President Donald Trump has signed the Tax Reconciliation Act of 2017 (the Act) into law. Tax reform is now a reality. Most of the provisions are effective for years beginning after December 31, 2017. The major provisions affecting insurance companies are summarized below. We’ve also included a discussion of some potential consequences for financial statements prepared under generally accepted accounting principles (GAAP) and statutory accounting principles (SAP).
General C Corporation Provisions
- Corporate Income Tax Rate Reduction – The Act includes a flat corporate income tax rate of 21 percent. The change will be effective January 1, 2018.
- This represents a significant reduction in the federal income tax rate, except for companies with taxable income under $50,000, which were previously taxed at 15 percent.
- Alternative Minimum Tax (AMT) – The Act also includes a repeal of the AMT, coupled with accelerated usage and refunding of existing credits.
- Net Operating Losses (NOL) – NOL carrybacks will no longer be allowed and carryforwards aren’t subject to expiration. NOLs generated after December 31, 2017, can only offset 80 percent of regular taxable income in any given year.
- The 80 percent limitation is intended to ensure all companies with current-year taxable income (pre-NOL) will pay some tax. However, NOLs of property/casualty and other non-life insurers will continue to be governed by existing law (two-year carryback, 20-year carryforward and 100 percent offset of regular taxable income).
- Bonus Depreciation and Section 179 Expensing – 100 percent bonus depreciation is available through 2022 (acquired and placed in service after September 27, 2017) with phased-out bonus depreciation through 2027 and expanded §179 expensing. The Act allows for a $1 million expensing limitation with a phaseout beginning at $2.5 million.
- Companies that haven’t previously taken advantage of bonus depreciation and §179 expensing should consider availing themselves of such accelerated deductions to increase the value of the deductions in 2017 at the 35 percent tax rate.
- Business Interest – Net interest expense in excess of 30 percent of adjusted taxable income is disallowed.
- This provision seemingly would have a limited effect on insurers. However, the classification of “business interest income” in the determination of net interest expense requires clarification.
- Income Inclusion – This change in the timing rule creates uncertainty as income must be included no later than its inclusion in applicable financial statements.
- It’s unclear whether this provision will require insurers to include market discount and accrued dividends in income currently—more to come on this topic.
- Deferred Compensation – Earlier versions of the House and Senate bills included changes to deferred compensation rules. The provisions were removed from the Act.
- Although this is good news for taxpayers, future legislative attacks on deferred compensation plans are likely and careful monitoring of proposed legislation is encouraged.
- §162(m) Compensation Limitation – The Act redefines “covered employee” to match the U.S. Securities and Exchange Commission definition and repeals the performance-based compensation exceptions.
- This provision only affects public companies.
- Dividends Received Deduction (DRD) – The 80 percent DRD (applicable to holdings from 20 percent to less than 80 percent) is reduced to 65 percent, with the 70 percent DRD (applicable to less than 20 percent holdings) reduced to 50 percent.
- The combination of reduced corporate tax rates and DRD percentages keeps the after-tax income from dividends relatively constant.
Non-Life Insurance Company Provisions
- Corporate Income Tax Rate Reduction – A flat corporate income tax rate of 21 percent is effective for tax years beginning after December 31, 2017.
- This provision will reduce current taxes in future years but may result in an immediate reduction in GAAP and SAP deferred tax assets (DTA). On the GAAP side, the reduction generally will increase the effective tax rate and include reductions in DTAs that originally were included in other comprehensive income (OCI). The effect for SAP will be included in surplus in “Change in net deferred income tax” in the change in surplus. Because the Act was signed into law by December 31, 2017, with the change in tax rate effective January 1, 2018, the reduction in DTA will be reported in 2017.
- NOLs – The Act has no change for non-life insurers, retaining the existing two-year carryback and 20-year carryforward with no 80 percent limitation on usage.
- The Act makes paragraph 11.a. of Statement of Statutory Accounting Principles No. 101 (SSAP 101) moot with respect to ordinary DTAs of life insurance companies only, as tax law won’t provide for a carryback. Non-life companies with ordinary DTAs can still look to carryback taxes for admissibility.
- Proration – The Act includes an increase in the proration charge applicable to the DRD and tax-exempt interest from its current level of 15 percent to 25 percent.
