The taxpayer in the ruling is an accrual-method domestic corporation (X) that conducts a business that is inherently harmful to people and property. X is required by government regulation to remediate that harm. X will incur certain future costs when it ceases to conduct its operations. These costs will be expended to restore its business location to its pre-operational condition. The exact amount and timing of the future remediation costs will depend on several factors. There is, however, no doubt that the remediation costs will be incurred.
X estimated that the present value of future remediation costs was $150 million, based on the relevant factors and use of an appropriate discount rate. X paid an unaffiliated domestic insurance company $150 million. The insurance company agreed to reimburse X for future remediation costs not to exceed $300 million. There were no limits on the duration of the coverage.
Insurance premiums for coverage against casualty, theft, or other similar losses are deductible as an ordinary and necessary business expense under Sec. 162. Accrual-basis taxpayers generally incur and take into account a liability in the tax year in which all the events have occurred that establish the fact of the liability, the amount of the liability can be determined with reasonable accuracy, and economic performance has occurred with respect to the liability (Regs. Sec. 1.461-1(a)(2)). When a liability arises out of payments for insurance, economic performance occurs as the payment is made to the person to whom the liability is owed. When the coverage extends substantially beyond the close of the tax year, the amount taken into account in the payment year is determined in accordance with the capitalization rules under Sec. 263 (Regs. Sec. 1.461-4(g)(8), Example (6); Regs. Sec. 1.263(a)-4(d)(3)(i)).
The ruling concludes that X's payment to the insurance company is not insurance for federal income tax purposes. X therefore cannot deduct the amount it paid as an insurance premium, and the insurance company cannot account for the arrangement as an insurance contract.
The ruling noted that although "insurance" and "insurance contract" are not defined in the Code or regulations, the Supreme Court in Le Gierse, 312 US 531 (1941), held that an agreement must involve risk shifting and risk distribution for it to be treated as insurance for tax purposes. The IRS also cited nontax insurance treatises to further its position in the ruling. It concluded that the agreement lacked the necessary insurance risk to be treated as an insurance contract.
X believed that the future remediation costs attached when it commenced operations. At the beginning of its operations, X believed that it was certain to incur those costs. X was also certain that the insurance company would at some time in the future reimburse X for the remediation costs. The IRS characterized the agreement as X prefunding its future obligations.
Joel E. Ackerman, CPA, MST is with Holtz Rubenstein Reminick LLP, DFK International/USA Melville, NY.
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