Change the character of your net capital losses
Insurance companies’ losses fluctuate from year to year due to unpredictable claims in their lines of business. These fluctuations can create abnormal losses, which — stay with us for a moment — can cause cash flow issues. The cash flow squeeze can, in turn, drive insurers to sell investments. Since the timing of these sales can't necessarily be controlled, capital losses may be the result. In most instances, capital losses are deductible, to the extent there are capital gains. Once capital losses exceed capital gains, the net capital loss creates a tax carryback or a carryforward.
First, the good news: There’s a tax attribute that can be carried back three years and carried forward five years to offset net capital gains. The bad news? If you don’t use it, you lose it.
But, there’s more good news: An insurance company that sells its investments to cover abnormal losses or dividends to policyholders may not be subject to the same capital loss limitations. Allow us to introduce IRC Section 832(C)(5), which provides an opportunity to change the character of an insurer’s net capital loss into an ordinary loss, which would be a deductible in the current year.
The bad news? If you don’t use it, you lose it.
Since the code section doesn’t define “abnormal losses” but instead provides a formula to determine applicability, we've developed a simple, three-part approach you can use to see whether it's relevant in your situation. We’ll discuss the formula in part 1. If you pass that, parts 2 and 3 will help you determine the limitations that may apply.
Begin with Schedule G, lines 1 to 10, on tax form 1120-PC. First, add current year dividends/distributions paid, losses paid, and expenses paid. Let's call this amount A.
Next, add current year interest received, dividends received, and all rents, royalties, lease income, other income received from a trade or business other than insurance activity income, and net premiums received. Let's call this amount B.
Now, compare the two amounts by subtracting amount B from amount A. Let’s call this difference amount C. If amount C is negative, you don’t qualify. If amount C is positive, you’ve passed part 1.
The heart of part 2 is line 11 of Schedule G. Line 11 allows you to list the detail of all investment transactions resulting in a capital loss to be recharacterized to ordinary loss. The caveat is that the total gross proceeds reported in column C of line 11 cannot exceed amount C from the paragraph above.
Reporting the wrong investments on line 11 can hurt the company’s potential ordinary deduction. This means you'll want to be strategic and report the investments with the lowest gross proceeds received that also resulted in the largest capital losses.
There’s no need to report the investments on both Schedule D and Schedule G. Choose and report the investments on Schedule G as outlined above, and then report the remaining capital transactions on Schedule D. Be aware that sometimes a pro-rata approach is used for the last investment listed on Schedule G. In that instance, report the appropriate pro-rata portion separately on Schedules D and G.
In addition to the determination in part 1 and the gross proceeds limitation in part 2, there is a third limitation on how much ordinary loss a taxpayer can take in a tax year. The ordinary losses recharacterized from capital losses cannot create a taxable loss. This means that the maximum ordinary loss a taxpayer is allowed to recharacterize is limited to the taxpayer's taxable income. If there’s more ordinary loss than taxable income, these losses must retain their capital loss properties and would add to the taxpayer’s capital loss carryforward.
Although abnormal losses can have negative downstream effects, the ability to change the character of a net capital loss to an ordinary loss that's deductible in the current year offers a silver lining. Use the process outlined above to ensure you don't miss the opportunity.
As always, if you have any questions, feel free to give us a call.