Internal Revenue Service
Revenue Ruling

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 Rev. Rul. 77-39

1977-1 C.B. 191

Section 446
Section 461
Section 809
Section 818

IRS Headnote

Life insurance companies; forfeitable coupon certificates. The redemption by a life insurance company of forfeitable coupon certificates, which after maturing with the timely payment of an annual premium entitle the owner to the payment or credit of a specified percentage of the premium paid or may be converted after twenty years to a fully paid-up life insurance policy, is treated as an accrued benefit, rather than as a return premium, and is taken into account as a deduction under section 809(d)(1) of the Code. The potential liability for unmatured coupons, however, is not deductible in computing the company's gain or loss from operations under section 809(b) until such coupons mature.

Full Text

Rev. Rul. 77-39

Advice has been requested as to the proper treatment for Federal income tax purposes of the redemption by a life insurance company of matured coupon certificates under the type of coupon life insurance policy described below. Advice has also been requested whether the life insurance company, in computing its taxable income, may accrue the potential liability for the redemption of unmatured coupon certificates included in the coupon life insurance policy.

A life insurance company issues a nonparticipating life insurance policy attached to which are annual coupon certificates. The policy provides for a number of coupon certificates that mature serially upon the timely payment of an annual premium under the premium payment terms of the policy. Each coupon is a promise that, upon its maturity and surrender, the company will pay or credit a specified percentage of the premium to the owner. If all such coupon benefits are left with the company, under the principal option provided for in the policy, then at the twentieth anniversary of the policy, the accumulated benefits will be sufficient to convert the policy to a fully paid-up life insurance policy. However, if prior to maturity of the coupons, the policyholder defaults in the premium payments and the policy is thereby cancelled, all unmatured coupon benefits are forfeited to the company. Matured coupon benefits are withdrawable in cash at any time by the policyholder, or, may be left on deposit with the company at the option of the policyholder.

The reserves established for the coupon benefits are not based upon mortality tables and assumed rates of interest. Therefore, such reserves are not life insurance reserves within the meaning of section 801(b) of the Internal Revenue Code of 1954.

The life insurance coverage under the policy is based upon annual premiums that are paid in semi-annual, quarterly, or monthly installments at specified rates. Such installment payments may span more than 1 calendar year. For example, a policy with a July anniversary date whose premiums are paid in equal monthly installments will have its premium for 1 policy year spread into 2 calendar years.

The specific questions are: (1) whether the redemption of matured coupon certificates under a policy whose premium is paid in installments is treated, for Federal income tax purposes, as an accrued benefit under section 809(d)(1) of the Code as distinguished from a "return premium," and (2) whether the potential liability for the redemption of unmatured coupon certificates may be deducted as an accrued liability by the life insurance company in computing its gain and loss from operations under section 809.

Section 809(c)(1) of the Code provides, in part, that the gross amount of premiums less return premiums shall be taken into account by a life insurance company in determining its gain or loss from operations under section 809(b).

Section 809(d)(1) of the Code provides, in part, that all claims and benefits accrued, and all losses incurred, during the taxable year on insurance and annuity contracts shall be allowed as deductions by a life insurance company in determining its gain or loss from operations under section 809(b).

Return premiums, as defined in section 1.809-4(a)(1)(ii) of the Income Tax Regulations, are amounts returned or credited that are fixed by contract and do not depend on the experience of the company or the discretion of the management. Return premiums are limited to those situations where the premium has been erroneously calculated, where the policy has been cancelled before the end of the contract period, or where the policy has been procured through fraud, or issued through a mistake of law or fact, or is void. Thus, return premiums refer to a refund of premiums to which no insurance risk has attached. See Rev. Rul. 67-180, 1967-1 C.B. 172.

On the other hand, the deductions allowed under section 809(d)(1) of the Code include all claims and benefits accrued. In this regard, section 1.809-5(a)(1) of the regulations provides, in part, that the term "all claims and benefits accrued" includes, for example, matured endowments and amounts on surrender.

In the instant case, the unmatured coupon benefits are forfeited to the company in the event of cancellation of the policy before the end of the contract period. Furthermore, where the premium is paid in installments spread over the policy year term, in no event can the coupon benefits be withdrawn by the policyholder until after the premium has been paid in full. Thus, the coupon benefits are not return premiums that are returnable to the policyholder in the event of cancellation of the policy to which no risk has attached, as contemplated by section 1.809-4(a)(1)(ii) of the regulations.

When matured coupon benefits are left with the company under the principal policy option, the benefits will be paid to the policyholder in the form of paid-up life insurance. Therefore, under the terms of the policy, the principal means of paying coupon benefits is in terms of life insurance benefits. If the policyholder elects to redeem the coupon certificates in cash as they mature, such amounts fit within the meaning of amounts "allowed on surrender" under section 1.809-5(a)(1) of the regulations as they are amounts allowed in cash for surrender of the option to leave such benefits with the company for paid-up life insurance to be provided in later years. Accordingly, in the instant case, the redemption of matured coupon certificates is to be treated as an accrued benefit under the coupon policy, rather than as a return premium, and is to be taken into account as a deduction under section 809(d)(1) of the Code.

Section 818(a) of the Code provides, in part, that all computations entering into the determination of Federal income taxes for purposes of Part I of subchapter L shall be made under the accrual method of accounting, or to the extent permitted under the regulations, under a combination of an accrual method of accounting with any other method permitted under chapter 1 (other than the cash receipts and disbursements method).

Section 1.818-2(a) of the regulations provides, in part, that the term "accrual method" shall have the same meaning and application in section 818 of the Code as it does under section 446 (relating to general rule for methods of accounting) and the regulations thereunder. For general rules relating to the taxable year for deduction of expenses under an accrual method of accounting, see section 461 and the regulations thereunder.

Section 1.461-1(a)(2) of the regulations provides, in part, that under an accrual method of accounting, an expense is deductible for the taxable year in which all of the events have occurred that determine the fact of the liability and the amount thereof can be determined with reasonable accuracy.

In the instant case, the company is not obligated to pay coupon certificate benefits until the annual premiums are paid in full. In the meantime, such benefits may be forfeited to the company in the event of cancellation of the policy because of a default in payment of the full amount of the premiums due. Therefore, the company's liability for the payment of the coupon benefits remains contingent until the entire annual premium relating thereto has been paid. Thus, the company may not accrue the potential liability for unmatured coupon certificates as a deduction under section 809(d)(1) of the Code or under any other applicable provision of the Code.

Accordingly, the benefits arising from such coupon certificates are not deductible in computing the company's gain or loss from operations under section 809(b) until such benefits mature upon timely payment of the entire amount of the annual premium.