In a November court ruling, State Farm Mutual Insurance saw its argument shot down when judges sided with the Internal Revenue Service in a case related to contingent liabilities. In the case, which was decided on November 8, petitioner State Farm claimed that based on its method of accounting, $202 million was properly included in its loss reserves. The IRS, and eventually several courts, saw it differently.

The case revolved around a 30-year-old automobile insurance policy issued to a Mr. Campbell, with a contract effective date of August 8, 1980. In 1983, a Utah state court determined that Campbell was responsible for an accident and entered a judgment of $185,849 against him. That amount exceeded the $50,000 per accident limit under his policy. As a result, Campbell filed an action against State Farm in Utah state court. The Utah Supreme Court affirmed the lower court’s judgment in the accident case, and the complaint was dismissed.

However, Campbell filed a second complaint against State Farm in Utah state court. The new complaint got a better reception than the first one. In fact, in 2001, the Utah Supreme Court awarded Campbell $145 million in punitive damages and $1 million in compensatory damages. Further, the U.S. Supreme Court reversed the 2001 decision and remanded the case back to the Utah Supreme Court. The Utah Supreme Court then reduced the size of the judgment with the result that, from May 2003 to August 2005, State Farm paid a total of $16,927,635 to Campbell, including $9,018,781 in punitive damages. These payments fully satisfied the judgment, including interest and costs.

State Farm reported its reserves for unpaid losses in its 2001 and 2002 annual financial statements. In determining its year-end unpaid loss reserve for 2001, the insurance company increased its unpaid loss reserve by $202 million. This increase was attributable to the 2001 decision and the denial by the Utah Supreme Court of the company’s request for rehearing in December 2001.

State Farm applied a discount factor to the $202 million and deducted the resulting $187,665,182 from its 2001 taxable income. The company then increased its 2003 taxable income by $181,665,182 to reflect a decrease in the reserve for unpaid losses. But the IRS disallowed the deductions State Farm claimed as a result of the adjustments made to the reserve for unpaid losses attributable to the judgment of the Utah Supreme Court in Campbell’s case. The U.S. Tax Court agreed with the IRS — see State Farm Mutual Automobile Insurance Co. v. Commissioner, 135 T.C. No. 26 (2010).

Annual Statement Controls?
State Farm argued that the “annual statement method of accounting” controls for federal tax purposes, and that the $202 million was properly included in the annual statement loss reserves. In this case, it was conceded that the loss was “extracontractual”; that is, it was not a loss covered by the liability policy of an insured. However, the Illinois Department of Insurance treated it as such for purposes of computing State Farm’s “insured losses incurred.”

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.