Second Circuit Finds No Fixed Liability Existed With Respect to New York Life Policyholder Dividends

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By Robert Willens, Robert Willens LLC

New York Life Insurance Co. (NYL) is a mutual life insurance company; the company issues policies that entitle their holders to receive a “policyholder dividend.”

Because the Internal Revenue Code allows life insurance companies to deduct “an amount equal to the policyholder dividends paid or accrued during the taxable year,” the company deducted the amount of these dividends.1

According to the explicit terms of the policies at issue in a recent Second Circuit Court of Appeals ruling, NYL paid “Annual Dividends” to a policyholder only if:

  • as of the policy's anniversary date, the policy was then in force; and

  • all premiums due had been paid to that anniversary.

The company's practice was to credit a policyholder's account with the amount of the Annual Dividend on a date that was before, but not more than 30 days before, the policy's anniversary date. NYL did not pay the dividend until the anniversary date.

For most policies, the credit date fell within the same calendar year as the anniversary date. For policies with a January anniversary date, however, the credit date and the anniversary date, of necessity, fell in different calendar years.

The company deducted from its gross income for 1990 the Annual Dividends on policies that had credit dates in December 1990 and anniversary dates in January 1991. It followed the same procedure for the years 1991 through 1995.

Certain policies were also eligible to receive an amount the company called a “Termination Dividend.” This was a share of the company's surplus that it paid the policyholder, or beneficiary thereof, upon the policy's termination.

If the terminating event occurred before it credited the policy with the Annual Dividend, the company would pay the Termination Dividend only; if the terminating event occurred after it credited the policy with the Annual Dividend, the company would pay both; and if no terminating event occurred, the company would pay the Annual Dividend only. Therefore, under any scenario, NYL alleges, it paid at least the lesser of the Annual Dividend or the Termination Dividend to these policyholders.

In each December from 1990 through 1995, the company calculated the Annual Dividends and Termination Dividends it expected to pay in the following year to eligible policyholders. The company then determined, on a policy by policy basis, the lesser of the two amounts and claimed the aggregate of those amounts on its tax returns as a deduction for an accrued dividend.

All Events Test

The Internal Revenue Service rejected both deductions, ruling that the company was entitled to deduct these dividends only in the years of actual payment.

A federal district court granted the Service's motion to dismiss the ensuing complaint of the taxpayer. The court concluded that the deductions did not satisfy the “all events” test, a black letter requirement for deduction of an accrued expense. The district court's holding was affirmed by the Second Circuit Court of Appeals in N.Y. Life Ins. Co. v. United States, __F.3d__ (2d Cir.8/1/13).

Regulations Section 1.461-1(a)(2) provides that a liability is incurred and is taken into account in the taxable year in which:

  • all the events have occurred that establish the fact of the liability;

  • the amount of the liability can be determined with reasonable accuracy; and

  • economic performance has occurred with respect to the liability.

Two Supreme Court cases governed the court's analysis of the first prong of the test.

In United States v. Hughes Props., Inc., 476 U.S. 593 (1986), a casino owner claimed a deduction related to its payout obligation on “progressive” slot machines. Nevada law prohibited the casino from reducing the amount of the jackpot payable on such a machine until a winner appeared. The casino owner claimed a deduction each year for the amount by which his liability increased. The Supreme Court concluded that all events had occurred and permitted the deduction. The court held that the effect of the state law was to fix the casino's liability.

In United States v. Gen. Dynamics Corp., 481 U.S. 239 (1987), the company self-insured with respect to its employees' medical coverage. It required its employees to submit a claims form before it would reimburse an employee's expenses. The company sought to deduct the cost of medical services that each employee received in the year at issue, but for which they had yet to submit claims forms. The Supreme Court refused the deduction because filing the claims form was “crucial” to establishing the company's liability. The employee's receipt of medical services did not constitute “the last link in the chain of events creating liability.” If a taxpayer's obligation remains in some way contingent—dependent on some discrete event that has not yet occurred—the deduction will not satisfy the all events test.

Here, the last link in the chain of events creating liability, the policyholder's decision to keep his or her policy in force through the policy's anniversary date, did not occur until January of the following year. NYL was obligated to pay an Annual Dividend only if two conditions held:

  • the policyholder had paid the last premium necessary to keep the policy in force through its anniversary date; and

  • the policy was in force on the anniversary date.

The court took as true that the first condition was satisfied: The company deducted the Annual Dividend only with respect to those January policyholders who had already paid the premiums necessary to keep the policy in force through the anniversary date.

NYL's liability, however, also turned on satisfaction of the second condition. The company was obligated to pay the Annual Dividend only if the policyholder maintained his or her policy in force through its anniversary date. Nowhere does the policy provide that NYL is obligated to pay the Annual Dividend if a policyholder chooses to cash in his or her policy before the anniversary date.

That policyholders who pay their last premium might even be “statistically certain” to keep their policies in force through the anniversary date does not matter. The relevant inquiry is whether the liability was based on any event that had not occurred by the close of the taxable year. That was the case here.

No Contractual Obligation

NYL's practice of comparing the size of the Annual Dividends and Termination Dividends and deducting the lesser amount in the taxable year before payment also fails to satisfy the requirement that all events have occurred to establish the fact of the liability.

NYL was under no contractual, statutory, or other obligation to pay a Termination Dividend when the policyholder surrendered his or her policy. Without such an obligation, the company was not entitled to deduct the minimum liability dividend in advance of payment.

Nowhere do the provisions discussing the company's dividend obligations mention a dividend payable in addition to the cash value otherwise due the policyholder upon surrender of the policy. Nothing in New York state insurance law requires NYL to pay a Termination Dividend upon surrender of a policy.

The company has pointed to no source from which the court might reasonably infer that payment of the Termination Dividend upon surrender was anything other than a voluntary practice. Absent an obligation to pay a dividend when a holder surrendered his or her policy, the court could not say that the fact of the minimum liability dividend was “firmly established” at the time of deduction.

State law may provide the source of an obligation. Alternatively, an obligation might stem from the terms of an express or implied contract. Here, there was no such source. That NYL's board of directors met annually in November and approved the payment during the following year of a Termination Dividend does not cure this defect. A board's resolution cannot, the court observed, convert a voluntary expense into an accrued liability.

NYL argued that an irrevocable board resolution may fix a liability so as to satisfy the all events test. It cited several authorities in support of this proposition. However, the decisions it cites are each inapposite. The deductions there were permitted because, the court found, the company was under an “implied contract” to pay the amounts in question.2

Here, the court “saw no basis for finding a contractual obligation binding NYL to pay a Termination Dividend upon surrender of a policy.” Thus, NYL's complaint was dismissed. The deductions it sought were deferred until the year in which the relevant dividends, both Annual and Termination, were actually paid.

For More Information
Text of the Second Circuit's decision is in TaxCore.

Robert Willens is president of the tax and consulting firm Robert Willens LLC in New York and an adjunct professor of finance at Columbia University Graduate School of Business.

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