Rev. Proc. 78-6

Section 1. Purpose.

The purpose of this Revenue Procedure is to provide a procedure whereby life insurance companies may request permission to change their method of accounting as a result of the decision of the Supreme Court of the United States in Commissioner v. Standard Life & Accident Insurance Co., 433 U.S. 148 (1977), Ct. D. 1986, 1977-2 C.B. 230. For convenience, this Procedure treats the year 1977 as the year of change. The purpose, however, because of the unique circumstances set forth below, is also to have the Procedure apply to the first open taxable year of a series of taxable years that a company qualified as a life insurance company under section 801(a) of the Internal Revenue Code of 1954. See section 6.02 of this Revenue Procedure.

Section 2. Background.

In the Standard Life & Accident case, the Supreme Court held that only the "net valuation" portion of deferred and uncollected life insurance premiums (the portion that a life insurance company is required to add to its reserves) but not the "loading" portion (the portion used for commissions, overhead, and profit) is required to be included in a life insurance company's gross premiums under section 809(c)(1) of the Code and assets under section 805(b)(4) for purposes of computing its Federal income tax liability. The Court also held that no deduction is allowable for commissions and state premium taxes until properly accruable.

Although June 29, 1977 was the last day that Form 3115 (Application for Change in Accounting Method) could be timely filed for the taxable year ending December 31, 1977 under section 1.446-1(e) of the Income Tax Regulations, the Internal Revenue Service extended the time for filing the Form 3115 by a series of News Releases (IR-1851, IR-1888, and IR-1955) and is further extending the time for filing, as set forth in sections 3.01 and 7 of this Revenue Procedure.

Section 802(b) of the Code states that the term "life insurance company taxable income" means the sum of:

(1) the taxable investment income (as defined in section 804) or, if smaller, the gain from operations (as defined in section 809),

(2) if the gain from operations exceeds the taxable investment income, an amount equal to fifty percent (50%) of such excess, plus

(3) the amount subtracted from the policyholders' surplus account for the taxable year, as determined under section 815.

Section 1.802-4 of the regulations indicates that if for any taxable year there is a loss from operations (as defined in section 809(b)(2) of the Code), the amount taken into account under section 802(b)(1) and (2) shall be zero. However, even in such case, there may still be an amount includible in life insurance company taxable income (and hence subject to tax) by reason of an amount includible under section 802(b)(3).

Section 3. Application.

.01 A life insurance company desiring to change its method of accounting for the taxable year 1977 to the method approved in the Standard Life & Accident case may do so by filing an application on Form 3115, in duplicate, with the Commissioner of Internal Revenue, Attention T:C:C:1, 1111 Constitution Avenue, N.W., Washington, D.C. 20224, on or before May 15, 1978. Reference to this Revenue Procedure should be made a part of the application.

.02 There is an adjustment required to prevent amounts from being duplicated or omitted within the meaning of section 481 of the Code when making the change in method of accounting permitted in the Standard Life & Accident case. This adjustment is computed as follows:

Determine that portion of the gross amount of premiums included under section 809(c)(1) of the Code for 1977 as a result of the Standard Life & Accident case that was also included under section 809(c)(1) for 1976. Reduce this amount by the loading portion of deferred and uncollected premiums as of January 1, 1958. This reduction is necessary to prevent a double omission of an item of income. The amount resulting from the reduction referred to above in this paragraph, as well as those other adjustments which are necessary by reason of the change in method in order to prevent amounts from being duplicated or omitted, will be taken into account as an offset against premiums as determined under section 809(c)(1) (if negative) or as an addition to premiums as determined under section 809(c)(1) (if positive). Such offset or addition as the case may be will be taken into account ratably over a period of taxable years equal to the number of taxable years the company used the method of accounting for deferred and uncollected premiums other than the method approved in Standard Life & Accident. This period may not exceed 10 taxable years. In making the calculation of the net adjustment, a life insurance company's consideration should include the effect the Standard Life & Accident case has on the determination of the "gross amount of premiums" under section 809(c)(1) and any miscellaneous deductions which might have been claimed under section 809 for "increase in loading." The net adjustment is being applied to premiums for computational purposes since in that manner any duplications or omissions that would otherwise have resulted from deductions under sections 809(d)(3), (d)(5) and (d)(6) will be automatically corrected. Although a change in "assets" is part of the change in method of accounting, no adjustment under section 481 arises in determining "taxable investment income" under section 804. Also, no adjustment under section 481 arises in determining that portion of life insurance company taxable income includible under section 802(b)(3).