- The combination of a 21 percent income tax rate and 25 percent proration percentage keeps the after-tax yield for tax-exempt bonds the same as under existing law. However, the tax rate reduction will enhance the after-tax yield of taxable bonds. It’s uncertain how this narrowing of the yield gap between taxable and tax-exempt securities will affect the investment decisions of non-life insurers and the future borrowing costs of state and local governments.
- Loss Reserve Discounting – Three provisions will lead to a reduced deduction for discounted loss and loss adjustment expense (LAE) reserves. Insurers will no longer be able to use their own experience to discount these reserves and will have to use the IRS’s published factors based on industry experience. The interest rates used in developing those factors generally will be higher and payment patterns longer, which will result in deeper discounts of reserve deductions.
- The reduction in currently deductible loss and LAE reserves will be offset by an increase in the DTA. Combined with SSAP 101’s three-year reversal window, this may result in a greater amount of DTA being nonadmitted.
- §847 Repeal – The Act provides for a repeal of the §847 election.
- Although the repeal of §847 shouldn’t have a net effect on insurers, non-life companies that have taken the deduction should confirm §847 account balances to resolve any differences and avoid surprises.
Life Insurance Company Provisions
- Operations Loss Deductions (OLD) – An OLD is essentially an NOL for a life insurer. OLDs will be treated the same as NOLs for general corporations mentioned above, with no carryback provision, an unlimited carryforward period and an annual limitation of 80 percent on usage.
- The elimination of the NOL/OLD carryback will make the first part of the SSAP 101 admissibility test moot with respect to ordinary DTAs of life insurers, and push more short-term ordinary DTAs into the second part of the test. This could bring into play the surplus limitation and result in smaller admitted DTAs.
- Small Life Insurance Company Deduction (SLICD) – The small life insurance company deduction is repealed under the Act.
- The loss of the SLICD is a blow to small life insurers. However, most of these companies have paid the AMT and have AMT credits that may have never been used under pre-Act law. The ability to finally monetize these credits with the repeal of the AMT may somewhat ameliorate the loss of the SLICD.
- Deferred Acquisition Costs (DAC) – The Act makes changes to DAC rules with expanded capitalization (2.09 percent for annuities, 2.45 percent for group life and 9.2 percent for other specified contracts) and extended amortization (the 60-month amortization remains but the 120-month amortization is increased to 180 months).
- The 180-month amortization period is a welcome change from the originally proposed 600-month period in an earlier version of the Senate bill.
- Company Share/Policyholder Share – The Act standardizes the company share and policyholder share percentages at 70 percent and 30 percent, respectively.
- The company/policyholder share percentage determines the extent of the tax benefit of tax-exempt interest and the DRD for life insurers. The calculation under pre-Act law is complicated and results in percentages unique to each company and tax year. The Act’s changes will make after-tax yields more predictable and actually may be beneficial to companies with company share percentages consistently below 70 percent under existing law.
- Computation of Life Insurance Reserves – The Act limits life reserves for tax purposes to the greater of net surrender value or 92.81 percent of National Association of Insurance Commissioners’ required reserves.
- Reserve Strengthening/Weakening – The Act also includes provisions to align §807(f) reserve strengthening and weakening with §481 accounting method changes.
- This will change the reserves strengthening/weakening from a 10-year period of inclusion to a four-year period of inclusion for unfavorable changes and a one-year period of inclusion for favorable changes.
- Policyholder Surplus Account (PSA) – Companies with existing PSA balances will be required to bring those amounts into taxable income over an eight-year period.
- The ability to amortize this balance into taxable income over eight years at a lower tax rate may somewhat ease the pain for the few companies that have a PSA account balance, the tax on which they likely hoped to defer indefinitely.
From a planning perspective, companies should look for opportunities to accelerate deductions into higher tax rate years and defer income into lower tax rate years.
Opportunities worthy of consideration include:
- Guaranteeing policyholder dividends to ensure deductibility in year of accrual
- Adopting a tax accounting method change to deduct certain prepaid expenses
- Making payroll liabilities fixed and determinable at year-end
- Funding of qualified plan liabilities
- Conducting a cost segregation study on existing real property
- Using bonus depreciation and §179 expensing
BKD will strive to keep you updated on the status of tax reform legislation over the next few weeks. If you have any questions, please contact Tom Wheeland, Brandy Shy, Susan Kelley or Kara Cramer—all members of our insurance tax team.