Indeed, the tax court, in Sears, Roebuck & Co. v. Commissioner, 972 F.2d 858 (7th Cir. 1992), held that the insurance annual statement controls as to the timing of the deduction of insured losses. However, the IRS would distinguish Sears, Roebuck & Co. from the present case on two grounds: (1) the losses in Sears, Roebuck & Co. arose from insured events and were not extracontractual and (2) the Seventh Circuit case did not address punitive damages.
In Sears, Roebuck & Co., the court held that Section 832 of the Internal Revenue Code required an insurer to compute losses incurred according to its annual statement. But the IRS asserts that Section 832, by its terms, applies the annual statement rule only to insured losses and the accounting treatment of the punitive damage award does not control the tax treatment. Punitive damages, it argues, are in the nature of a punishment to modify behavior, not a foreseen result of meeting an obligation to cover an insured event. The taxpayer’s argument, by contrast, is that the annual statement controls the tax treatment for nonclaim payments as well as claim payments.
The tax court concluded that the IRS “had the better argument.” The court was not convinced that Section 832(b) was intended to have the annual statement control the treatment of extracontractual losses for federal tax purposes. Punitive damage awards are not an “inherent component” of insurance underwriting and can arise in many contexts. Therefore, there is no reason to presume that Congress intended that Section 832(b)(5) be the applicable section to determine tax deductions for punitive damage awards. To adopt the taxpayer’s position would require that its contingent liability for a punitive damage award — that was incurred on account of its own misconduct and “was foreign to its normal experience of underwriting risks” — be allowed under Section 832(b)(5) as “losses incurred.”
As a result, the court concluded that State Farm may not include the original award to Campbell in its loss reserves under Section 832(b)(5). In short, the annual statement treatment of extracontractual losses does not control the tax treatment thereof. General principles of tax law will control the deductibility of such losses.
Contributor Robert Willens, founder and principal of Robert Willens LLC, writes a weekly tax column for CFO.com.