Searching over 5,500,000 cases.

Buy This Entire Record For $7.95

Download the entire decision to receive the complete text, official citation,
docket number, dissents and concurrences, and footnotes for this case.

Learn more about what you receive with purchase of this case.

Indianapolis Life Insurance Company v. United States

May 20, 1997




Appeal from the United States District Court for the Southern District of Indiana, Indianapolis Division.

No. IP 95-0770-C H/G David F. Hamilton, Judge.

Before EASTERBROOK, KANNE, and EVANS, Circuit Judges.

EASTERBROOK, Circuit Judge.


DECIDED MAY 20, 1997

Life insurance companies invest their premium income. Some of the earnings are held in reserve to pay the death benefits or annuities promised in the policies. Earnings in excess of the amounts needed for these purposes may be distributed to holders of whole life or "participating" policies as dividends. These dividends are not taxed at the insurance company level; the insurer is treated like a mutual fund, which passes income through to the investor. For mutual insurance companies, some of the dividends may not be what they seem. Policyholders of a mutual insurer also are nominal "owners" of the company. Perhaps some of their premiums are equivalent to purchase of the insurer's stock. Then dividends could be a combination of return on investment by the insurer (taxed only at the policyholder level) and return on investment in the insurer (taxed at both levels, because corporations cannot deduct dividends on their own stock).

Section 809 of the Internal Revenue Code, 26 U.S.C. sec. 809, establishes a complex formula for allocating distributions to mutual policyholders between investment earnings and implicit dividends on imputed stock ownership. Simplified radically, the statute provides that when a rolling average of reported earnings of major stock life insurance companies exceeds the earnings of a mutual insurer, the mutual insurer must treat about 90 percent of the excess (multiplied by the firm's equity base) as taxable income. The difference between the stock rate and the mutual rate is the return on policyholders' imputed equity investment, and these sums cannot be deducted as dividends. What happens if the mutual's income exceeds the stock-company average? May the mutual deduct the difference? Stated otherwise, can the excess of the stock rate over the mutual rate be negative? The Commissioner of Internal Revenue believes that the answer is no. 26 C.F.R. 1.809-9(a). The only court of appeals that has considered the issue agrees. American Mutual Life Insurance Co. v. United States, 43 F.3d 1172 (8th Cir. 1994). If the Commissioner is wrong, the United States must refund about $5 billion to mutual insurers. The district court concluded that the Commissioner is right, although not for the Commissioner's preferred reasons. 940 F. Supp. 1370 (S.D. Ind. 1996). The district court disapproved the analysis in American Mutual Life but decided against the taxpayer for a reason the Commissioner declines to defend on appeal. The Treasury Department's own understanding of sec. 809 has fluctuated. For a brief time it sided with the mutual insurers but then switched views; in a report to Congress the Secretary of the Treasury critiqued both the design and operation of sec. 809 and called for revision, which has not taken place. Final Report to The Congress on Life Insurance Company Taxation 23-36 (1989).

Facts of this case matter little, but we summarize them to show how the question arises. During the 1986 taxable year, Indianapolis Life paid or accrued about $21 million in policyholder dividends. Section 808(c)(1) allows an insurer to deduct these dividends; sec. 808(c)(2) and sec. 809(a)(1) require a mutual insurer to reduce the dividends deduction by the "differential earnings amount." This amount depends on the relation between the earnings rate of the stock life insurance industry and the post-dividend earnings rate of the mutual life insurance industry, with adjustments to normalize these returns to the 1984 level (when Congress enacted sec. 809). 26 U.S.C. sec. 809(d). Earnings of mutual companies are computed year-by-year, but trail the current year. Earnings of stock companies are averaged over three years. When calculating its taxes for 1986, Indianapolis Life was required to use the mutual rate for 1984, compared to the stock rate for 1984-86. It is not possible for the IRS to complete the calculations to determine these industry-wide earnings rates before insurers must remit their taxes. So the IRS publishes a preliminary figure, which mutual insurers use. The preliminary figure for the 1986 tax year showed that the mutual rate was less than the stock rate by an amount that required Indianapolis Life to reduce its dividends deduction by approximately $10.5 million, which it did.

