Insurer's Punitive Damage Payments Are Deductible Expenses
FSA 1993-1054
- Institutional AuthorsInternal Revenue Service
- Code Sections
- Subject Area/Tax Topics
- Index Termsbusiness expense deductioninsurance companies, non-life, deductions
- Industry GroupsInsurance
- Jurisdictions
- LanguageEnglish
- Tax Analysts Document NumberDoc 1999-2494 (8 original pages)
- Tax Analysts Electronic Citation1999 TNT 95-23
INTERNAL REVENUE SERVICE
MEMORANDUM
CC:TL-N-2615-92
FS:FI&P:MNelson
date: March 24, 1992
to: District Counsel, * * *
from: Assistant Chief Counsel (Field Service) CC:FS
subject: Request for Field Service Advice -- * * *
* * *
[1] This memorandum is in response to your request for Field Service Advice concerning an issue that has arisen during the audit of the taxpayer identified above. We have reviewed the legal opinion prepared by * * * Special Litigation Assistant, and we agree with his conclusions, although our analysis of Issue 2 is somewhat different. Because we agree completely with * * * analysis of Issue 1, we will not repeat it in this memorandum but instead will confine our discussion to Issue 2. 1
[2] ISSUES
1. Whether the $* * * punitive damages payment made by the taxpayer to one of its insured in connection with the settlement of a lawsuit brought against the taxpayer by the insured should be treated as a "fine or similar penalty" under section 162(f) and therefore not be allowed as a deductible expense;
2. If the payment is not treated as a fine or penalty under section 162(f), should it be treated as an expense of the taxpayer deductible under section 162(a) and section 832(c)(1) or should it be treated as unpaid loss or unpaid loss adjustment expense deductible under section 832(c)(4).
[3] CONCLUSIONS
1. Section 162(f) prohibits the deduction of fines or similar penalties paid to a governmental entity. Because the payment in question here was made to a private individual in connection with the settlement of a civil lawsuit, the prohibition of section 162(f) does not apply.
2. The payment should be deducted under section 832(c) 1) as an "expenses incurred" by the taxpayer and not under section 832(c)(4) as "losses incurred."
FACTS
[4] * * * ("taxpayer") insured * * * under a comprehensive dishonesty, disappearance, and destruction policy, designed to indemnify * * * for "loss of Money, Securities, and other property which the Insured shall sustain . . . resulting directly from one or more fraudulent or dishonest acts committed by an Employee, acting alone or in collusion with others." The Table of Limits of Liability limited * * * coverage to $* * * In * * * several of * * * employees engaged in a fraudulent check cashing scheme that deprived * * * of approximately $* * * claim for loss was initially rejected by the taxpayer on the grounds that the bank that had cashed the checks was the "direct" cause of * * * loss and the taxpayer was not obligated under the policy.
[5] * * * sued the taxpayer. Despite efforts by * * * to settle the litigation by paying the claim, plus costs, * * * persevered and won. In * * * the jury returned a verdict in which it awarded * * * $* * * in compensatory damages, $* * * in costs, and $* * * in punitive damages. The taxpayer appealed, but in * * * the parties settled the litigation, with the taxpayer agreeing to pay $* * * to * * *
[6] Although it is not clear, it appears that in * * * the taxpayer included the $* * * in its estimate of unpaid losses for the * * * accident year on both its annual statement filed with the state regulatory authorities and on its tax return. In * * * after the litigation was settled, the taxpayer adjusted its loss reserves accordingly, i.e., to reflect the payment of $* * * in full settlement.
ANALYSIS
[7] As stated above, the prohibition against deduction of fines and penalties does not apply in this instance because the amount at issue was paid to a private litigant and therefore the punitive damage award is not properly characterized as a "fine or similar penalty" within the meaning of section 162(f). The real issue is not whether the punitive damages award is deductible at all but whether it is deductible under section 832(c)(4) as "losses incurred," as defined by section 832(b)(5), instead of under section 832(c)(1) as "expenses incurred," as defined by section 832(b)(6). If the award is treated as a loss instead of as an expense, the taxpayer may deduct it in * * * If the award is properly treated as an expense, it is not deductible until * * * We think the award is not deductible until * * *
[8] Section 832(c) provides that in computing the taxable income of an insurance company subject to the tax imposed by section 832, there shall be allowed as deductions:
(1) all ordinary and necessary expenses incurred, as provided in section 162 (relating to trade or business expenses); . . . . . .
