Small Life Insurance Company Deduction Discussed

2. Alternatively, whether * * * is entitled to the 25 percent gross- up.

2. * * * is not eligible for the * * *

[5] For the years at issue, * * * and * * * filed partnership returns (Forms 1065), and reported substantial excess deductions, primarily interest expense deductions resulting from the debt financing. * * * filed life insurance company returns (Forms 1120L) for * * * and * * * which were not included in the consolidated return of * * * We assume that * * * filed Forms 1120L for * * * and * * * and that these returns were included in the * * * consolidated return.

[6] The partnership losses for * * * and * * * were split in the following manner: * * * percent; * * * percent; and * * * percent. Each partner has contributed sufficient capital to cover its share of the losses for each year. * * * and * * * the interest expenses flowing from * * * by * * * percent, resulting in additional deductions for * * * and * * * in excess of * * * The taxpayers claim authority for this treatment in * * *

[7] During the years at issue, * * * and * * * the * * * group had assets in excess of * * * and therefore did not qualify for the small life insurance company deduction under I.R.C. section 806(a) /1/. It is not clear whether * * * qualified for the small company deduction in years prior to * * * the Special Litigation Assistant speculates on page 2 of her submission that the * * * group did not qualify in * * *

[8] The question raised by the revenue agent is whether the * * * applies independently of the small life insurance company deduction, as in effect under section 806(a) during the years at issue, or whether the * * * applies only if the taxpayers qualify for the small life insurance company deduction. The Special Litigation Assistant has raised an additional inquiry as to whether * * * would be entitled to the * * * in the event that * * * and * * * are not.

[10] Although your request for advice concerns only the taxable years * * * and * * * a full understanding of the law, as in effect during the years in which the * * * was available, is necessary. Accordingly, we will begin our analysis with a review of the basic rules for the taxation of life insurance companies in effect during * * * through * * * We will then focus on the * * * at issue.

[11] The 1984 Act amended the Life Insurance Company Income Tax Act of 1959 ("the 1959 Act") for years beginning after 1983, and replaced it with a totally revised, comprehensive system of taxing life insurance companies. The basic framework for life insurance company taxation was adopted in Section 211 of the 1984 Act and was incorporated, in substantial part, into the Internal Revenue Code as Subchapter L, Part I, sections 801 through 818.

[12] For taxable years after 1983, section 801(a) of the Code provides that life insurance companies are taxed on "life insurance company taxable income" ("LICTI"), which is defined by section 801(b) as insurance gross income reduced by life insurance deductions. Section 803 provides that "life insurance gross income" means the sum of premiums, decreases in certain reserves, and all other amounts which are includible in gross income under subtitle A of the Code, including capital gain.

[13] For taxable years after 1983, but prior to 1987, section 804 provided that "life insurance deductions" were the general deductions provided in section 805, the special life insurance company deduction determined under section 806(a), and the small life insurance company deduction, if any, determined under section 806(b). The special life insurance company deduction and the small life insurance company deduction were collectively referred to in section 806 as "special deductions." ²

[14] Section 806(a) provided that the "special life insurance company deduction" for any taxable year was 20 percent of the excess of the tentative LICTI for such taxable year over the small life insurance company deduction, if any, provided in section 806(b). Section 806(b)(1) provided that the small life insurance deduction was 60 percent of the first $3 million of tentative LICTI. Section 806(b)(2) provided that the amount of the deduction was to be reduced by 15 percent of tentative LICTI in excess of $3 million, phasing out entirely when tentative LICTI equaled or exceeded $15 million. Section 806(b)(3) provided that the small life insurance company deduction was not available to life insurance companies with assets of $500 million or more. Section 806(c) provided that the term "tentative LICTI" meant LICTI determined without regard to special life insurance company deduction, the small life insurance company deduction, and items attributable to noninsurance business, as defined in section 806(c)(3).

[15] The 20 percent special life insurance company deduction effectively reduced the tax rate for all life insurance companies on income from insurance business from the general corporate rate of 46 percent to 36.8 percent. Income from noninsurance business was taxed at the general corporate rate. Thus, for a life insurance company with income from insurance business of $3 million or less before taking the special life insurance company deduction, that deduction, when combined with the 60 percent small company deduction, reduced the effective tax rate on the income of the company's insurance business to 14.7 percent.

