Revenue Code (IRC), are under criticism from almost everyone, but there is no consensus on how they should be reformed.

This report gives the background on the way life insurance company income is measured, goes into some detail on the problem of equating mutual and stock company measurements, and discusses some of the proposed solutions to the stock/mutual measurement problem.

OVERVIEW OF THE TAXATION OF LIFE INSURANCE

Life insurance companies have posed difficult problems in the design of the U.S. income tax for all of its modern history. To impose a separate tax on corporations at the company level, as the U.S. system does, it is necessary to define the company's income, as distinct from that of its owners, managers, or customers. This can be difficult for any company whose business is managing other people's money, and such financial intermediation is a large part of the insurance business (although only part). Establishing separate claims on income can also be difficult in the case of mutual and cooperative companies, because the owners and customers are the same; and a large and important segment of the life insurance industry is organized on a mutual basis. So the modern U.S. income tax system has contained several very different attempts at defining a taxable income for life insurance companies, and none of them have been altogether successful. ¹

Part of the problem in taxing life insurance companies arises because of the dual nature of the industry's services. On the one hand, the industry provides the pure insurance service of sharing the risk of financial loss individuals might incur due to death or illness. On the other hand, the industry invests and manages the funds entrusted to it by its customers, much as a bank, mutual fund, or other financial intermediary would.

The two types of services provided give rise to two conceptually distinct types of profit. Fees for insurance services are added to premiums charged, so the excess of premiums over benefits paid and other expenses is one source of profits. But, like all financial intermediaries, the companies also profit from the difference between the return their investments earn and the return they pay to the customers whose money they are managing.

In practice, however, these two profits are not distinct at all. The premiums charged for insurance are often reduced ("discounted") by the interest the invested money will earn, so the investment income is actually used to pay for part of the insurance coverage. And because the industry is regulated (by the States) for the safety of its funds, its accounting rules reduce current income for additions to reserves for future claims as well as for payments of current claims.

Regulatory accounting in the insurance industry is extremely conservative, because its principal purpose is the safety of the policyholders' funds in the companies' hands. So regulatory accounting is designed to make sure that the companies do not overstate their income. Tax accounting rules for the insurance industry are based on the regulatory accounting scheme (although less conservative, since avoiding OVERstatement of income is not the problem in tax accounting). The unique feature of this accounting system is the extensive use of reserves. For most tax accounting, deductions are allowed only when the expense is incurred and the income to which it relates is reported. Reserves for future expenses generally do not give rise to current deductions.

In the insurance industry, however, current additions to reserves to pay future claims are allowed as deductions from the current year's premiums and investment income. Portions of the reserved funds are credited to policyholders by law and/or by the terms of the policies, and a share of the investment income of the company is attributed to these funds and also credited to the policyholders. (Past tax schemes have relied on the concept of "free" reserves -- i.e., extra reserves not credited to any policyholders -- t o determine the companies' shares of investment income.) Both sources of additions to reserves produce tax deductions for the companies that shelter a large part of their income from tax.

In addition, some policies, called "participating policies," pay dividends based on the company's performance, giving rise to an additional deduction that further reduces the industry's tax bill. Since mutual companies issue far more participating policies than stock companies do, this is primarily a deduction for the mutual segment of the industry; and it is this deduction that causes the difficulties in comparing the taxable incomes of the mutual and stock companies. ²

POLICYHOLDER DIVIDENDS

One way in which the life insurance industry is unique is that many of the largest life insurance companies are organized as mutual companies, with no stockholders apart from their customers (policyholders). Although policyholders have virtually no influence on company operations (unlike a stockholder, a policyholder cannot invest more money and have more votes) and have no claim on the company's assets outside the terms of their policies, they share in the company's earnings (through participating policies) and are the only identifiable owners of the company. Thus they are at least analogous to the stockholders of a stock company.

Policyholder dividends, however, are treated very differently from stockholder dividends for tax purposes. They are not taxed to the policyholders who receive them unless the total received over the life of the policy exceeds the total amount of premiums paid for the policy. This is apparently because they are regarded as either a refund of premiums or a return of capital (i.e., as a reduction in the cost of or investment in the policy). Stockholder dividends are taxed as ordinary income unless they are clearly a return of capital (i.e., unless the company has no income from which to pay them). And policyholder dividends are deductible by the paying company (with some limitations), but dividends to stockholders are not deductible.

Policies that pay dividends -- "participating policies" -- are actually issued by both stock and mutual companies; but they are far more important to the mutual companies, for whom they represent the only current source of contributed equity capital. (Stock companies can always issue more stock.) The deductibility of policyholder dividends, therefore, is the major source of difference in the tax treatment of stock and mutual insurance companies; mutual companies get a tax deduction for their payments for the use of equity capital, but stock companies do not. (Both, of course, can deduct interest paid for the use of borrowed capital.)

