Tax Return Basics for Insurance Companies: Reviewing Your 1120-L or 1120-PC

Tax Return Basics for Insurance Companies: Reviewing Your 1120-L or 1120-PC

January 27, 2025

Your tax advisor sent you a draft of your insurance company’s tax return to review. You have the company’s internal financial statements and the NAIC annual statement, both of which you understand very well. But the information presented on the tax return looks different. How do you make sense of the tax information, and what are some key items to look for?

It might help to have a basic understanding of how the IRS views insurance companies for tax purposes. You also need to know that when calculating taxable income, certain insurance related items are treated differently than they are for financial reporting purposes. You also need to make sure the amounts paid to the IRS are correct.

IRS Definition of an Insurance Company

To be treated as an insurance company for federal income tax purposes, more than half of a company’s business must be the issuance or reinsurance of insurance-type contracts. Once that is established, if more than 50% of a company’s total reserves are life insurance reserves, the company will be treated as a life insurance company and will file Form 1120-L. The IRS considers all other insurance companies “nonlife” insurance companies and requires them to file Form 1120-PC, regardless of the type of coverage provided.

In computing taxable income, the starting point for any insurance company is statutory income, which then gets adjusted for some specific differences between financial and tax reporting. Thus, the figures reported in the annual statement are the starting point and will be helpful to reference.

When making the book-to-tax adjustments, it is fundamental to understand that statutory accounting is very conservative. Insurance department regulators watch out for policyholders and are concerned about an insurance company’s solvency and ability to cover claims. This means statutory accounting principles lead to recognizing less income and larger deductions that generally result in lower net income relative to taxable income. Subchapter L of the Internal Revenue Code, which governs the taxation of insurance companies, is designed to unwind that conservatism. This results in accelerating recognition of income and deferring deductions. It is important to keep in mind that these are timing differences. For example, over the life of any policy, the amount of premium income reported on the financial statements will equal the amount of taxable premium, even though it will be recognized in different periods.

Book vs. Tax Treatment

Some of the key adjustments from book income to taxable income affect premium income, the deduction for losses, and deferred acquisition costs. For both life insurance and nonlife insurance companies, arriving at taxable premiums requires an adjustment from a balance sheet approach. Life insurance premiums must be adjusted by subtracting the change in premiums due and deferred, adding the change in loading, and adding the change in advanced premiums. These adjustments effectively make taxable premiums reflect something closer to the premiums collected during the year. Premiums from nonlife insurance products are adjusted for what is referred to as the “20% haircut”. Starting with net written premiums, a nonlife insurance company must add 80% of the prior year unearned premium reserve and subtract 80% of the current year unearned premium reserve.

The deduction for losses is discounted for tax purposes. The internal revenue code typically does not allow taxpayers to deduct estimates. Total losses deducted when computing statutory income include an estimate for incurred but not reported (IBNR) losses. Because this is the nature of the business, the IRS allows insurance company taxpayers to deduct losses but requires those losses to be discounted. Discount rates for property and casualty lines of business are issued annually by the IRS, while the discount for life insurance reserves is actuarially determined.

The last major departure from statutory income is the deduction for deferred acquisition costs (DAC). Life insurance companies calculate what is referred to as a proxy tax DAC, which is based on the level of premiums written and the type of product. The resulting amount is capitalized and amortized over 60 or 180 months. Insurance companies that sell only nonlife products are not required to capitalize deferred acquisition costs for tax purposes but rather deduct them currently.

Insurance companies will typically invest their premium income to match the duration of the coverage provided. For tax purposes there are some differences between what gets recorded as investment income and what investment income is taxed. Except for interest income from certain tax-exempt investments, interest income on the annual statement will often be equivalent to taxable interest income. For dividends, however, taxpayers are taxed on dividends received rather than earned. Corporate taxpayers can receive a “dividends received deduction” (DRD) for dividends from domestic corporations, so long as the equity held meets specific holding period requirements. When the company disposes of certain investments, the calculation of the gain or loss is the same for financial statement and tax purposes. However, a taxpayer can only use capital losses to the extent they offset capital gains. Thus, a net capital loss reported one year can be carried backward three years and forward five years to offset the capital gains reported in a different taxable period. Lastly, investments in partnerships or LLCs often mean cash distributions for the insurance company. Cash distributions do not equal taxable income. For these types of investments, taxpayers will receive a Schedule K-1 indicating the amount and character of any taxable income.

Tax Deposits

A couple of final things that are important to verify on your tax return relate to estimated tax payments and penalties. It is possible that your tax preparer and you do not have the same records of payments you have made to the IRS for a certain tax period. The front page of your tax return reports the amount of estimated tax deposits and extension payments. You will need to compare these amounts to your records. Additionally, if your tax return shows a penalty for underpayment of estimated taxes, it is possible that penalty could be reduced by using the annualized income installment method. Using this method requires completing Form 2220. If you see that the underpayment of estimated tax penalty applies, check with your tax preparer to make sure they have the necessary information to compute quarterly taxable income to determine whether the penalty can be reduced. Quarterly payments are due April 15, June 15, September 15, and December 15. Making sufficient quarterly estimated payments will help avoid the penalty all together.

Because the taxpayer is ultimately responsible for tax filings, it is important to understand what is reported on your insurance company’s tax return. Remember that taxable income begins with statutory income, but that premiums, losses, and deferred acquisition costs are among some of the primary elements of net income that are treated differently on your tax return than on your annual statement. Also realize that net investment income on the books will be different than taxable investment income. And finally, take the time to go over your tax payment history to make sure the tax return captures what you have already paid to the IRS. When you have questions, your tax preparer would love to discuss them with you!  Larson and Company has developed a suite of services specifically to serve the needs of companies of all sizes in a wide range of industries.