THE EQUITABLE LIFE ASSURANCE SOCIETY OF THE UNITED STATES v. UNITED STATES
2002-1 U.S.T.C. 83,686 (SDNY Feb. 6, 2002).

DECISION AND ORDER

Berman, District Judge: On May 31, 2000, The Equitable Life Assurance Society of the United States ("Equitable" or "Plaintiff"), a New York corporation and mutual life insurance company ("MLIC"), filed a complaint ("Compl.") against the United States ("IRS" or "Defendant") seeking a refund of $76,902,609 in taxes (plus interest, costs and attorneys' fees).[Fn. 1] Compl. ¶¶ 7, 58. Plaintiff asserts that it was taxed improperly for certain "releases" of life insurance reserves in 1982.[Fn. 2] Compl. ¶¶ 38-40, 49, 53, 56-58. On October 16, 2000, Defendant filed a motion to dismiss ("Def. Mem.") pursuant to Federal Rule of Civil Procedure ("Fed. R. Civ. P.") 12(b)(6), arguing that the so-called "tax benefit rule" does not apply to MLICs such as Plaintiff. Plaintiff filed an opposition to Defendant's motion on November 16, 2000 ("Pl. Opp."); and, on December 1, 2000, Defendant filed a reply ("Reply"). On October 23, 2001, Defendant submitted a letter "to inform the Court of a recent decision of the United States Court of Appeals for the Federal Circuit [("Federal Circuit")] relevant to the Government's . . . motion to dismiss . . .," (see Letter from David S. Jones, dated October 23, 2001 ("Jones letter")); and, on November 8, 2001, Plaintiff submitted a written response to the Jones letter, (see Letter from Myron Kirschbaum, dated November 8, 2001 ("Kirschbaum letter")).[Fn. 3] For the reasons set forth herein, [83,687] the Defendant's motion to dismiss is granted.

I. Background

Under Subchapter L of the Internal Revenue Code of 1954, 26 U.S.C. section 801 et seq. (1954) (the "Code"), as amended by the Life Insurance Company Income Tax Act of 1959 (the "1959 Act"), a life insurance company's taxable (investment) income was referred to as "Phase I" income, while its entire "gain from operations," including both investment income and underwriting income, was referred to as "Phase II" income. Compl. ¶¶ 31-32. "For the years 1958-1981, Equitable was effectively taxed based on its Phase I [income], . . . not its underwriting income." Pl. Opp. at 1.

MLIC underwriting income is held in the form of reserves until the (corresponding) policy(ies) mature.[Fn. 4] For accounting purposes, the creation of a reserve is considered a loss and the release of a reserve ("reserve release") is considered a gain. (Equitable contends that the release of a reserve is a "recovery" or the initial loss). The reserve represents a liability owed to the policy holder and the reserve release reflects payment to the policy holder.

Life insurance companies may deduct increases to reserves from gross income and, conversely, they must include in gross income decreases to reserves. See 26 U.S.C. sections 809(c)(2) and 809(d)(2); see also Compl. ¶ 35. Equitable contends here that because "reserve increases only reduce Phase II income (which includes underwriting income)," and because Equitable "did not pay tax based upon its Phase II income [from 1958-81]," any deductions Equitable may have taken for adding to its reserves in those years "provided no tax benefit to Equitable." Pl. Opp. at 1-2.[Fn. 5]

Beginning in 1982, "Equitable was characterized . . . as a 'Phase II company,' i.e., the amount of federal income tax imposed on Equitable was based on its [Phase II income, that is, its investment income plus its underwriting income]." Compl. ¶¶ 34. Plaintiff alleges that much, if not all, of the 1982 reserve releases on which the IRS taxed Equitable was created from 1959-1981. Id. ¶ 38. Consequently, Equitable contends that "the Government has erroneously taxed it on decreases in . . . insurance reserves which were not subject to tax under the tax benefit rule." Pl. Opp. at 1. Defendant's position in opposition is clear: "The tax benefit rule does not apply." Def. Mem. at 2 (emphasis added).

II. Standard of Review

"In reviewing a [Fed. R. Civ. P.] 12(b)(6) motion, this Court must accept the factual allegations of the complaint as true and must draw all reasonable inferences in favor of the plaintiff." Bernheim v. Litt, 79 F.3d 318, 321 (2d Cir. 1996) (citing Hernandez v. Coughlin, 18 F.3d 133, 136 (2d Cir.), cert. denied, 513 U.S. 836 (1994)). The movant's burden is very substantial, as "the issue is not whether a plaintiff is likely to prevail ultimately, 'but whether the claimant is entitled to offer evidence to support the claims.' " Gant v. Wallingford Burton Dep. of Educ., 69 F.3d 669 (2d Cir. 1995) (quoting Weisman v. LeLandais, 532 F.2d 308, 311 (2d Cir. 1976) (per curia)).