During the next year, the IRS provided a final calculation called the "recomputed differential earnings amount." This calculation showed that the mutual earnings rate actually had been higher than the three-year average of the stock earnings rate (at least after normalization). Under sec. 809(f)(2), when the "differential earnings amount" exceeds the "recomputed differential earnings amount" calculated under sec. 809(f)(3) -- which happened for the 1986 tax year -- "such excess shall be allowed as a life insurance deduction for the succeeding taxable year." Indianapolis Life ran the calculations using the "recomputed differential earnings amount" for 1986 and took a "life insurance deduction" of $12.2 million for 1986 on its 1987 return. This meant that the dividend deduction of $10.5 million from 1986, plus the life insurance deduction from 1987 (attributable to 1986 results), exceeded by about $1.7 million the policyholder dividends paid or accrued in 1986. This happened because the "excess" of the stock rate over the mutual rate was negative, and operation of the statutory formula produced a deduction larger than dividends paid -- just as the formula reduces the dividends deduction when the stock rate is greater than the mutual rate.

The Commissioner disallowed the extra $1.7 million deduction, leading to this suit in which Indianapolis Life seeks a refund. Because the refund claim depends on loss carrybacks, several tax years are in question, and the sum in dispute turns out to differ slightly from $1.7 million. But the legal question is clear. If operation of the sec. 809 formula produces a negative number (when the mutual rate exceeds the stock rate), may mutual insurers deduct from income earned in a year more than they paid that year in policyholder dividends? The Commissioner insists that the answer is "no" because "negative excess" is contradictory, but the concept of negative numbers, although rejected by the Greeks and Romans, has been accepted in western culture since the 16th Century. Elliott Mendelson, Number Systems and the Foundations of Analysis (1973). Today mathematics even comprises irrational, complex, and imaginary numbers, of which all too many appear on tax returns. The Commissioner also observes that sec. 809 is captioned "[r]eduction in certain deductions" and sec. 809(a)(1) reads: "In the case of any mutual life insurance company, the amount of the deduction allowed under section 808 shall be reduced (but not below zero) by the differential earnings amount." As the Commissioner sees things, sec. 809 reduces deductions but never increases them. But complex statutes often do things that are hard to encapsulate in a caption. Undoubtedly the principal effect of sec. 809 is dividend reduction. Does sec. 809(f)(2) -- which authorizes "life insurance deductions" rather than dividend reductions -- sometimes produce a deduction that exceeds dividends paid? That question cannot be answered by examining the caption of sec. 809 or the text of sec. 809(a)(1).

Nor can it be answered by reference to arguments about "windfalls." The Commissioner says that any deduction exceeding dividends paid would be a "windfall," but this is an unhelpful concept in the law of taxation. A greater deduction means a lower tax, but the mutual insurer will continue to be a net taxpayer. How high that tax will be depends on the interaction of many provisions, and a particular tax shield is just part of the edifice rather than a "windfall." For the period 1984-87, sec. 809 decreases Indianapolis Life's deductions by $15,918,822 if we accept its position, and by $17,602,644 if we accept the Commissioner's. A "negative excess" that smoothes the imputed dividend stream over time is no more a "windfall" than is an operating loss carryback or carryforward. Many parts of the tax code break the link between the calendar or fiscal year and the computation of tax; sec. 809 itself, with its rolling average of stock-company earnings and the lookback provision for recomputed differentials in sec. 809(f), is such a section.

If the mutuals are right about what sec. 809(f)(2) does, and if the mutual earnings rate always exceeded the stock earnings rate, then sec. 809 would authorize deductions exceeding actual dividends year in and year out. That is hardly what Congress expected to happen -- the implicit dividend on policyholders' imputed equity investments cannot be negative over the long run -- but the operation of many a provision in the Internal Revenue Code surprises its drafters. Some loopholes in the Code are concessions to interest groups but others are just loopholes. Let us bypass fantasies, however; the mutual earnings rate does not exceed the stock rate and is not likely to do so. Historically, the mutual earnings rate has been about 3 percent lower than that of stock life insurance firms. According to the mutuals, allowance of negative excesses is essential to limit the dividend reduction to that 3 percent, on average. An example illustrates:

Mutual Year Rate




1 12

2 18

3 ...

Buy This Entire Record For $7.95

Download the entire decision to receive the complete text, official citation,
docket number, dissents and concurrences, and footnotes for this case.

Learn more about what you receive with purchase of this case.