.03 Commencing with the year of change and for all subsequent taxable years the life insurance company will determine the "policy and other contract liability requirements" under section 805 of the Code by including in "assets" at the beginning and end of the taxable year only the "net valuation" portion of the deferred and uncollected premiums in determining both the current earnings rate and the average earnings rate. In determining the average earnings rate for the year of change, the current earnings rate for the year of change and the preceding 4 years (excluding any years for which the company was not an insurance company) will be computed by including in the beginning and ending "assets" only the net valuation portion of the deferred and uncollected premiums. (The policy and other contract liability requirements is divided by the company's investment yield to determine what portion of each and every item of investment yield is includible in taxable investment income under section 804.)

.04 Commencing with the year of change and for all subsequent taxable years, the life insurance company will make the necessary corrections to the balances of its policyholders and its shareholders surplus accounts each year. If, as a result of such corrections, there is in any year an additional amount to be included in the life insurance company's taxable income (LICTI) under section 802(b)(3) of the Code, such additional amount shall be included in LICTI for that particular year.

Section 4. Example.

This section illustrates the adjustment that is required under section 3.02 of this Revenue Procedure in order for a life insurance company to make the change in method of accounting and the manner for taking the adjustment into account during the appropriate spread period.

Assume that for 1977, prior to applying the adjustment required by section 3.02 of this Revenue Procedure, that taxable investment income with assets determined under section 3.03 of this Revenue Procedure is $10,000,000. Premiums under section 809(c)(1) computed in accordance with Standard Life & Accident are $100,000,000. Death Benefits, etc., deductible under section 809(d)(1) are $30,000,000 and the amount deductible under section 809(d)(2) for the net increase in reserves is $50,000,000. The amount of dividends to policyholders computed in accordance with section 811(b) is $30,250,000. Assume further for purposes of this example that the company had a tentative deduction for 1977 under section 809(d)(6) of $38,000. After subtracting the loading portion of the deferred and uncollected premiums as of January 1, 1958, the net adjustment as of January 1, 1977 is a negative $15,000,000. Such adjustment is taken into account ratably as an offset against premiums determined under section 809(c)(1) over 10 taxable years in accordance with section 3.02 of this Revenue Procedure. Application of the net adjustment is as follows:

                 Computation of Gain From Operations

   Computation of Portion of Life Insurance Company Taxable Income

In filing its application a life insurance company must state in its application:

(1) the amount of the net adjustment computed under section 3.02 of this Revenue Procedure and whether such net adjustment is negative or positive.

(2) the scope of any timely filed claims for refund that are pending for taxable years beginning before 1977 and are relied upon in requesting a retroactive change in method of accounting under section 6.02 below. A copy of any such claims for refund must be attached to the company's application.

(3) that commencing with the year of change and for all subsequent taxable years "the gross amount of premiums" under section 809(c)(1) of the Code and "assets" as defined under section 805(b)(4) will be determined in accordance with the Supreme Court's opinion in Standard Life & Accident.

(4) that it will include a ratable portion of the net adjustment computed under section 3.02 of the Revenue Procedure as an offset to premiums determined under section 809(c)(1) (if negative) or as an addition to premiums determined under section 809(c)(1) (if positive) over each of the appropriate succeeding consecutive taxable years commencing with the year of change.

(5) that commencing with the year of change and for all subsequent taxable years, it will make the necessary corrections to the balances of its "shareholders surplus account" and "policyholders surplus account" and report any additional income that results from such corrections in the manner explained in section 3.04 of this Revenue Procedure.