III. Analysis

"The tax benefit rule, codified in part as section 111 of the Internal Revenue Code of 1986 . . . was established to ensure that if a taxpayer takes a deduction attributable to a specific event, and the amount is recovered in a [83,688] subsequent year, income tax consequences of the latter event depend in some degree on the prior related tax treatment." American Mutual Life Ins. v. United States, 2001 W L 1159779, at *1 (Fed. Cir. Oct. 3, 2001). The rule is meant to "achieve rough transactional parity in tax . . . and to protect the Government and the taxpayer from the adverse effects of reporting a transaction on the basis of assumptions that an event in a subsequent year proves to have been erroneous." Hillsboro Nat'l Bank v. Comm'r, 460 U.S. 370, 383 (1983).

The rule has both inclusionary and exclusionary elements. "The inclusionary aspect requires a taxpayer to include within income recovery of [a loss] previously deducted. The exclusionary aspect permits a taxpayer to exclude from income that portion of a recovery [of a loss whose deduction did not result] in a prior tax benefit." Allstate Ins. Co. v. United States, 936 F.2d 1271, 1272 (Fed. Cir. 1991)[Fn. 6]

In Hillsboro, the U.S. Supreme Court outlined some basic principles relating to the tax benefit rule: (i) where there exists an inherent tension between a Code provision and the tax benefit rule, courts should "focus on the particular provisions of the Code;" 460 U.S. at 385-86; (ii) "a [physical] 'recovery' will not always be necessary to invoke the tax benefit rule;" 460 U.S. at 381; and (iii) the later event or "recovery" must be "fundamentally inconsistent with the premise upon which the deduction was originally based;" 460 U.S. at 383-84.[Fn. 7]

Defendant contends, inter alia, that: 1) MLICs are governed by a portion of the tax Code that subsumes the tax benefit rule; 2) reserve releases do not qualify as "recoveries;" and 3) reserve releases are not "fundamentally inconsistent" events. Plaintiff responds that: 1) the tax benefit rule is a general rule of law that applies throughout the Code and also applies to MLICs; 2) reserve releases "fit" within the broad definition of "recoveries;" and 3) reserve releases are "fundamentally inconsistent" events.

A. The Code

In American Mutual, a case very much on point, the Federal Circuit Court of Appeals stated:

Where, as in this case, the events giving rise to the tax benefit question are governed by provisions of the Code, there may be an inherent tension between the tax benefit rule and these provisions. The Supreme Court . . . recognized that there is no blanket rule that the tax benefit rule prevails over the particular provisions of the Code at issue. It instead directed us to focus on the provisions "that govern these transactions to determine whether the deductions taken by the taxpayers were actually inconsistent with later events and whether specific . . . provisions [of the Code] prevail over the principle of the tax benefit rule."

267 F.3d 1344, 2001 WL 1159779, at *5 (quoting Hillsboro, 460 U.S. 370, 385-86 (1983)).

Section 809(c)(2) of the Code specifically directs that decreases in life insurance reserves must be included in gross income.[Fn. 8] This provision of the tax Code prevails over the principles of the tax benefit rule, as applied to Plaintiff here. See American Mutual, 267 F.3d 1344, 2001 WL 1159779, at *6 ("The statute, both before and after Congress' 1984 amendments to the Code, contemplated the releases. The Code mandates taking the reserve releases into taxable income.") (emphasis added).

B. Recovery

Defendant contends that there is no "recovery" here under section 111 of the Code which states that "gross income does not include income attributable to the recovery during the taxable year of any amount deducted in any prior taxable year. . . . " 26 U.S.C. section 111 (emphasis added). Equitable asserts that in "taxable year 1982, Equitable released amounts from its total life insurance reserves in the normal course of business," Compl. ¶ 37, and that these reserve releases constitute a recovery. Equitable also contends that "events that do not fit within the ordinary definition of 'recovery,' such as 'the bookkeeping entry' of the cancellation of a debt are subject to the tax benefit rule." Pl. Opp. at 13.