(4) losses incurred, as defined in subsection(b)(5) of this section;
Section 832(b) provides:
(5) LOSSES INCURRED. --
(A) IN GENERAL. -- The term "losses incurred" means losses incurred during the taxable year on insurance contracts computed follows:
(i) To losses paid during the taxable year, deduct salvage and reinsurance recovered during the taxable year.
(ii) To the result so obtained, add all unpaid losses on life insurance contracts plus all discounted unpaid losses (as defined in section 846) outstanding at the end of the taxable year and deduct all unpaid losses on life insurance contracts plus all discounted unpaid losses outstanding at the end of the preceding taxable year. [emphasis added]
(iii) To the results so obtained, add estimated salvage and reinsurance recoverable as of the end of the preceding taxable year and deduct estimated salvage and reinsurance recoverable as of the end of the taxable year.
(6) EXPENSES INCURRED. -- The term "expenses incurred" means all expenses shown on the annual statement approved by the National Association of Insurance Commissioners, and shall be computed as follows: To all expenses paid during the taxable year, add expenses unpaid at the end of the taxable year and deduct expenses unpaid at the end of the preceding taxable year. For purposes of this subchapter. the term "expenses unpaid" shall not include any unpaid loss adjustment expenses shown on the annual statement. but such unpaid loss adjustment expenses shall be included in unpaid losses. For the purpose of computing the taxable income subject to the tax imposed by section 831, there shall be deducted from expenses incurred (as defined in this paragraph) all expenses incurred which are not allowed as deductions by subsection (c). [emphasis added]
[10] Under section 461, an expense has not been incurred by an accrual basis taxpayer before the year "in which all the events have occurred which determine the fact of the liability [for the expense] and the amount thereof can be determined with reasonable accuracy." Treas. Reg. section 1.461-1(a)(2). 2 Under the accrual accounting rules of section 461, if a taxpayer disputes his liability to pay a claimed amount, deduction of the resulting settlement, judgment, or award is postponed until settlement of the dispute by the parties or until its final adjudication by the courts, see Treas. Reg. section 1.461-1(a)(3)(ii), unless the taxpayer makes a transfer that satisfies the requirements of Treas. Reg. section 1.461-2(a). Thus, if the punitive damages award is properly characterized as an "expense incurred" deductible under section 832(c)(1), it may not be deducted by the taxpayer until * * *
[11] If the award is properly characterized as an unpaid loss or an unpaid loss adjustment expense, then the taxpayer's inclusion of the $* * * in its computation of the "loss incurred" deduction for * * * is correct. This is because section 832(b)(6) specifically provides that unpaid loss adjustment expense is to be included in unpaid losses under section 832(b)(5) and unpaid losses are included, on a discounted basis, in the computation of the "losses incurred" deduction in the year in which the loss was incurred, not in the year in which it was accrued within the meaning of section 461. That is, "unpaid losses" are estimates of what the company reasonably expects to pay after the end of the taxable year on losses occurring before the end of the taxable year. See Treas. Reg. section 1.832-4T(b).
[12] "Unpaid losses" includes losses suffered by the insured during the tax year that the insurance company does not yet have knowledge of ("incurred but not reported" or "IBNR" losses). It also includes losses suffered by the insured during the tax year that the insurance company initially resists paying but in a later taxable year pays ("resisted" losses). Rev. Rul. 70-643, 1970-2 C.B. 141. Thus, if the taxpayer were subject to section 461 for the deduction of its underwriting losses, it would not be entitled to deduct the $* * * punitive damages award in * * * because it appealed that judgment; rather, it would have to wait until * * * when it settled the litigation. Because property and casualty insurance companies do not have to satisfy the requirements of section 461 for the deduction of losses but instead are allowed to deduct the loss in the accident year in which it arises, the taxpayer would be entitled to deduct the $* * * punitive damages award in * * * if the award were properly characterized as either an unpaid loss or as unpaid loss adjustment expense.
