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Article Author:

Maximizing Tax Benefits of P&C Insurers’ Capital Losses

Douglas J. Youngren, JD, CPA
Tax Partner
dyoungren@BlackmanKallick.com, 312-980-2944

In a year fraught with so many losses, is there anything in the current tax code that allows realized capital losses to offset underwriting income? Can those losses be carried back to offset underwriting gains in prior years like a net operating loss? For property and casualty (P&C) insurers, the answer might be yes.

Capital losses can be deducted against ordinary income

Losses incurred by a corporation from the sale of investment assets are normally deductible only against capital gains. But a special provision for P&C insurance companies lets you deduct capital losses against ordinary income. The provision allows capital losses to be turned into “abnormal losses” (i.e., capital losses resulting from sales of investment assets made to fund operating cash deficits).

This provision was created to allow P&C insurers to fund operating cash deficits with sales of capital assets.

Example: Last Property and Casualty Insurance Company (Last Property) has the following basic cash flow statement:

Last Property and Casualty Insurance Company Statement of Cash Flows    

Net Premiums Received	$125,000,000
Dividends Received	1,500,000
Interest Received	3,500,000
Losses Paid	(85,000,000)
Expenses Paid	(50,000,000)
Net Cash Increase (Deficit)
Not Including Capital Gain (Loss)	$  (5,000,000)

 

Since there is a net deficit in cash, the company can use its current year capital loss to offset taxable income.

Last Property had a single sale of a capital asset for $5,000,000 (the exact amount of its cash shortfall), resulting in the following loss: 

Sale Proceeds	$5,000,000
Basis	8,000,000
Capital Loss	($3,000,000)

Since the sale provides the $5,000,000 needed to fund the operating cash deficit, the $3,000,000 capital loss can be converted into an abnormal loss.

Abnormal losses—assuming there are no capital gains—can be used to offset ordinary taxable income in the current year. To the extent that the abnormal losses fully offset current-year income, they can be carried backward and forward as abnormal losses.Consider the following two scenarios:

If Last Property Had Current Year Taxable Income

Assume that Last Property had taxable income of $4,500,000 before converting the capital loss to an abnormal loss. The impact on taxable income of that conversion would be as follows:

Taxable Income Before Abnormal Loss	$4,500,000
Less Capital Loss Converted to Abnormal Loss	(3,000,000)
Net Taxable Income	$1,500,000

The otherwise nondeductible capital loss becomes the equivalent of an ordinary loss and creates a tax benefit of $1,020,000 ($3,000,000 x 34%).

If Last Property Had Current Year Net Loss

If instead, there is a $1,500,000 tax loss before the converted capital loss, the taxable loss for the current year would be calculated as follows:

Taxable Loss Before Abnormal Loss Adjustment	($1,500,000)
Less Capital Loss Converted to Abnormal Loss	(3,000,000)
Net Taxable Loss	($4,500,000)

Under this assumption, there are two separate carrybacks or carryovers: a $1,500,000 net operating loss (NOL) and a $3,000,000 abnormal loss.

Assume the following facts in the three prior years:

	Taxable Income Before Capital Gain	Total Capital Gain	Total Taxable Income
Third Prior Year	$1,000,000	$500,000	$2,150,000
Second Prior Year	$2,000,000	$150,000	$2,150,000
First Prior Year	$750,000	$1,200,000	$1,950,000

 The use of the losses in the third prior year would be as follows:

Third Prior Year

	Taxable Income Before Capital Gain	Total Capital Gain	Total Taxable Income
Third Prior Year Taxable Income Before Carryback	$1,000,000	$500,000	$1,500,000
Carryback of Abnormal Loss as Capital Loss	0	(500,000)	(500,000)
Carryback of Abnormal Loss as Ordinary Loss	(1,000,000)	0	(1,000,000)
Third Prior Year Taxable Income After Carryback	$0	$0	$0

Under the ordering rules, the abnormal loss is treated first as a capital loss. The loss can then be converted to offset ordinary income. In the example, after the abnormal loss has offset $500,000 of capital gains, it is treated as an ordinary loss, which offsets the $1,000,000 ordinary taxable income.

So, after the carryback to the third prior year, there are still the following carrybacks to the second prior year:

Carrybacks to Second Prior Year 

	Net Operating Loss	Abnormal Loss
Original Carryover Amounts	$1,500,000	$3,000,000
Abnormal Loss Used in Third Prior Year	0	(1,500,000)
Remaining Carryback to Second Prior Year	$1,500,000	$1,500,000

The use of the carrybacks to the second prior year would be as follows:

Second Prior Year

	Taxable Income Before Capital Gain	Total Capital Gain	Total Taxable Income
Second Prior Year Taxable Income Before Carryback	$2,000,000	$150,000	$2,150,000
Carryback of Abnormal Loss as Capital Loss	0	(150,000)	(150,000)
Carryback of Abnormal Loss as Ordinary Loss	(1,350,000)	0	(1,350,000)
Carryback of NOL	(650,000)	0	(650,000)
Second Prior Year Taxable Income After Carryback	$0	$0	$0

This example shows the ordering rules for an interaction between an NOL and an abnormal loss carryback. First, the abnormal loss is treated as a capital loss and used to offset any capital gains in the carryback year. Then, if any abnormal loss remains and there is still taxable income, it is used as an ordinary loss. Any remaining taxable income is offset by the NOL.

The resulting carryforward schedule is updated as follows:

Carrybacks to First Prior Year

	NOL	Abnormal Loss
Original Carryover Amounts	$1,500,000	$3,000,000
Abnormal Loss Used in Third Prior Year	0	(1,500,000)
Remaining Carryback to Second Prior Year	1,500,000	1,500,000
Abnormal Loss Used in Second Prior Year	0	(1,500,000)
NOL Used in Second Prior Year	(650,000)	0
Remaining Carryback to First Prior Year	$850,000	$0

The remaining carryback to the first prior year would be calculated as follows:

First Prior Year

	Taxable Income Before Capital Gain	Total Capital Gain	Total Taxable Income
First Prior Year Before Carryback	$750,000	$1,200,000	$1,950,000
Carryback of NOL	(750,000)	(100,000)	(850,000)
First Prior Year After Carryback	$0	$1,100,000	$1,100,000

You don’t need a Troubled Assets Relief Program (TARP) fund to utilize your net capital losses.

The updated carryforward schedule to years subsequent to the current year would look as follows:

Carryforward to Future Years

	NOL	Abnormal Loss
Original Carryover Amounts	$1,500,000	$3,000,000
Abnormal Loss Used in Third Prior Year	0	(1,500,000)
Remaining Carryback to Second Prior Year	1,500,000	1,500,000
Abnormal Loss Used in Second Prior Year	0	(1,500,000)
NOL Used in Second Prior Year	(650,000)	0
Remaining Carryback to First Prior Year	850,000	0
Used in First Prior Year as NOL	(850,000)	0
Net Remaining	$0	$0

You don’t need a Troubled Assets Relief Program (TARP) fund to utilize your net capital losses. You already have the tools to create current tax benefits to help lessen the impact of losses that would otherwise be nondeductible.

Questions about tax benefits of capital losses? Contact Doug Youngren at 312-980-2944.

This publication is part of Blackman Kallick’s marketing of professional services, and is not written tax advice directed at the specific facts and circumstances of any person and/or entity. Contents of this publication are of a general nature, and you should not act on this information without obtaining professional advice from your business advisor that is appropriately tailored to your individual needs and circumstances. This written advice is not intended or written to be used, and cannot be used by any taxpayer, for the purpose of avoiding penalties that may be imposed under the Internal Revenue Code.