[83,689]

The analysis in American Mutual is contrary to Equitable's position and is dispositive:

A "recovery" is what happens when a bad debt is collected, when state taxes are refunded or credited, when taxes accrued are canceled, or when a previous year's casualty payment is offset by a later subrogation receipt. . . . Here, nothing is paid to the taxpayer when reserves are released. The taxpayer merely has an accounting or "book" change reflecting the reversal of a previous potential, estimated liability. In most cases, this discharge is accompanied by a payment of the exact liability—a reduction in assets.

45 Fed.Cl. at 453. The analysis by the Claims Court in American Mutual is not, as Equitable contends, a "serious[] misreading [of] Hillsboro." Pl. Opp. at 15. Among other things, Justice O'Connor, writing for the majority in Hillsboro, stated that "a 'recovery' will not always be necessary to invoke the tax benefit rule." 460 U.S. at 381. In American Mutual, both the Claims Court and the Federal Circuit, in detailed well reasoned opinions, followed the directive of the U.S. Supreme Court in Hillsboro to apply the tax benefit rule "on a case-by-case basis." See Hillsboro, 460 U.S. at 385. After having analyzed whether the tax benefit rule applies in the context of life insurance reserve releases, both courts concluded that "life insurance reserve releases were not a . . . 'recovery' " for purposes of the tax benefit rule. See 267 F.3d 1344, 2001 WL 1159779, at *4 (emphasis added); see also American Mutual, 46 Fed.Cl. at 453-54. This Court agrees.

C. Fundamentally (In)consistent

The U.S. Supreme Court has held that "the tax benefit rule will 'cancel out' an earlier deduction only when careful examination shows that the later event is indeed fundamentally inconsistent with the premise on which the deduction was initially based. That is, if that event had occurred within the same taxable year, it would have foreclosed the deduction." Hillsboro, 460 U.S. at 383-84.

Defendant contends that "the release of reserves is a fully anticipated and consistent event for life insurance companies," and that "if a [life insurance] policy was originated and terminated in the same year, no reserve would have been associated with that policy at the end of that year or in any subsequent year." Def. Mem. at 15. Plaintiff counters that "fundamentally inconsistent" means "whether the subsequent event would have canceled out the prior deduction had the two events occurred in the same year." Pl. Opp. at 15. Plaintiff asserts that "the reason no year-end reserve is generated when a policy is written and retired during the same year is precisely because the increase and decrease in reserves that result from those events cancel each other out. That [according to Plaintiff] is exactly why the Hillsboro test is satisfied here, i.e., if the two events in question occurred in the same year, there would be no net tax effect." Id. at 18.

Having considered this very issue, the Claims Court in American Mutual concluded:

If there is anything that is consistent and foreseen, it is that life insurance reserves will be released on the coming of one or another of a limited number of defined and inevitable events, the principal one being the certainty of death.

In one sense, the release of a reserve might be considered as "inconsistent" with its earlier establishment, at least in a way that a negative is inconsistent with the positive it cancels out. And it is certainly true that the release of a reserve completes the earlier transaction such that it would "foreclose the deduction" if it happened in the same year. But this says nothing more than that the establishment and later release of a reserve amount is a completed transaction that (usually) crosses tax years. It does not establish this multi-year transaction as one qualifying for the Tax Benefit Rule.

American Mutual, 46 Fed.Cl. at 453 (emphasis added). And, the Federal Circuit stated: "We do not read the test so narrowly (sic) the 'deduction foreclosed' inquiry is but one facet of the fundamentally inconsistent test. Further, the deduction foreclosed inquiry is not helpful in the context of life insurance reserves." American Mutual, 267 F.3d 1344, 2001 WL 1159779, at *5. "We agree with the Court of Federal Claims that the life insurance reserve releases were not a fundamentally inconsistent' occurrence. . . ." Id. (emphasis added).

Because this Court is in accord with the conclusion(s) reached in American Mutual, Plaintiff can prove no set of facts in support of its claim that would entitle it to relief.[Fn. 9]

[83,690]

IV. Conclusion

For the reasons state[d] herein, Defendant's motion to dismiss [6-1] is granted. The Clerk is respectfully requested to close this case.

[83,686] 1 "Equitable has exhausted the administrative remedies available to it within the IRS with respect to the claims presented in this Complaint." Compl. ¶ 24; see also Compl. ¶¶ 21, 23, Ex. A, Ex. B.