[13] Whether or not an amount is properly characterized as an unpaid loss or as an unpaid loss adjustment expense for purposes of section 832(b)(5) is determined by reference to section 846. Section 846 provides the definition for "discounted unpaid losses" as used in section 832(b)(5). Under section 846(a)(2), an insurance company's discounted unpaid losses are computed by applying an applicable interest rate and an applicable loss payment pattern to the company's undiscounted unpaid losses. "Undiscounted unpaid losses" are defined by section 846(b) as the unpaid losses shown in the annual statement filed by the taxpayer with the state insurance regulator. Under section 846(f), the term "unpaid losses" includes any unpaid loss adjustment expense shown on the annual statement. Thus, the treatment of punitive damages awards on the annual statement by the state insurance regulators is determinative of how the amounts are to be characterized for federal income tax purposes.
[14] After extensive but not exhaustive research, we have concluded that to the extent state insurance regulators have specifically addressed the issue of how to treat punitive damages, they have determined that such amounts should not be treated as unpaid losses or loss adjustment expense. Taking the position that the states do not allow punitive damages to be included in unpaid losses and loss adjustment expense is not free of litigation hazards, however. This is because, in general, the insurance regulators do not care about the charactrization of the payment when analyzing the solvency of the insurance company; as long as the potential cost of punitive damages is reserved for as soon as the potential for liability arises, the solvency concerns of the regulators are satisfied. Accordingly, the statutes give broad definitions of these terms. For example, under the applicable * * * statute, the terms "loss payments" [i.e., losses incurred] and "loss expense payments" [i.e., loss adjustment expense] are defined as:
* * *
[15] Arguably, punitive damages could be characterized as loss expense payments in * * * under the broad statutory language "and all other payments made by such insurer on account of claims under such policies. . . ." This assumes that the punitive damages would not have been awarded but for the claim filed under the policy not being paid promptly. The proximate cause of the punitive damage award in this case was not the fact of the claim being filed, however; it was the inappropriate conduct of the insurance company. Thus, we should argue that the punitive damages award was not paid "on account of claims" within the meaning of the statute.
[16] In addition, the regulators do not allow punitive damages awards assessed against insurance companies as a result of improper business conduct to be treated as an unpaid loss or as a loss adjustment expense for ratemaking purposes, and this appears to be the only place where the insurance regulators have specifically addressed the issue. According to conversations conducted with attorneys on the General Counsels' staffs in the ratemaking departments of the insurance regulators for the States of * * * punitive damages would not be treated by those states as either unpaid losses or unpaid loss adjustment expenses of the insurance company for ratemaking purposes. Indeed, the * * * has issued an emergency regulation that addresses this issue specifically (current regulations ignore the issue). * * * published * * * adopts regulation section * * * which provides:
* * *
[17] Accordingly, it appears that while the state insurance regulators have not specifically addressed our question, the trend is to treat punitive damages as an "extra-contractual" amount that is subject to special rules. We therefore recommend that the revenue agent auditing this case not allow the taxpayer to include $* * * in unpaid losses in * * * but instead require the taxpayer to wait until * * * to deduct $* * *
[18] If you have any questions, please call Maureen Nelson at FTS 566-3345.
[19] This document may include confidential information subject to the attorney-client and deliberative process privileges and may also have been prepared in anticipation of litigation. This document should not be disclosed to anyone outside the IRS, including the taxpayers involved, and its use within the IRS should be limited to those with a need to review the document in relation to the subject matter discussed herein.
By: Richard L. Carlisle
Branch Chief, FI&P Branch
Field Service Division
1 As * * * points out in his memorandum, the question raised by the District regarding an appropriate way to allocate the settlement does not present a legal issue, and we understand that * * * is not seeking our views on this subject. Accordingly, we have not addressed Issue 2 in * * * memorandum.
2 Since the enactment of section 461(h), certain liabilities are deemed not to have incurred before "economic performance."
END OF FOOTNOTES
- Institutional AuthorsInternal Revenue Service
- Code Sections
- Subject Area/Tax Topics
- Index Termsbusiness expense deductioninsurance companies, non-life, deductions
- Industry GroupsInsurance
- Jurisdictions
- LanguageEnglish
- Tax Analysts Document NumberDoc 1999-2494 (8 original pages)
- Tax Analysts Electronic Citation1999 TNT 95-23