The large mutual companies hold vast amounts of assets and earn large amounts of investment income that is not attributed to any particular policies. Like all life insurance companies, they deduct additions to reserves for future claims from premium income and the portion of investment income credited to policyholders. They are often in the position of paying the rest of their net income after expenses, including the investment earnings on assets not "reserved" to policyholders, to their policyholders as dividends. If they were also allowed to deduct all of these policyholder dividends, they would often have no taxable income at all and pay no income tax. Since they compete in the same markets as the stock companies, paying no income tax would give an obvious competitive advantage to the mutual companies.

Several different ways of dealing with this problem have been tried since 1921. Taxing only investment earnings for both stock and mutual companies, as was done from 1921 to 1959, assured that mutual companies paid some tax but exempted any profit on underwriting (the insurance activity itself) from tax (and did nothing to assure that the two types of companies were taxed alike). The elaborate system used from 1959 to 1981 in effect taxed companies with lots of investment income (mostly mutuals) on that basis and companies with large underwriting gains (mostly stocks) on that basis. The formulas used worked to the disadvantage of the mutual companies as interest rates rose, however, and by the end of the 1970s mutual companies would have been paying huge tax bills if they had not found a loophole in the law that virtually exempted them (and many stock companies) from tax. The loophole, called "modified coinsurance," involved swapping income; a company that was being taxed on investment income swapped enough income with a company being taxed on underwriting income to reduce or eliminate BOTH companies' taxes. ³ The tax provision allowing these income swaps was repealed in 1982 and replaced with a temporary provision denying mutual companies a fixed percentage of their policyholder dividends deduction. What was supposed to be a permanent solution was enacted in the Deficit Reduction Act of 1984 (P.L. 98-369) as IRC section 809. ⁴

SECTION 809

Policyholder dividends can be seen as composed of several parts. One part can be viewed as a rebate of some of the premiums the policyholder paid; another part could be a payment for the use of deposited funds, akin to the interest paid on a certificate of deposit, for example; another part can be seen as a distribution of the companies' profits, the same as dividends paid to stockholders. Section 809 was devised to distinguish the part of policyholder dividends representing a distribution of company profits from the other parts of the payments.

Section 809 contains a formula by which mutual companies are to determine what part of the dividends they pay represents a distribution of earnings and is therefore disallowed as a deduction. Since mutual companies do not calculate net earnings before dividends in their normal accounting, the formula uses the net earnings of STOCK companies to compute a pre-dividend rate of return on equity.

The formula in section 809 is based on several assumptions. It assumes that the stock and mutual company earnings rates are the same before deducting policyholder dividends. It assumes that the dividend payout rates are the same. It assumes that the average pre-tax earnings rate of mutual companies AFTER deducting policyholder dividends is lower than that of stock companies, and that this difference represents the earnings that will be paid as nondeductible dividends to stockholders by the stock companies. ⁵ It is also based on the assumption that the mutual company segment of the industry is supposed to pay 55 percent of the industry's tax bill. (The Committee report justifies this on the grounds that it is the historical ratio of taxes paid by the segments, it is the approximate ratio of assets held, and policyholder dividends are not taxable to the recipients.) ⁶

The stock company earnings rate used in the formula is calculated (by IRS) based on the average earnings rates of the 50 largest stock companies for three recent years (initially, the second previous year and the two years prior to that). The second step in the formula is to calculate an IMPUTED earnings rate for mutual companies, set by law at 16.5 percent in 1984. This figure was chosen because, in 1984 data, it caused mutual companies to pay 55 percent of the taxes. The 16.5 percent is adjusted each year in a way that is supposed to keep the mutual companies' share of taxes at 55 percent. ⁷

The next step in the formula is to calculate the difference between the average stock and imputed mutual earnings rates. This calculation gives the "differential earnings rate" published by IRS that is then applied by each mutual company to its own equity base to impute an amount that is supposed to represent that year's net earnings distributed as a part of policyholder dividends. Adding this back to taxable income is supposed to put mutual and stock company taxable income on the same basis.

Because the stock company data used is not current, the whole formula is recalculated the next year when more current data is available, and the mutual company's taxes for the year are increased or decreased accordingly (this is called a "true-up").

