Subchapters C and L Interaction in Section 338 Election Explained

2. Are the reserve liabilities relating to the acquired life insurance company's existing insurance and annuity contracts treated as released for tax purposes as a result of the deemed sale (and purchase) characterized by section 338?

3. Are these reserve liabilities taken into consideration in determining the "adjusted grossed-up basis" of the life insurance company's stock for purposes of determining the tax basis of the life insurance company's assets after the deemed sale (and purchase) characterized by section 338?

4. For transactions occurring prior to 1987, is the acquired life insurance company required to recognize income from a decrease in its reserves on the transfer of its insurance and annuity obligations pursuant to a section 338 deemed sale?

2. and 3. The basis of the acquired life insurance company's assets (including "insurance-in-force") must be first determined under the rules of Treas. Reg. section 1.338-2T, and then taken into account for purposes of determining the income and deductions of the old target ("ceding company") and new target ("reinsurer") under the provisions of Treas. Reg. section 1.817-4(d). Because the reserves of the acquired company are relevant for both basis and income determination purposes, we believe that tax, rather than statutory, reserves must be used for both purposes.

4. With respect to any transaction entered into after April 7, 1986 (including an election to treat a stock purchase that is treated as an asset acquisition made prior to the effective date of the 1986 amendments to the corporate liquidation provisions), the Service may take the position that under the provisions of subchapter L, an acquired life insurance company is required to recognize income from a decrease in its reserves on the deemed transfer of its insurance and annuity obligations to a new corporation pursuant to a section 338 election.

[5] Section 338 of the Code generally provides that if a corporation ("purchasing corporation") acquires the stock of another corporation ("target") in a qualified stock purchase, the purchasing corporation may elect (or may be deemed to have elected under certain consistency rules) to have the acquired subsidiary treated as if it had sold all of its assets pursuant to a plan of liquidation at the close of the stock acquisition date. The target corporation is then treated as a new corporation that purchased those same assets on the day following the stock acquisition date.

[6] It is generally recognized that in the life insurance industry, the functional equivalent of an asset acquisition is an assumption reinsurance transaction. Security Industrial Insurance Company v. United States, 702 F.2d 1234, 1237 (5th Cir. 1983) (assumption reinsurance is the insurance industry's functional equivalent of a sale of assets); Beneficial Life Insurance Company v. Commissioner, 79 T.C. 627, 645 (1982) (assumption reinsurance treated as a sale of insurance contracts from the ceding company to the reinsurer).

[7] Because section 338 was enacted to provide parity in the tax treatment of stock acquisitions and asset acquisitions, the results of a section 338 election should parallel the results of a direct asset acquisition.

[8] If a life insurance company had actually purchased the assets and assumed all of the contract liabilities of another insurance company pursuant to an actual sale of that company's entire business, the portion of the transaction representing the assumption of the selling company's insurance liabilities would be subject to the subchapter L rules for assumption reinsurance. Buckeye Union Casualty Company v. Commissioner, 448 F. 2d 228 (6th Cir. 1971), aff'g 54 T.C. 13 (1970). Furthermore, a reinsurance transaction would also be recognized in the case of a business combination of insurance companies that fails to satisfy the subchapter C requirements for nonrecognition as a statutory merger or other reorganization under I.R.C. section 368(a). Jerome Stern et. al. v. Commissioner, 66 T.C. 91 (1976).

[9] In enacting section 338, Congress eliminated the prior-law requirement that a purchasing corporation must actually liquidate the acquired subsidiary in order to obtain a stepped-up basis in the subsidiary's assets. Under section 338(a)(1), the acquired corporation is treated as having sold (and purchased) all of its assets in a single transaction even though this corporation does not terminate its legal existence under state law. Therefore, we attach no significance to the absence of a formal reinsurance agreement as part of the stock acquisition.

[10] Following the deemed sale (and purchase) characterized by section 338(a), the new target is treated for all tax purposes as a new corporation that has acquired all of the assets and assumed all of the liabilities of the old target. If these transactions had actually taken place, the portion of the transaction represented by the transfer of the old target's insurance liabilities would have been effected by means of an assumption reinsurance agreement. ²

Treatment of the Acquired Life Insurance Company's Reserve Liabilities for Purposes of the Section 338 Deemed Sale (Issues 2 and 3)

[11] The second and third issues concern the effect of the acquired life insurance company's reserves for purposes of determining the tax basis of the assets acquired in the section 338 deemed sale and the income and deductions of the old and new target.

[12] This issue actually involves two questions: (1) whether reserve liabilities are taken into account for purposes of determining the "adjusted grossed-up basis" of the acquired life insurance company's stock, i.e., the amount used to determine the basis of the life insurance company's assets immediately following the section 338 deemed sale; and (2) whether statutory or tax reserves are used for basis allocation purposes.

