Rev. Rul. 77-92

Advice has been requested, under the circumstances described below, as to the Federal income tax consequences of the transfer from one insurance company to a second insurance company of the "retired lives reserve" under the taxpayer's group term insurance program.

The taxpayer, an industrial corporation, files its Federal income tax returns on a calendar year basis using an accrual method of accounting. It has a program under which group term life insurance benefits are provided to certain of its active and retired employees. These group term benefits are provided for by a group term insurance contract issued to the taxpayer by an insurance company. The premiums required to be paid under the group term insurance contract are paid by the taxpayer to the insurance company. The amount of premiums left over after payment of claims and expenses is placed in a "retired lives reserve" established and maintained by the insurance company for the purpose of accumulating a fund that would be used to pay all or a portion of the cost of continuing coverage for the retired employees.

Under the provisions of the contract, the taxpayer has the option to discontinue insurance coverage on its retired employees. If the taxpayer exercises the option the amount in the retired lives reserve can either be used to pay the premiums for insurance for the retired employees until it is used up or returned to the taxpayer. In addition, the taxpayer can exercise an additional option, upon written notice to the insurance company. Specifically upon discontinuance of the payment of premiums for the retired employees, the taxpayer may designate in writing that payment in cash of any balance remaining in the retired lives reserve be made to another insurance company.

On January 2, 1975, the taxpayer exercised the option to have the insurance coverage on its retired employees carried by another insurance company and directed that the amount accumulated in the retired lives reserve attributable to its contract be transferred on that date to the insurance company designated by the taxpayer. The second insurance company would henceforth carry only the life insurance coverage for retired employees who are covered under the program so long as any retired employee covered by the revised program remains alive. Under the provisions of the new group term contract with the second insurance company, the taxpayer no longer has the right to recover any premiums paid.

Section 1.162-10 of the Income Tax Regulations provides, in part, that amounts paid or accrued within the taxable year for a sickness, accident, hospitalization, medical expense, or similar benefit plan, are deductible under section 162(a) of the Internal Revenue Code of 1954 if they are ordinary and necessary expenses of the trade or business.

Section 111 of the Code and regulations thereunder provide in effect that gross income does not include the recovery of items, including expenses previously deducted or credited for Federal income tax purposes to the extent that no reduction in tax resulted.

Rev. Rul. 69-382, 1969-2 C.B. 28, holds, in part, that where a portion of premiums paid or incurred by an employer policyholder under contracts providing group term life and health and accident coverage for its active and retired employees for taxable years ending after June 17, 1969, is placed in a retired lives reserve, such portion is not deductible if the policyholder retains the right to recapture any portion of the reserve while any active or retired employee remains alive.

Rev. Rul. 73-599 holds that the accumulated balance in the retired lives reserve, made up in part by premiums paid and deducted by the taxpayer for Federal income tax purposes and in part by interest increments added by the insurance company but not taken into income by the taxpayer is includible in the gross income of the taxpayer under section 61 of the Code for the taxable year in which its right to receive such balance becomes fixed notwithstanding that, at its request, the insurance company transferred such balance to a section 501(c)(9) trust. Rev. Rul. 73-599 also holds that the annual contributions by the taxpayer to the fund maintained by the trustee for retired lives are business expenses deductible under section 162 in the taxable year paid or incurred but only to the extent that such contributions are actuarially determined and made on a level basis.

The facts presented herein are in substance the same as those contained in Rev. Rul. 73-599, 1973-2 C.B. 40, except that the right reserved by the taxpayer in the instant case to transfer funds remaining in the retired lives reserve under the revised program consists of the right to direct payment of such funds to another insurance company rather than to a trust that qualifies for exemption under section 501(c)(9) of the Code. However, this difference is not considered material since the right to control over the retired lives reserve is substantially the same, and therefore the same Federal income tax rules apply.

Accordingly, when the taxpayer directs the retired lives reserve to be transferred to the second insurance company, that portion of the reserve accumulated out of premiums paid or incurred in taxable years ending on or before June 17, 1969 (in the instant case December 31, 1968), for which the taxpayer received deductions for premiums paid or incurred, plus the interest increments attributable to those years, is includible in the gross income of the taxpayer under section 61 of the Code in the taxable year in which the taxpayer directs the transfer to be made, since that is the year in which the taxpayer's right to receive such income becomes fixed. To the extent that the tax benefit rule under section 111 is applicable, it applies only to that part of the transferred reserve accumulated out of premiums paid, and not to that part attributable to interest increments. That portion of the transferred reserve accumulated out of premiums paid or incurred in taxable years ending after June 17, 1969 (in the instant case December 31, 1969) is not includible in the taxpayer's income. Such premiums were not deducted by the taxpayer in determining its tax liability because the taxpayer retained the right of recapture. The interest added to this portion of the reserve is, however, included in the taxpayer's gross income under section 61 of the Code in the taxable year in which the taxpayer directs the transfer to be made.

It is further held that the nonrefundable annual premium paid by the taxpayer to the second insurance company is a business expense deductible under section 162 of the Code in the taxable year paid or incurred only to the extent that such payment is actuarially determined. Therefore, out of the entire amount transferred from the prior insurance company to the second insurance company, which amount is held for retired lives, the taxpayer may have that portion that is actuarially determined and made on a level basis represent its otherwise annual payment to the second insurance company and only to that extent will it be deductible under section 162 in the year of transfer. The excess, if any, of the amount transferred to the second insurance company for the year of transfer will be a prepayment of future annual payments to such insurance company. The prepayment may represent the taxpayer's future annual payments to the insurance company and in future taxable years, if determined on an actuarial basis, will be deductible under section 162.

Consistent with the above, Rev. Rul. 73-599 is modified to similarly distinguish between that portion of the retired lives reserve accumulated in taxable years ending on or before June 17, 1969, and that portion accumulated in taxable years ending after June 17, 1969.