[83,686] 2 "In 1982, which was the first year in which Equitable paid tax under the 1959 Tax Act on its Phase II income, Equitable reduced reserves in the normal course of business which corresponded to additions to reserves which had been made in 1958-81. . . . Equitable erroneously included those reserves decreases in calculating its Phase II income for 1982. . . . Equitable now seeks, and is entitled to, a refund of the additional tax that it paid as a result of the erroneous inclusion in its 1982 income of those decreases in reserves, since the deductions for such reserves in 1958-81 did not result in any tax benefit for Equitable." Plaintiff's Memorandum Of Law In Opposition To Defendant's Motion To Dismiss The Complaint at 2.

[83,686] 3 The Federal Circuit decision, dated October 3, 2001, involved an appeal from an April 13, 2000 decision of the United States Court of Federal Claims ("Claims Court "), in which the Claims Court, in a case similar to the instant case, held that the tax benefit role did not apply to life insurance reserves. See American Mutual Life Ins. Co. v. United States, 46 Fed.Cl. 445 [83,687] (Fed.Cl.), aff'd, 267 F.3d 1344, 2001 WL 1159779 (Fed. Cir. Oct. 3, 2001). "To our knowledge, no recorded case in the Rule's more than 70-year judge-made and then statutorily-embodied history applies the Tax Benefit Rule in the manner sought by plaintiff. . . . Annual variations in life insurance reserves do not . . . meet the Rule's preconditions and tests." 46 Fed.Cl. at 447, 451.

Respectfully, the letter from Mr. Jones does not persuade the Court that reliance upon American Mutual is "misplaced." See Jones letter at 1. As in the instant case, "American Mutual contends that it essentially received no tax benefit from a portion of the increases in the past years 1962-1981, and so the Tax Benefit Rule should relieve it of the requirement that the entire amounts of the decreases now be added to income . . . . We must examine in more detail the tax scheme governing life insurance companies during the first period [1962-81], when American Mutual had net increases in reserves." American Mutual, 46 Fed.Cl. at 448.

[83,687] 4 Section 816(b) of the 1986 Code (restating the Code's definition) states:

(b) LIFE INSURANCE RESERVES DEFINED.—

(1) In general—For purposes of this part the term "life insurance reserves" means amounts—

(A) which are computed or estimated on the basis of recognized mortality or morbidity tables and assumed rates of interest, and

(B) which are set aside to mature or liquidate, either by payment or reinsurance, future unaccrued claims arising from life insurance, annuity, and noncancellable accident and health insurance contracts. . . .

[83,687] 5 "Indeed, while the Government for purposes of this motion assumes arguendo the truth of the factual allegations in the complaint, the assertion that plaintiff received no tax benefit from reserve increases from 1959-1981 flies in the face of the statutory scheme. Under that scheme, increases in reserves decrease the company's share of investment yield and thus its taxable investment income not only for the year of the increase, but for all subsequent years." Def. Mem. at 7 n.6.

[83,688] 6 This case, according to Plaintiff, concerns the exclusionary aspect of the rule, which provides: "Gross income does not include income attributable to the recovery during the taxable year of any amount deducted in any prior taxable year to the extent such amount did not reduce the amount of tax imposed by this chapter." 26 U.S.C. section 111.

[83,688] 7 The Court also noted that the tax benefit rule should not apply automatically but, rather, on a "case-by-case basis." 460 U.S. at 383.

[83,688] 8 Section 809(c)(2) of the Code states:

(c) GROSS AMOUNT.—For purposes of subsections (b)(1) and (2), the following items shall be taken into account:

(2) DECREASES IN CERTAIN RESERVES.—Each net decrease in reserves which is required by section 810 or 811(b)(2) to be taken into account. . . .

26 U.S.C. section 809(c)(2)(1954) (emphasis added).

[83,689] 9 Plaintiff relies heavily on Allstate Ins. Co. v. United States, 936 F.2d 1271 (Fed. Cir. 1991), a decision in which the Federal Circuit concluded, among other things, that the subrogation recovery at issue fit within the exclusionary aspect of the tax benefit rule under section 111. Both American Mutual courts also considered Allstate and its effect, if any, on life insurance reserve releases. " 'Allstate is not our situation. . . . The Federal Circuit [in Allstate] stated that 'subrogation is, by definition, a recovery from a previously deducted loss. . . . Subrogation, by its [83,690] nature, demands application of the Tax Benefit Rule." American Mutual, 46 Fed.Cl. at 454 (quoting Allstate, 936 F.2d at 1274). "This case is distinguishable because different underlying tax provisions are at issue and because a subrogation recovery is the type of 'inconsistent' event that meets the tax benefit rule's preconditions and tests." American Mutual, 2001 WL 1159779, at *7 (Fed. Cir. 2001).