By Craig Swindelhurst, CPA, Tax Manager
Under the Tax Cuts and Jobs Act (“TCJA”), insurance companies are required to change the way they calculate their tax reserves. This change is applicable to both life and non-life insurance companies and will affect tax returns beginning with tax year 2018.
Non-Life Insurance Companies
On December 19, 2018 the IRS issued Rev. Proc. 2019-06, which contains the unpaid loss discount factors and salvage discount factors (the “discount factors”) for the 2018 accident year. Under the TCJA the way these discount factors are computed has changed, with the Treasury now using a corporate bond yield curve rather than the applicable federal mid-term rates to compute the discount factors.
All non-life insurance companies are required to recalculate their 2017 tax reserves using the new discount factors found in Rev. Proc. 2019-06 and compare the recalculated 2017 tax reserves to the amount computed in the prior year. The resulting difference is a transition adjustment which is required to be brought into taxable income over eight years beginning with tax year 2018. Because the corporate bond yield curve is higher than the applicable federal mid-term rates used in the past, this transition adjustment will be unfavorable for the vast majority of non-life insurance companies.
Life Insurance Companies
Under the TCJA, the general rule for calculating life tax reserves is the greater of the contract’s net surrender value (if any) or 92.81% of the statutory reserves. Life tax reserves for variable contracts is the greater of the contract’s net surrender value (if any) or the separate account reserve amount under IRC section 817 plus 92.81% of the excess of the amount determined using the NAIC reserve method. Similar to non-life insurance companies, the recalculation is performed on the 2017 tax reserves and compared to the tax reserves computed in the prior year. This resulting difference is our transition adjustment and is brought into income over eight years beginning with tax year 2018.
Example
For example, consider an insurance company with computed tax reserves of $10,000,000 reported on their 2017 tax return. If the recalculation of the tax reserves using the rules found in the TCJA resulted in $9,000,000 of tax reserves, the company would have a transition adjustment of $1,000,000. This transition adjustment will be taken into account ratably over eight years beginning in tax year 2018, resulting in an increase to taxable income of $125,000 each year.
As a result of the transition adjustment, there will be some changes required to the financial statements and tax return presentation as noted below.
Financial Statement Adjustments
(1) The beginning deferred tax asset (“DTA”) balance related to tax reserves should be adjusted to reflect the transition adjustment. In the above example, the company’s beginning gross DTA would increase by $1 million due to the higher book reserve to tax reserve difference. If a 21% tax rate is used, the tax-effected amount would be $210,000.
(2) Conversely, a deferred tax liability (“DTL”) is also recorded for the 8-year transition adjustment with 1/8 being reversed in tax year 2018 and the seven succeeding taxable years. In the above example, a DTL would be set up for the $1 million transition adjustment with $125,000 being reversed in tax year 2018 and each of the subsequent seven tax years. If a 21% tax rate is used, the tax-effected DTL amount would be $210,000, with $26,250 affecting tax expense on an annual basis over 8 years.
Tax Return Presentation (non-life)
(1) The amount of the recomputed 2017 tax reserves should be reported on Schedule F, line 4b. This amount will not tie to the prior year Schedule F, line 2b as it normally would. In the above example, $9,000,000 would be reported on the 2018 Form 1120-PC, Schedule F, line 4b.
(2) The 1/8 portion of the transition adjustment to be included in taxable income in the current year should be included in “Other Income” on Schedule A, line 13. In the above example, $125,000 would be included in “Other Income” on Schedule A, line 13.
Tax Return Presentation (life)
(1) The amount of the recomputed 2017 tax reserves should be reported on Schedule F, lines 1-6 column (a). This amount will not tie to the prior year Schedule F as it normally would. In the above example, $9,000,000 would be reported on the appropriate line, depending on the type of life reserve, on the 2018 Form 1120-L, Schedule F, lines 1-6.
(2) The 1/8 portion of the transition adjustment to be included in taxable income in the current year should be included in “Other Income” on Form 1120-L, line 7. In the above example, $125,000 would be included in “Other Income” on Form 1120-L, line 7.
For more information on tax reserve changes, the transition adjustment, Rev. Proc. 2019-06, or other changes to insurance company taxation brought about by the TCJA, please contact the tax professionals at Larson & Company.
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