142 F.3d 973 (7th Cir. 1998), 96-2260, Bankers Life and Cas. Co. v. United States

Docket Nº:96-2260.
Citation:142 F.3d 973
Party Name:BANKERS LIFE AND CASUALTY COMPANY, Plaintiff-Appellant, v. UNITED STATES of America, Defendant-Appellee.
Case Date:April 17, 1998
Court:United States Courts of Appeals, Court of Appeals for the Seventh Circuit

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142 F.3d 973 (7th Cir. 1998)



UNITED STATES of America, Defendant-Appellee.

No. 96-2260.

United States Court of Appeals, Seventh Circuit

April 17, 1998

Argued Feb. 20, 1998.

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Robert F. Forrer, Gary H. Kline (argued), Thomas E. Chomicz, Wilson & McIlvaine, Chicago, IL, for Plaintiff-Appellant.

Gary R. Allen, David I. Pincus, Robert W. Metzler (argued), Dept. of Justice, Tax Division, Appellate Section, Washington, DC, Thomas P. Walsh, Office of the U.S. Attorney, Civil Division, Chicago, IL, for Defendant-Appellee.

Before CUMMINGS, KANNE, and EVANS, Circuit Judges.

TERENCE T. EVANS, Circuit Judge.

Upon first glance, this lawsuit seems overly ambitious. Bankers Life and Casualty Company invites us to invalidate a seemingly straightforward and long-standing Treasury regulation. The insurance company's bold argument makes sense in light of one crucial fact: Bankers Life seeks a tax refund of $71 million plus interest from 1983. In effect, Bankers Life is betting on a long shot. It must know its chances of winning are slim, but the huge potential payoff apparently justifies the effort.

In a nutshell, Bankers Life attacks the validity of Treasury Regulation § 1.815-2(b)(3). The regulation had been on the books for 22 years--since the end of the Eisenhower Administration--at the time it was applied to Bankers Life. The regulation measured the value of a life insurance company's distribution of real property to its shareholders according to market value--rather than adjusted basis--for the purpose of determining whether the distribution triggered a tax on previously untaxed income. The district court, after upholding the validity of the regulation, granted summary judgment in favor of the government, and Bankers Life, on this appeal, asks us to reverse the judgment.

As one might expect in a case involving the interpretation of the tax code and its accompanying regulations, a certain amount of dry exposition is necessary to lay out the controversy. This story begins with the death of John D. MacArthur, the owner of Bankers Life and Casualty, in 1978. MacArthur's death invoked the terms of a trust agreement that transferred ownership of the insurance

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company to the John D. and Catherine T. MacArthur Foundation (a name well-known to public television and radio audiences). In 1983, because of legal limits on the foundation's ability to hold corporate stock, see I.R.C. § 4943(c)(6), the insurance company transferred some of its real estate holdings to the foundation as a distribution to the sole shareholder. Eventually, in 1984, the foundation divested itself of Bankers Life by selling the company to the ICH Corporation. This case focuses on the amount of tax owed by Bankers Life because of the 1983 distribution of real estate assets. The fair market value of these real estate holdings was a whopping $875 million. Their aggregate adjusted tax basis, however, was just under $210 million. The difference between the two valuations results in a $71 million tax differential.

The distribution invoked the arcane rules for taxation of life insurance company income. See United States v. Atlas Life Ins. Co., 381 U.S. 233, 235 n. 2, 85 S.Ct. 1379, 1381 n. 2, 14 L.Ed.2d 358 (1965) (describing the life insurance taxation system); Continental Bankers Life Ins. Co. v. Commissioner, 93 T.C. 52, 60, 1989 WL 75161 (1989) (same). For our purposes, matters are even more obscure because Congress changed these rules in 1984. 1 See Tax Reform Act of 1984, Pub.L. No. 98-369, §§ 211-24, 98 Stat. 494. In any event, under these complex rules, life insurance companies paid taxes in three distinct "phases." Under "Phase I" taxation, an insurance company paid a tax on the lesser of either its gain from investment or its gain from investment and underwriting. See I.R.C. § 802(b)(1). Under "Phase II" taxation, an insurer paid taxes on one-half of the amount by which the gain from underwriting exceeded the gain from investment. See I.R.C. § 802(b)(2). In effect, Phases I and II taxed the insurance company's income--except for the remaining one-half of the gains from underwriting. This remaining income received special deferred taxation--"Phase III" taxation--the general subject of this case. The law required the insurance company to keep a running tally of this Phase III income and to pay a tax on the money when the company issued certain distributions to its shareholders. See I.R.C. § 802(b)(3).

