Opinion ID: 415638
Heading Depth: 1
Heading Rank: 3

Heading: deep background: the codal underpinnings

Text: 25 Code sections 801-820 govern the income tax treatment of life insurance companies. 5 In enacting these special provisions, Congress recognized that life insurance companies have two potential sources of income: investment income and underwriting income. See S.Rep. No. 291, 86th Cong., 1st Sess., reprinted in 1959 U.S.Code Cong. & Ad.News 1575, 1576, 1581. When a life insurance company derives a profit from its investment of premiums and reserves, it reaps investment income. By contrast, underwriting income results when the premiums collected by a life insurance company exceed benefits paid and expenses incurred. 6 26 Section 802(a) imposes a tax on the life insurance company taxable income of every life insurance company; section 802(b) defines life insurance company taxable income in terms of investment income and underwriting income. To paraphrase the cryptic and convoluted Codal parlance, life insurance company taxable income generally includes the sum of a life insurance company's taxable investment income and fifty percent of its underwriting income. I.R.C. Sec. 802(b)(1), (2). The other fifty percent of the company's underwriting income is placed in a policyholders surplus account, see id. Sec. 815(c), and is included in life insurance company taxable income only if it is distributed to the company's shareholders. Id. Sec. 802(b)(3). 7 27 Thus the Code permits a life insurance company to accumulate fifty percent of its annual underwriting income in a policyholders surplus account, which is not taxed on a current basis. By allowing this special exclusion from life insurance company taxable income, Congress provided life insurance companies with a cushion to cover any special contingencies that might arise. S.Rep. No. 291, 86th Cong., 1st Sess., reprinted in 1959 U.S.Code Cong. & Ad.News 1575, 1601. Congress concluded, however, that a distribution to shareholders from the policyholders surplus account represents a determination by the life insurance company that the cushion is not needed. Id. Consequently, the Code requires that amounts distributed out of the policyholders surplus account must be included in life insurance company taxable income for the year of distribution. I.R.C. Sec. 802(b)(3). 28 The tax deferral possibilities inherent in the concept of policyholders surplus accounts prompted Congress to enact some additional statutory provisions designed to forestall abuse. Section 815(d)(4) limits the amounts that may be maintained in the policyholders surplus account. In addition, section 815(d)(2) generally provides that when a life insurance company terminates its operations, it must include in income for its last taxable year the amounts contained in its policyholders surplus account. Thus the tax shelter potential of these surplus accounts is not untrammeled. 29 In the context of this case, we focus our attention on the deferral termination mechanism of section 815(d)(2)(A). 8 This section provides that, except as provided in section 381(c)(22) relating to carryovers in certain corporate readjustments, a life insurance company that is not an insurance company for any taxable year must include in its life insurance company taxable income for the last preceding taxable year the amount remaining in its policyholders surplus account. For example, a life insurance company that was not an insurance company for the taxable year 1982 must include in its 1981 life insurance company taxable income the remaining balance in its policyholders surplus account, assuming section 381(c)(22) does not apply. 30 If section 381(c)(22) does apply, however, it supersedes the section 815(d)(2) requirement that policyholders surplus accounts be included in taxable income. Section 381 governs the carryover of tax attributes in connection with certain corporate acquisitions. Section 381(a) provides as follows: 31 (a) General rule.--In the case of the acquisition of assets of a corporation by another corporation-- 32 (1) in a distribution to such other corporation to which section 332 (relating to liquidations of subsidiaries) applies, except in a case in which the basis of the assets distributed is determined under section 334(b)(2); or 33 (2) in a transfer to which section 361 (relating to nonrecognition of gain or loss to corporations) applies, but only if the transfer is in connection with a reorganization described in subparagraph (A), (C), (D), (F), or (G) of section 368(a)(1), 34 the acquiring corporation shall succeed to and take into account, as of the close of the day of distribution or transfer, the items described in subsection (c) of the distributor or transferor corporation, subject to the conditions and limitations specified in subsections (b) and (c). 35 Section 381(c)(22) permits an acquiring corporation that is a life insurance company to succeed to various tax attributes of an acquired life insurance company, including the acquired corporation's policyholders surplus account. See Treas.Reg. Sec. 1.381(c)(22)-1(a), (b)(7)(i). When sections 381(a) and 381(c)(22) are read together with section 815(b)(2)(A), they provide that when a life insurance company ceases to be an insurance company by virtue of either a section 332 liquidation to which section 334(b)(2) does not apply or a corporate reorganization described in section 368(a)(1)(A), (C), (D), (F), or (G), its policyholders surplus account may be carried over to its successor without adverse tax consequences to either corporation. 36 In the instant case, Southern and Standard at some point terminated their activities as insurance companies. Under the general rule of section 815(b)(2)(A), each company is required to include the balance remaining in its policyholders surplus account in its taxable income for the taxable year preceding its termination. This general rule does not apply, however, if the terminations of Southern and Standard fulfill the requirements of section 381(a). Thus, if the Southern and Standard acquisitions were section 332 complete liquidations to which section 334(b)(2) would not apply or corporate reorganizations described in section 368(a)(1)(A), (C), (D), (F), or (G), Security (as successor to Southern and Standard) may carry over the policyholders surplus accounts, and no tax may be imposed on Southern, Standard, or Security. 37 Security's entitlement to a refund in this case thus hinges upon the application of section 381(a). The district court held that the Southern and Standard transactions were F reorganizations and allowed the tax-free carryover of their policyholders surplus accounts to Security. On this appeal, the government contends that the district court erred in determining that F reorganizations had occurred. Additionally, the government urges that Security fails to satisfy the alternative requirement of section 381(a) because the Southern and Standard acquisitions were complete liquidations to which section 334(b)(2) does apply. We now turn to an appraisal of these positions.