Rev. Rul. 79-260

ISSUE

Are life insurance policies that participate in the surplus of the company only at the end of the second policy year and annually thereafter to be treated as nonparticipating for purposes of the deduction for certain nonparticipating policies under section 809(d)(5) of the Internal Revenue Code during that period?

FACTS

The taxpayer, a life insurance company subject to taxation under section 802 of the Code, is engaged in the business of issuing individual life and annuity insurance contracts on both a participating and nonparticipating basis. The taxpayer's participating contracts provide that at the end of the second and each succeeding policy year, the policies, while in force or being continued as paid-up life or extended insurance under the non-forfeiture provisions of the contracts, shall be credited with a share of the divisible surplus from the participating business as determined and apportioned by the company. The face of each contract states, "the policy is participating and provides for annual dividends." The contract premium established with respect to the class of policies issued by the taxpayer labeled "participating" contains, in addition to the amounts necessary to cover the cost of the insurance and expenses, a redundant charge, that is, an extra amount for contingencies. If this extra amount is not needed and the surplus for contingencies is adequate, the overcharge in the premium will be rebated as policyholder dividends.

LAW AND ANALYSIS

Section 809(d)(5) of the Code provides that, for certain nonparticipating contracts, there shall be allowed a deduction in an amount equal to 10 percent of the increase for the taxable year in the reserves for nonparticipating contracts or (if greater) an amount equal to 3 percent of the premiums for the taxable year (excluding that portion of the premiums which is allocable to annuity features) attributable to nonparticipating contracts (other than group contracts) which are issued or renewed for periods of 5 years or more.

Section 1.809-5(a)(5)(ii) of the Income Tax Regulations defines "nonparticipating contracts" as those contracts which during the taxable year contain no right to participate in the divisible surplus of the company.

The surplus of the life insurance company that issues participating policies is basically divided into two parts: a portion that is set aside for contingencies, and the balance, known as the divisible surplus, that contractually is available as "dividends" to the participating policyholders. Since the divisible surplus arises out of deviations from conservative assumptions on which the premiums are based, the dividends paid to the participating policyholders are not a distribution of earnings but rather the return of the overcharges in the premiums when those excesses are definitely established.

In any given year it is possible that a loss or net decrease in surplus will occur and that some or all of the primary sources of the surplus will be negative. In particular, it is frequently the case that the savings from loading will be negative in the first policy year when the company's expenses will be higher than in renewal years. Thus, newly issued policies generally produce no excess and hence do not contribute to the surplus until the end of the second policy year. It is for this reason that many participating policies state that no dividend will be paid until the end of the second policy year.

A class of policies that has not yet generated any excesses and, therefore, cannot participate in a divisible surplus to which it has not contributed, does not make that class of policies nonparticipating. Neither does the fact that dividends are payable on a deferred basis at the end of a tontine period such as every 5, 10, or 20 years. Because of deliberate overcharges in premiums, such policies generate excesses in which the policyholders have a contractual right to participate, notwithstanding that such participation is on a deferred basis.

Deferred dividend or semi-tontine policies are distinguishable from that class of policies that never had the right to participate in the divisible surplus but that do participate later, through public announcement by the company to the effect that beginning with a certain date, they will have such right. Until then they are, in fact, nonparticipating contracts and the company would be entitled to a deduction under section 809(d)(5) of the Code. Beginning with the period set forth in the announcement, however, they would become participating contracts to which section 809(d)(5) would not apply. This is the situation to which section 1.809-5(a)(5)(ii) of the regulations is addressed. The distinction between the annual and deferred dividend policies, on the one hand, and the nonparticipating changed to participating contracts, on the other hand, is that with respect to the former there is always the right to receive the overcharges built into the premiums on the dividend distribution date, albeit on a delayed basis, but with respect to the latter there is never such a right until the company makes the announcement giving such right to all or to a particular class of its nonparticipating policyholders and becoming contractually liable for distribution to them when management declares the dividend.

HOLDING

Life insurance policies that participate in the divisible surplus of the company only at the end of the second policy year and annually thereafter, may not be treated as nonparticipating policies for purposes of the deduction allowable for certain nonparticipating policies under section 809(d)(5) of the Code.