(6) that commencing with the year of change and for all subsequent taxable years it will determine the "policy and other contract liability requirements" under section 805 of the Code by including in "assets" only the "net valuation" portion of the deferred and uncollected premiums in determining both the current earnings rate and the average earnings rate.

(7) that commencing with the year of change and all subsequent taxable years any tentative deductions under section 809(d)(5) of the Code (relating to 3 percent of premiums on certain nonparticipating contracts) and under section 809(d)(6) (relating to 2 percent of premiums on certain accident and health insurance and group life insurance contracts) will not be based on the "loading" portion of any unpaid premiums.

(8) that commencing with the year of change and all subsequent taxable years no "miscellaneous deductions" will be claimed under section 809 of the Code for "increase in loading."

(9) that it qualified as a life insurance company within the meaning of section 801(a) for all taxable years commencing with the year of change.

(10) that the year of change and all the succeeding taxable years, to which the net adjustment under section 3.02 will be taken into account ratably, are not barred by law or rule of law at the time the company's application for change in method of accounting is filed.

(11) that it agrees the above conditions (1) through (10) are subject to verification by the District Director or the Appellate Branch Office.

The above conditions are imposed under section 1.446-1(e)(3) of the regulations.

Section 6. Claims For Refund and Cases Pending in District Directors and Appellate Branch Offices Including Those Involving Net Positive Section 481 Adjustments.

.01 The Government's position as argued in the Standard Life & Accident case was that under the formula provided by the statutes, the entire amount of unpaid life insurance premiums, including the "loading" portion, should be included in "gross amount of premiums" under section 809(c)(1) of the Code and in "assets" under section 805(b)(4) since the life insurance reserves are calculated on the fictional assumption that the entire unpaid premiums have been paid. No argument was advanced by the Government that this treatment of deferred and uncollected premiums was an accounting problem.

The Supreme Court, in its option, started from the premise that unpaid premiums must be reflected in life insurance reserves as this has been the consistent and unbroken practice since the inception of the Federal income tax on life insurance companies in 1913. From this premise, it was stated that the difficult question evolves as to how far to apply this fictional assumption. The Court stated that since this is essentially an accounting problem the question is governed by section 818 of the Code (relating to accounting provisions applicable to life insurance companies) and under that section only the net valuation portion of the unpaid premiums is included in gross amount of premiums and assets as well as reserves, while the loading portion is entirely excluded.

Section 818 of the Code and the regulations thereunder, with certain exceptions not here applicable, look to the accounting provisions (section 446 and sequence) for operating rules relating to methods of accounting.

.02 The life insurance industry contested the position of the Service beginning with the hearings on the proposed regulations. This opposition was continued in a series of cases, involving almost constant litigation, initially resulting in favorable decisions for the Government in four Courts of Appeals. Most life insurance companies protected their interests by filing claims for refund since the Service, under the regulations implementing sections 801-820 of the Code, would have denied requests from life insurance companies to change their method of accounting to the method subsequently approved by the Supreme Court in Standard Life & Accident. Members of the life insurance industry, therefore, now find themselves in varying postures of open and closed years due to the 19 year litigation history. In view of the extraordinary circumstances, set forth above, those life insurance companies that took action to protect their rights by filing refund claims will be permitted, within the proper scope of those claims, to change retroactively their method of accounting so as to promote a fair and equitable solution to this unique problem.

This change in method of accounting may be made for the first open taxable year of a series of consecutive open taxable years ending with 1977 in which the company qualified as a life insurance company under section 801(a) of the Code. For purposes of this section (6.02), "open taxable year" means open because the statute of limitations has not yet expired or by virtue of a timely filed claim for refund. Sections 3, 4, and 5 of this Revenue Procedure are applicable to such change in accounting for purposes of computing the amount of the net adjustment, the manner for taking the net adjustment into account during the appropriate "spread period", and the representations required to be filed with its application. Companies desiring to make a retroactive change in method of accounting under this section (6.02), must file a Form 3115 by the extended date as set forth in section 7 of this Revenue Procedure and request permission to change its method of accounting in accordance with section 5 hereof, with a copy to the appropriate District Director or Appellate Branch Office. For those companies whose taxable years before 1977 are open by virtue of claims for refund and who apply for a retroactive change in method of accounting under this section (6.02), the amount of the net adjustment will be computed in accordance with the scope of the claims for refund.