[16] The special life insurance company deduction under section 806(a) was repealed by the 1986 Act. Congress concluded that because of the reduction in general corporate rates under the 1986 Act, the special life insurance deduction was no longer needed. Under the 1986 Act, corporations are taxed under the following graduated rate structure:

 Taxable Income                              Tax Rate

[17] As a result of the repeal of the special life insurance company deduction, section 806(b), relating to the small life insurance company deduction, was recodified as section 806(a), and section 806(c), defining tentative LICTI, was recodified as section 806(b). Thus, for taxable years beginning after 1986, section 804 provides that "life insurance deductions" are the general deductions provided in section 805, and the small life insurance company deduction, if any, determined under section 806(a). The small life insurance company deduction is calculated in the manner described above, based on tentative LICTI as defined in section 806(b).

* * *

[18] Accordingly, it is not necessary to address your alternative question as to whether * * * might qualify for the * * * provision on the theory that it would qualify for the small life insurance company deduction. We note briefly, however, that * * * filed partnership tax returns rather than corporate tax returns for the years at issue, and therefore would not qualify for the * * * the * * * or any other life insurance tax provisions. See Rev. Rul. 83-132, 1983-2 C.B. 270; Krizer v. Commissioner, T.C. Memo 1991-638.

[19] We express concern, however, that the taxpayers are taking a higher benefit than was intended. The estimated cost to the government is $ * * * in the * * * and * * * to * * * of * * * in the * * * We understand, however, that for the * * * at issue, the * * * yielded an additional * * * of deductions. We have not been provided with tax returns for * * * and its life insurance subsidiaries. We note, however, that Exhibit C-1 of the revenue agent's submission, which reflects the * * * calculation for * * * indicates that only the excess interest deductions flowing from * * * were * * * The statute provides that all * * * The phrase "attributable to" is not specifically defined in the statute, although it is offered in the context of the "debt-financed acquisition." We do not have enough information to determine whether any additional items flowing from * * * are "attributable to the ownership of the * * * stock," i.e., whether any other income or deductions are related to the debt financing. Accordingly, you should instruct the revenue agent to make this determination, and adjust the taxpayers' * * * calculations, if appropriate.

[20] 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 Service, including the taxpayer(s) involved, and its use within the Service should be limited to those with a need to review the document in relation to the subject matter or case discussed herein. This document also is tax information of the instant taxpayer which is subject to I.R.C. section 6103.

[21] Please contact Nancy Vozar at FTS 622-7870 if you have any questions about this matter.

FACTS: On * * * a partnership. -- * * * was formed. The general partner is * * * and the two limited partners are * * * and * * * On * * * this partnership acquired all of the stock of * * * An agreement was signed on this date -- * * * whereby * * * loaned the partnership * * * through * * * Purchase Money Debeutures due * * * Interest was to be paid semi-annually. The partnership files Form 1065 each year reporting substantial excess deductions primarily arising from the interest expense deduction. As the stock of * * * is owned by the partnership, * * * files a Form 1120L each year and is not included on the consolidated return of * * * The partnership loss has been split in the following manner each year' * * * - * * * % * * * and * * * The ownership of capital and profit percentages have varied throughout the years. So that they may continue to claim the losses each year, each partner contributes capital each year to cover its share of the current year's loss.

* * *

[22] Taxpayer believes that the * * * computation as included in * * * applies and has claimed its losses based on this for * * * and * * * However, we question this interpretation as the corporations do not qualify for the * * * We would appreciate your researching this question and providing your interpretation. * * * However, in researching these sections of the law, it appears that the * * * no longer applies.

[23] If you have any questions or need additional information, please contact * * * Team Coordinator, at * * * on * * * (on site at taxpayer).

Exhibit A

Exhibit B - 1

Exhibit B - 2

² Historical Note: Prior to the 1984 Act, life insurance companies were allowed a small business deduction of up to ten percent of investment yield, and special deductions for certain nonparticipating contracts, accident and health insurance, and group life insurance. The 1984 Act replaced those deductions with the special life insurance company deduction under section 806(a) of the Code and the small life insurance company deduction under section 806(b).

³ Division of 46 by 36.8 yields a quotient of 1.25, which in effect provides a 25 percent gross-up. The legislative history, discussed below, does not disclose the logic underlying this approach. We observe that the ratio of 46 to 36.8 corresponds to the pre-1986 Act ratio of the 46 percent rate on noninsurance business, which is excluded from tentative LICTI, and the 36.8 percent effective rate on insurance business, which is included in tentative LICTI. Thus, it can be inferred that the 25 percent gross-up was meant to preserve for taxable years 1987 and beyond the same ratio between amounts excluded from tentative LICTI and amounts included in tentative LICTI.