Rev. Rul. 83-66

ISSUE

Are reserve premiums subject to a retrospective rate credit refund clause under the medical malpractice liability insurance policy described below deductible in the year paid as ordinary and necessary business expenses under section 162 of the Internal Revenue Code?

FACTS

Taxpayer, an individual, is a cash method, calendar year taxpayer engaged in the practice of medicine. In 1981 taxpayer obtained medical malpractice insurance from a stock casualty insurance company under an annual policy issued pursuant to a master agreement between the insurance company and a medical society of which the taxpayer was a member.

The malpractice insurance policy obtained by the taxpayer contained a retrospective rate credit refund provision under which the taxpayer could receive a refund of a portion of the premiums paid if the insurance company's expected loss experience was not as great as projected. Although the insurance company was willing to agree to refund a portion of the premiums, it was unwilling to reduce its rates unless claims were actually reduced.

To carry out the retrospective refund feature of the policy, the taxpayer's premiums were broken down into two separate amounts. The first amount was referred to as the "basic premium" and the second amount was referred to as the "reserve premium." The reserve premium was the difference between the actuarially computed premium necessary to cover anticipated losses based on the current trend in the malpractice area and the premium necessary to cover malpractice losses if the insurance company achieved a favorable loss experience for the group.

Because liability was not limited to claims filed during a policy year, refunds were only paid commencing 5 years after the close of a policy year. Although the determination of whether a refund is due is based on each policy year, the insurance company is permitted to offset refunds not yet paid out by losses experienced in other policy years over the total premiums for those years.

The reserve premium amount was not segregated in any manner and the assets underlying the funds were part of the insurance company's general assets. The insurance company maintains separate records for each insured in the program solely for the purpose of determining that member's pro rata share of any refunds. If a retrospective rate credit becomes payable, an appropriate interest element is computed and paid from the insurance company's general assets.

LAW AND ANALYSIS

Section 162(a) of the Code allows a deduction for all the ordinary and necessary expenses paid or incurred during a tax year in carrying on any trade or business.

Section 1.162-1(a) of the Income Tax Regulations includes in deductible business expenses insurance premiums against fire, storm, theft, accident, or similar losses.

Section 263(a) of the Code allows no deduction for capital expenditures. A capital expenditure is one that creates or results in the permanent improvement or betterment of an asset. Section 1.263(a)-1 of the regulations.

Section 1.461-1(a)(1) of the regulations provides that a taxpayer using the cash receipts and disbursements method of accounting must take into account amounts representing allowable deductions, as a general rule, in the tax year in which paid. Section 1.461-1(a)(1) further provides that if an expenditure results in the creation of an asset having a useful life that extends substantially beyond the close of the tax year the expenditure may not be deductible, or may be deductible only in part, for the tax year in which made.

Under the facts presented, the payments by the taxpayer resulted in a shifting of economic risk among the members of the medical society purchasing insurance from the insurance company. This shifting of risk occurred not only with respect to the basic premium but also the reserve premium because the reserve premium was available for the losses of the group as a whole. As such, the insurance payments in whole constitute ordinary and necessary business expenses under section 162 of the Code, unless the reserve premium creates a benefit that extends beyond the tax year in which paid or the reserve premium results in the creation, permanent improvement, or betterment of an asset.

In Midwest Motor Express, Inc. v. Commissioner, 27 T.C. 167, 186 (1956), the court in determining when a retrospective premium accrued stated that the fact that a settlement might result in an adjustment to the premium that would entitle the petitioner to a refund in the future did not affect or postpone the accruability of the premium expense.

Applying section 1.461-1(a)(1) of the regulations and the rationale of Midwest Motor Express, Inc., to the facts in this case, the cost of the reserve premiums should be deductible in full in the year paid. The reserve premium represents part of the cost of the insurance for the policy year in which paid, and while separately stated from the basic premium, it still represents the actuarially determined cost for the insurance.

The determination of whether the reserve premium constitutes a capital expenditure and thus must be capitalized under section 263 of the Code depends on whether the reserve premium creates, enhances, or is part of the cost of acquiring or defending a separate and distinct asset or property interest with a useful life in excess of one year. See Commissioner v. Lincoln Savings and Loan Association, 403 U.S. 345 (1971), 1971-2 C.B. 116.

In Lincoln Savings and Loan Association the Court ruled that premiums paid to a secondary reserve fund established by the Federal Savings and Loan Insurance Corporation (FSLIC) by a savings and loan association to cover losses if other accounts proved insufficient were nondeductible capital expenditures. The Court's position was based on the fact that: (1) the premium could only be used for losses after the exhaustion of all other assets; (2) the premiums paid into the reserve fund by the savings and loan association could be transferred by the savings and loan association in situations involving the merger or consolidation of the association; (3) the premiums were subject to refund in cash to the savings and loan association upon termination of the insured's status under the program or when the "primary reserve" reached a suspension level; (4) the funds in the secondary reserve could be used to discharge the annual premium of the savings and loan association if a designated suspension level was reached; and (5) the FSLIC was required to credit annually to the savings and loan association's reserve account its share of earnings on the assets reflected in the secondary reserve account.

Unlike the facts in Lincoln Savings and Loan Association, the facts presented here do not establish that the taxpayer's payment of a reserve premium created a separate and distinct asset or property interest with a useful life in excess of one year. While the reserve premiums could only be used after the exhaustion of the primary premiums, the reserve premium, unlike the secondary reserve fund in Lincoln Savings and Loan Association, represented the actuarially determined cost of providing the insurance coverage for the policy year. The only way the taxpayer could receive a refund of its reserve premiums was if the anticipated losses on claims failed to materialize. In addition, the reserve premium could never be used to discharge the taxpayer's premiums in a future year. The mere expectancy that a refund may be forthcoming in a future tax year because malpractice claims actually incurred for a policy year are less than originally expected does not create an asset in the hands of the taxpayer paying the premium.

HOLDING

The reserve premiums paid under this medical malpractice liability insurance policy are deductible as an ordinary and necessary business expense under section 162 of the Code in the year paid.