.03 The Service will honor claims for refund in those cases in which such claims for each taxable year commencing with 1958, or commencing with the first taxable year in which a company qualified as a life insurance company under section 801(a) of the Code and is subject to the tax imposed by section 802(a), are not precluded by any law or rule of law. Claims for refund for each such taxable year will be allowed in accordance with the decision of the Supreme Court of the United States in Standard Life & Accident. In such cases a life insurance company must submit to the appropriate office or personnel of the Service (District Director or Appellate Branch Office) considering the life insurance company's claims for refund, a detailed recomputation of LICTI for each taxable year commencing with 1958 (or commencing with a subsequent year in which it first qualified as a life insurance company). In making its recomputation of LICTI, the company must take into account the scope of its claims for refund. In the event the company has protected itself via claims for refund under both sections 804 and 809, the items to be taken into account include (but are not necessarily limited to) the effect the Standard Life & Accident case has on the determination of: (a) the "policy and other contract liability requirement" under section 805 by including in "assets" only the "net valuation" portion of the deferred and uncollected premiums, (b) "gross amount of premiums" under section 809(c)(1), (c) deductions claimed under sections 809(d)(3), 809(d)(5) and (6), and (d) any "miscellaneous deductions" which might have been claimed under section 809 for increase in loading. In processing the claims for refund, the Service will take into account appropriate "offsets" to the amounts of the claims, such as additional income under section 802(b)(3).

.04 In those instances in which the adjustment is positive, the company may request the application of this Revenue Procedure within the period set forth in section 7 of this Revenue Procedure. The provisions of Rev. Proc. 70-27, 1970-2 C.B. 509, as clarified by Rev. Proc. 75-18, 1975-1 C.B. 687, will normally be applied to determine the year of change. However, in the case of any taxpayer for which the Service for any prior taxable year proposed a positive adjustment to the company's treatment of deferred and uncollected premiums, and where such adjustment included an item involved in the net positive adjustment resulting from the proposed change to the method approved in the Standard Life & Accident case, the Commissioner will exercise his authority under section 1.446-1(e)(3)(ii) of the regulations to apply this Revenue Procedure to establish as the year of change the earliest taxable year that is not barred by any law or rule of law. In such case, the taxpayer will be granted for such net adjustment the spread period provided in section 3.02 above. If the company does not timely request the application of this procedure as provided in section 7, the Service upon examination of the company's returns, will change the company's method of accounting under section 481 for the first open taxable year that is then not barred by any law or rule of law without applying the provisions of this Revenue Procedure or of Rev. Proc. 70-27, and no spread of the section 481 adjustment will be permitted.

.05 Pending completion of action by the National Office on the request for application for change in method of accounting under this Revenue Procedure, the District Director (or Appellate Branch Office) will suspend action on this particular issue. Upon issuance of the grant letter by the National Office to the company (copy of which is forwarded to the District Director) the District Director or Appellate Branch Office will verify those items in section 5 of this Revenue Procedure that such office deems appropriate.

Section 7. Effect on Other Documents.

The time for filing Form 3115 for the year of change has been extended to May 15, 1978.

Section 8. Approval of Change.

If a life insurance company requesting permission to change its method of accounting for 1977 has not received its grant letter from the National Office on or before the due date of its return for 1977 (including extensions), it may assume that the permission will be granted, subject, however, to the Service's later determination that the requirements of this Revenue Procedure have been met.

Section 9. Inquiries.

Inquiries in regard to this Revenue Procedure should refer to its number and be addressed to the Commissioner of Internal Revenue, Attention T:C:C:1, 1111 Constitution Avenue, N.W., Washington, D.C. 20224.

¹ This publication of Rev. Proc. 78-6 is a restatement containing revisions to Rev. Proc. 78-6 published in 1978-6 I.R.B. 15 and is republished in lieu of the prior version. Also released as News Release IR-1976, dated March 29, 1978.