United States: Second Circuit Disagrees With Claims Court And Denies Deduction For Contingent Dividend Liability

On August 1, 2013, the U.S. Court of Appeals for the Second Circuit held in New York Life Ins. Co. v. U.S., that the taxpayer's liability for policyholder dividends was contingent, and therefore, was not deductible until the taxpayer paid them.  In so holding, the Second Circuit disagreed with the reasoning of the U.S. Court of Federal Claims in Massachusetts Mutual Life Insurance Co. v. U.S., 103 Fed. Cl. 111 (2012), a case with almost identical facts.  The Second Circuit did not discuss a number of issues, and its attempts to distinguish precedential authority were unpersuasive.

In New York Life Ins. Co. v. U.S., 780 F. Supp. 2d 324 (S.D.N.Y. 2011), the U.S. District Court for the Southern District of New York granted the government's motion to dismiss the taxpayer's complaint, concluding that New York Life failed to (and could not) allege that for the tax years in which they were deducted, certain liabilities to pay policyholder dividends satisfied the "all-events" test.  On August 1, 2013, the U.S. Court of Appeals for the Second Circuit affirmed, and held that the taxpayer's liability was contingent, and therefore the dividends were not deductible until the taxpayer paid them.  In so holding, the Second Circuit disagreed with the reasoning of the U.S. Court of Federal Claims in Massachusetts Mutual Life Insurance Co. v. U.S., 103 Fed. Cl. 111 (2012), a case with almost identical facts.  The Second Circuit did not discuss a number of issues, and its attempts to distinguish precedential authority were unpersuasive.

New York Life involved two types of dividends: (1) dividends that were payable annually, shortly after the end of the taxable year, if the policy remained in effect, the so-called "Annual Dividends for January Policies," and (2) dividends that were payable upon the termination of the policy, the so-called "Minimum Dividends."

Annual Dividends for January Policies

The Second Circuit found that the taxpayer could not deduct in year one the Annual Dividends for January Policies because the liability was contingent on the policy being in effect at the time of payment, which was in January of year two.  While to be deductible a liability must be "fixed" by the end of the year, a contingent liability can be "fixed" if the contingency is "remote and speculative."  The Second Circuit, however, did not address this issue, although it noted that its analysis would not change even if the policyholders were "statistically certain" to keep their policy in effect.  The court based its holding on the fact that a policyholder could cancel their policy at any time, but did not discuss whether such an event was "remote and speculative," which seems likely under the facts described by the court (the taxpayer accrued the liability only if the policyholder already paid their premiums in full).

In addition, a contingency prevents accrual only if it is a "condition precedent," and not if it is a "condition subsequent."  A condition precedent is an event that must occur before a liability is established and a condition subsequent is an event that, if it occurs, defeases an already established liability.  Although the Second Circuit did not discuss the difference, it presumably found the contingency was a condition precedent, which is of concern because conditions precedent normally require an event to occur that will establish the taxpayer's liability.  Here the taxpayer is liable for the dividend once the premiums are paid in full, unless the policyholder cancels the policy, which is indicative of a condition subsequent.  The Second Circuit, however, framed the issue as the taxpayer is not liable for the dividend until the policyholder does not cancel the policy, which is an unusual way to frame an event.

Minimum Dividends

The Second Circuit found that the taxpayer could not deduct the Minimum Dividends prior to payment because it "was under no contractual, statutory, or other obligation to pay" them.  The taxpayer accrued the Minimum Dividends, however, only after its board of directors approved payment of them.  Precedent in the Second Circuit (and the Internal Revenue Service's own position) is that a resolution of a board of directors is sufficient to establish a liability.  See Willoughby Camera Stores v. Commissioner, 125 F.2d 607 (2nd Cir. 1942) and Rev. Rul. 2011-29, 2011-49 I.R.B. 824.  The Second Circuit's attempt to distinguish the precedent is unpersuasive.  The court stated that, in the earlier cases there was an "implied contract" to pay bonuses to employees such that the board's approval of the bonuses established the liability to pay them.  In the present case, the taxpayer had a long-standing practice to pay the Minimum Dividends.  The court does not suggest that the policyholders were unaware of that practice and it would seem that they would be so aware.  It is, therefore, unclear how the facts in the present case would not establish the same implied contract found in the earlier cases. 

Mass Mutual

Finally, the Second Circuit stated that it would not follow the reasoning in Mass Mutual, a Court of Federal Claims case with almost identical facts.  In Mass Mutual the Court of Federal Claims held that the board resolution did establish the liability to pay the annual and guaranteed dividends and that the liability was not contingent.  In a lengthy analysis the court reasoned that, although the taxpayer was only liable to pay a dividend in year two if the policy was then in effect, such a contingency is not a condition precedent because the taxpayer accrued the liability only if the policyholder previously had paid the necessary premiums to keep the policy in effect.  It further reasoned that the board of directors' resolutions were unconditional, and therefore, fixed the liability, even if the board could have later revoked them or they were not enforceable.

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