PROBLEMS WITH SECTION 809

Section 809 has not worked out to anyone's satisfaction. It did not produce the expected increase in the total amount of taxes paid by the life insurance industry; total taxes collected from the industry have been below the projected amounts every year since 1984 (through 1991, the most recent year available). It also did not produce the expected ratio of taxes from the two segments of the industry; mutual companies have paid a smaller share than expected each year from 1984 through 1991. The "differential earnings rate" published each year by IRS has been very unstable and has even been NEGATIVE at times. (The formula assumes a stable and positive difference between the earnings rates of the mutual and stock companies.) The stock companies have felt that they were unfairly treated (because their tax share is higher than they expected); the mutual companies have always objected to the formula because it bases their taxes on industry averages instead of their own performance. Both the Treasury Department and the General Accounting Office were required by the 1984 act to study section 809 and report on its operation; both issued reports judging it a failure and calling for its repeal. ⁸

The reasons that section 809 did not work as anticipated are not obvious. It is possible that the period since 1984 has been especially unsettled in the life insurance industry; there has been a continuing shift in the mix of products sold and to some extent in investment strategies. It is possible that the industry is normally too volatile for a formula approach to produce predictable results and that the observed stability on which the 1984 assumptions were supposedly based was illusory. Or it could be that the assumptions themselves were flawed; certainly a negative difference between the mutual and stock earnings rates is counter to the original assumptions.

According to the original rationale for section 809, mutual companies have a tax advantage because they escape the corporate tax on profits they then distribute to owners (policyholders) and the stock companies do not. A negative differential, however, implies that this difference does not exist (or even that it favors the stock companies, which is hard to explain).

Mutual companies could be operating in such a way as to take no advantage of their potential tax preference. A review of tax return data published by IRS for the years 1988 through 1991 does show, however, that Federal income taxes were a smaller fraction of total receipts for mutual companies than for stock companies in each year. ⁹ This does not prove a tax advantage for mutual companies, since it could be due to stock companies being more profitable apart from policyholder dividends; but it is consistent with the view that mutuals are not paying the same taxes as stock companies. So a negative differential earnings rate may merely indicate that the formula in section 809 does not capture the actual differences in the earnings and payout rates of the two segments of the industry.

ALTERNATIVES TO SECTION 809

As mentioned above, both the GAO and Treasury reports in 1989 suggested repeal of section 809, but the reports offered different alternatives. GAO suggested disallowing a set percentage of mutuals' policyholder dividends, similar to the system used as a temporary expedient in 1982-3. The Treasury's suggested solution was to allow unlimited deduction of policyholder dividends but impose an additional tax on investment income to make up for the lost revenue. (Because of the mutual companies' larger share of investment income, they would have paid a larger share of the proposed additional tax.) In both reports, the fact that policyholder dividends were not taxed at the policyholder level was a principal rationale for imposing some additional tax at the company level. ¹⁰

The stock companies' dissatisfaction with section 809 led in the past few years to a campaign by some of their members to replace the section with a rule designed to force the mutual companies to pay more tax. A version of this rule is incorporated into H.R. 1497 in the 104th Congress. Under this bill, a mutual company would be allowed to deduct the first $35 million of policyholder dividends in full and 90 percent of any additional dividends up to 30 percent of taxable income (computed without deducting any dividends). It is apparently believed that this formula will cause the mutual companies to pay the 55-percent share of the industry's taxes intended in the 1984 revisions. ¹¹

Some analysts (and, of course, the mutual companies) favor repeal of section 809 without replacing it, thus allowing full deduction of all policyholder dividends. Their argument is that mutual companies were taxed on their equity capital when they received it, because it was a part of their taxable premium income, while the stock companies received contributed capital from their stockholders free of tax. (Contributions to capital are not taxable income to stockholder-owned companies.) In present value (given equal tax and discount rates), a tax-free investment generating taxable income and a taxable investment generating tax-free income produce equal amounts of tax, although the tax is paid at different times in the life of the investment. Thus policyholder dividends should be tax-free, because the tax on them has been "prepaid" when the premiums were initially received. ¹²

The logic of this "prepayment" analysis is generally accepted, but its application in the real world is questionable. For most of the history of the Federal income tax, a very large amount of the premium income of mutual insurance companies was, in fact, not taxed, either because they were taxed only on investment income or because their premium income was shielded from tax by excessive reserve deductions. In addition, a mutual insurance company cannot be started without capital from some source other than premiums (State regulators would insist on some capital base before policies could be issued), which would have been untaxed. (Most of the large mutual companies started as stock companies and converted to the mutual form.) So some currently unmeasurable portion of the mutuals' capital was received as tax-free as that of the stock companies, suggesting that even under the prepayment argument something less than 100 percent of policyholder dividends should be deductible. Finally, because of the use of reserve accounting by the companies and virtual tax exemption at the policyholders' level, very little of the income of any mutual OR stock life insurance company has been subject to any tax under the Federal income tax, making "prepayment" something of an unreal issue.