[13] Arguably, if the transfer of the acquired life insurance company's insurance business is treated exclusively under the rules for assumption reinsurance in subchapter L, the transferred reserve liabilities would not enter into the determination of the "adjusted grossed-up basis" of the acquired life insurance company's stock at all. Instead, under the provisions of I.R.C. sections 803 and 805 and section 1.817-4(d) of the regulations, the assumption reinsurance transaction would involve: (i) a reduction of the reserves of the ceding company, (ii) payment of a reinsurance premium by the ceding company and a deduction for such premium paid, (iii) receipt of premium income by the assuming company, (iv) increase in the assuming company's reserves together with a related tax deduction, (v) payment of a ceding commission by the assuming company with a reduction to the reinsurance premium paid by the ceding company, and (vi) amortization of the ceding commission paid by the assuming company over the estimated lives of the policies assumed.

[14] If a purchasing corporation acquires control of a life insurance company and continues to operate that company as a going concern, however, the stock acquisition transaction may involve goodwill and going concern value. The rules for allocating basis for section 338 transactions provide for the recognition of goodwill and going concern value by requiring the purchasing corporation to use a residual method of allocation. Under these rules, basis is allocated successively by category of asset, with more readily valued assets such as cash and marketable securities receiving basis first; any residual remaining after basis is allocated to identifiable tangible and intangible assets is then allocable to goodwill and going concern value. Proposed and temporary section 1.338-2T of the regulations; see also I.R.C. section 1060 and the regulations thereunder, which provide similar allocation rules in the case of certain business acquisitions occurring after May 6, 1986.

[15] To reconcile the provisions of subchapter L with the asset allocation rules for section 338 acquisitions, we believe that the basis of the acquired life insurance company's assets (including "insurance-in-force") must be first determined under the rules of section 1.338-2T of the regulations, and then taken into account for purposes of determining the income and deductions of the old target ("ceding company") and the new target ("reinsurer") under the provisions of section 1.817-4(d) of the regulations. ³

[16] Under this approach, there would still be the potentiality of goodwill, and going concern value arising from the stock acquisition; however, any net value attributable to the acquired life insurance company's policies would be recognized as underwriting income to the ceding company and an amortizable amount by the assuming company under the subchapter L rules for assumption reinsurance.

[17] Because the reserves of the acquired company are relevant for both basis and income determination purposes, we believe that tax reserves must be used for both purposes. Otherwise, if the purchasing corporation is permitted to use statutory reserves for basis allocation purposes and tax reserves to determine the reserve deductions of the new target, a double benefit would result. First, the purchasing corporation would apply the excess of statutory reserves over tax reserves to increase the basis of the new target's assets, such as amortizable insurance-in-force. Secondly, because the new target would determine its deduction for future increases in reserves by reference to the tax reserves of the old target, the excess of statutory over tax reserves at the stock acquisition would be taken into account as a reduction of new target's income by means of greater reserve deductions in later periods. In effect, the excess of statutory reserves over tax reserves could give rise to a double tax benefit -- once, as an increase in the basis of the new target's assets, and again, by means of greater reserve deductions realized by the new target. The use of tax reserves for both basis allocation and income determination purposes would eliminate this potential double benefit.

Application of Assumption Reinsurance Analysis to Pre-1987 Transactions (Issue 4)

[18] The final issue concerns the treatment of section 338 transactions involving insurance companies taking place prior to the revision of the general nonrecognition rules for corporate liquidations effected by the Tax Reform Act of 1986.

[19] In 1986, Congress amended the provisions of I.R.C. section 336 to provide for the recognition of gain or loss to a corporation on the distribution of its property in complete liquidation "as if such property was sold to the distributes at its fair market value." This rule is subject to only limited exceptions and supersedes the so-called General Utilities doctrine, under which distributions in complete liquidation did not trigger a corporate level tax except for limited recapture items such as LIFO inventory and accelerated depreciation.

[20] When section 338 was enacted in 1982, the deemed sale characterized by section 338 was treated as occurring under I.R.C. section 337. Section 337 provided that if a corporation adopted a plan of complete liquidation and distributed all of its assets within a 12-month period beginning on the date of adoption of such plan, any gain or loss from sales or exchanges of property made by the liquidating corporation within this 12-month period were generally not recognized.

[21] In Buckeye Union Casualty Company v. Commissioner, 448 F. 2d 228 (6th Cir. 1971), aff'g 54 T.C. 13 (1970), the Sixth Circuit Court of Appeals concluded that the provisions of section 337 did not shield the ceding commission received by a property and casualty insurance company in a reinsurance transaction that was undertaken as part of a section 337 liquidation. The court reasoned that the ceding commission did not qualify for nonrecognition under section 337 because the income resulted from the elimination of the requirement of maintaining reserves, rather than from a sale or exchange of property.

[22] Despite this court decision, the Internal Revenue Service issued a substantial number of private letter rulings during the 1970's and early 1980's which concluded that gain or income was not recognized by a liquidating insurance company with respect to its insurance reserves pursuant to an I.R.C. section 334(b)(2) liquidation. See, e.g., PLR 8112052 and PLR 8150040. The issuance of private letter rulings with respect to section 334(b)(2) or section 338 liquidations of insurance companies ceased in 1983, when the Service announced that this area was under study.

[23] In Daniel J. Wiles