In order to keep track of the Phase III income and determine when it owed taxes on the money, the revenue code required insurance companies to maintain two sets of bookkeeping entries, or, in IRS parlance, "tax return memorandum accounts." The first of these accounts--the "shareholders surplus account" ("SSA")--recorded the amount of accumulated after-tax earnings from Phase I and II income. See I.R.C. § 815(b). The second account-the "policyholders surplus account" ("PSA")-recorded the amount of accumulated Phase III income. See I.R.C. §§ 802(b)(3), 815(c).

The laws allowed an insurance company to distribute its Phase I and II after-tax earnings to its shareholders without consequence. Accordingly, whenever a life insurer issued a distribution, it deducted the amount of the distribution from the SSA without tax consequences. This made complete sense because the company already paid Phase I and II taxes on this money. If, however, the distribution exceeded the amount of money recorded in the SSA, the laws treated the excess amount of the distribution as a transfer of Phase III income and required the insurance company to pay Phase III taxes. Thus, the insurer deducted the excess from the PSA and paid a Phase III tax on this amount. See I.R.C. § 815. 2

To sum up, a life insurance company could have distributed its after-tax earnings (the amount of money in the SSA) without paying any additional tax. But when the company dipped into the previously untaxed earnings (the amount of money in the PSA) to make a

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distribution, it paid the Phase III income tax. In other words, the laws allowed the life insurance company simply to avoid paying taxes on a big chunk of its income until it distributed that income to the shareholders.

Why did life insurance companies receive this unusual treatment? 3 The Senate Finance Committee discussed the matter when it enacted the Life Insurance Company Income Tax Act of 1959 which established the three-phase tax structure. See Pub.L. No. 86-69, 73 Stat. 112. According to the committee report, Phase III taxation addressed the "long-term nature of life insurance contracts" by allowing the company to keep one-half of the annual underwriting gain as "a desirable 'cushion' for special contingencies which may arise." S.Rep. No. 86-291, at 26 (1959). The report explained that underwriting gains may appear as income under an annual tax system when, in fact, these gains merely serve to fulfill life insurance contracts down the road. See id.; see also H.R.Rep. No. 86-34, at 1, 15 (1959). The special deferred tax treatment adjusted for the conflict between a tax code based on annual income and the timetable of the insurance business in which income remains uncertain until actuarial predictions come to life (or death, as the case may be).

Congress reasoned that when a life insurance company made a distribution so large that it dipped into the PSA, then the company no longer needed a big reserve for a rainy day. As the Senate committee explained, "If the insurance company itself decides to distribute these amounts to stockholders, it has demonstrated that this cushion is no longer needed." S. Rep., supra, at 26. Thus, a distribution larger than the SSA triggered the Phase III tax.

So far, we have explained one part of the mechanism the IRS used to calculate Phase III taxes. We still need more information to determine the amount of tax. The missing link is the method for valuing the distribution. To determine the value of a distribution for purposes of Phase III taxation, the IRS relied on a regulation--Treasury Regulation § 1.815-2(b)(3)--developed under its general authority to promulgate necessary rules. See I.R.C. § 7805(a). Before issuing this regulation, the IRS followed full notice and comment procedures. Treasury Regulation § 1.8152(b)(3) provided that certain noncash distributions would be measured by fair market value:

Except in the case of a distribution in cash and as otherwise provided herein, the amount to be charged to the special surplus accounts referred to in subparagraph (1) of this paragraph with respect to any distributions to shareholders (as defined in section 815(a) and paragraph (c) of this section) shall be the fair market value of the property distributed, determined as of the date of distribution. However, for the amount of the adjustment to earnings and profits reflecting such distributions, see section 312 and the regulations thereunder. For a special rule relating to the determination of the amount to be charged to such special surplus accounts in the case of a distribution by a foreign life insurance company carrying on a life insurance business within the United States, see section 819(c)(1) and the regulations thereunder.

If we put some real world numbers to all of this abstract tax talk we can see why Bankers Life has a bone to pick with the IRS. In 1983 Bankers Life had an SSA of $241,014,695 and a PSA of $154,434,319. The real estate assets it distributed to the foundation, as we noted earlier, had a fair market value of over $875 million but an aggregate adjusted basis of only $209,650,747. Pursuant to Treasury Regulation § 1.815-2(b)(3), Bankers Life valued the distribution at fair market value. As a result, the life insurance company...

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