BEYOND SECTION 809

A solution to the problem of properly defining income for mutual and stock companies is made difficult, and perhaps impossible, in part because there is no clear definition of income for the life insurance industry itself. Attempts to define economic income for the industry have often been stymied by such considerations as the desire not to tax death benefits, respect for the regulatory accounting rules, and confusion over the nature (and sometimes ownership) of the vast "reserves" the industry holds, as well as the mutual company problem. Administration proposals leading up to the Tax Reform Act of 1986 contained a solution that taxed policyholders on all income paid or credited to them, including inside build-up, policyholder dividends, and any investment income used to provide insurance coverage, and taxed the companies on all income net of expenses not taxed to policyholders. ¹³ These proposals were not included in the final tax reform bill, in part because of an intensive lobbying campaign against them by the industry.

For historical reasons, tax policy toward the life insurance industry has often been discussed in terms different from those applied to other industries. Discussions have often proceeded as if there were some reason for the industry to pay a particular amount of tax, and that particular parts of the industry should pay particular shares of it. A more normal tax policy approach is to attempt to define economic income for the particular circumstances of the industry and impose the tax on that basis. This approach not only equates the tax burdens of companies competing in the same industry, it also "levels the playing field" between industries (such as banking, insurance, and mutual funds) who may be competing for the same investment dollars. It may be that a solution to the mutual/stock problem is possible only by taking this broader approach.

² Taxation of the industry is further complicated because individual policyholders are generally not taxed on the income it generates, either. Legislators have always been reluctant to impose taxes on families suffering the death or illness of a member, so benefits paid because of death or illness are generally tax free. Money that is credited to a policyholder's benefit while the policy remains in force ("inside build-up") is both restricted in use and a component of death benefits, and for both reasons it is not taxed. Even cash withdrawals from the policy, as some policies permit, and policyholder dividends from participating policies are generally not taxed. So large amounts of the income arising in the industry are not taxed at either the corporate or the individual level. For a summary of the tax preferences for the life insurance industry, see U.S. Congress. Senate. Committee on the Budget. Tax Expenditures: Compendium of Background Material on Individual Provisions. S.Prt. 103-101, December 1994. U.S. Govt. Print. Off., Washington: 1994. P. 157, 167.

³ Like most tax loopholes, this one was simply an extension of a rule allowing a common business practice. Insurance companies diversify their risks by transferring policies and/or assets to each other, often in quite complex transactions. The modified coinsurance provision, originally enacted to legitimize these transactions, allowed what were in effect sham transfers made solely to shift different types of income from one company to another.

⁴ U.S. Congress. Joint Committee on Taxation. General Explanation of the Revenue Provisions of the Deficit Reduction Act of 1984. JCS-41-84, December 31, 1984. U.S. Govt. Print. Off., Washington: 1985. P. 572-581, 612-619.

⁵ The Joint Committee on Taxation said that this latter assumption was based on several years' observations of a number of companies. U.S. Congress. Joint Committee on Taxation. Overview of Federal Tax Treatment of Life Insurance Companies and 1988 Interim Treasury Department Report. JCS-16-88, September 23, 1988. P. 10.

⁶ U.S. Congress. Senate. Committee on Finance. Deficit Reduction Act of 1984: Explanation of the Provisions Approved by the Committee on March 21, 1984. S.Prt. 98-169, April 2, 1984. U.S. Govt. Print. Off., Washington: 1984. P. 549.

⁷ Ibid.

⁸ U.S. Department of the Treasury. Final Report to Congress on Life Insurance Company Taxation. August 11, 1989. U.S. General Accounting Office. Allocation of Taxes within the Life Insurance Industry. GAO/GGD-90-19, October, 1989.

⁹ U.S. Treasury. Internal Revenue Service. Statistics of Income Source Book, Corporation Income Tax Returns, various years. Calculations by the author.

¹⁰ Treasury Final Report, P.4; GAO/GGD-90-19, P. 64.

¹¹ See Burstein, Emanuel. How Mutual Life Insurers Got Targeted to Fund Federal Programs. Tax Notes, January 31, 1994. P. 523.

¹² See Graetz, Michael J. Life Insurance Company Taxation: The Mutual vs. Stock Differential, in Graetz, Michael J., Ed. Life Insurance Company Taxation: The Mutual vs. Stock Differential. Rosenfeld Emanuel, Inc., Larchmont, N.Y.:1986. P. 1-1.

¹³ See U.S. Department of the Treasury. Tax Reform for Fairness, Simplicity, and Economic Growth. Volume 2, General Explanation of the Treasury Department Proposals. November 1984. P. 257-269.