REVENUE RULING 85-166
1985-2 C.B. 177

[IRS Annotation]
Capital losses; dispositions to meet normal insurance losses. Losses on capital assets sold or exchanged to meet abnormal insurance losses in excess of capital gains are deductible in the year incurred to the extent of taxable income; to the extent such losses exceed taxable income they become a net capital loss carryback or carryforward. Such losses retain their character when carried back or forward and must first be offset against capital gains in the carryback or carryforward year before being deducted against taxable income.

Rev. Rul. 85-166 

ISSUE
How are losses on capital assets sold or exchanged by an insurance company to meet abnormal insurance losses treated for federal income tax purposes when carried back or forward?

FACTS
Taxpayer is an insurance company that is taxable under section 831 of the Internal Revenue Code. Taxpayer uses the cash method of accounting and a calendar year tax period.

During its tax year ending December 31, 1981, the taxpayer sold at a loss stocks it was holding for investment. The taxpayer had no capital gains during 1981. The capital losses resulting from the sales are considered losses on sales to meet abnormal insurance losses under section 832(c)(5) of the Code. Taxpayer's abnormal insurance losses for the year exceeded its taxable income computed without regard to the abnormal insurance losses.

LAW AND ANALYSIS
Section 832(b)(1)(B) of the Code provides that, in the case of an insurance company subject to the tax imposed by section 831, gross income includes gain during the tax year from the sale or disposition of property.

Section 832(c)(5) of the Code allows an insurance company subject to the tax imposed by section 831 a deduction for capital losses to the extent provided in subchapter P (section 1201 and following, relating to capital gains and losses) plus losses from capital assets sold or exchanged in order to obtain funds to meet abnormal insurance losses and to provide for the payment of dividends and similar distributions to policyholders. Section 832(c)(5) further provides that in the application of section 1212 for purposes of section 832, the net capital loss for the taxable year is the amount by which losses for that year from sales or exchanges of capital assets exceed the sum of the gains from those sales or exchanges, and the lesser of: (A) the taxable income (computed without regard to gains or losses from sales or exchanges of capital assets), or (B) losses from the sale or exchange of capital assets sold or exchanged to obtain funds to meet abnormal insurance losses and to provide for the payment of dividends and similar distributions to policyholders.

The legislative history of section 207(b)(4)(F) of the 1939 Code, the predecessor of section 822(c)(6) of the Code, indicates that the purpose for enacting the abnormal insurance losses provision was as follows:

Representations were made that insurance companies other than life frequently had no control over the timing of the sale of their assets, since in years of abnormal insurance losses they were forced to liquidate assets in order to be able to pay losses . . . Consequently losses on assets sold for this purpose might safely be allowed as a deduction from regular income without possibility of abuse . . . A special rule is set forth for the application of the 5-year capital loss carry-over provisions of section 117(e) for the purposes of this section in order to prevent capital losses actually used to reduce net income in any year from again being used in a future year as an offset against capital gains in that year. S. Rep. No. 1631, 77th Cong., 2d Sess. 153 (1942), 1942-2 C.B. 504, 618.

Under section 832(c)(10) of the Code, net operating losses under section 172 may be deducted in computing taxable income of an insurance company subject to the tax imposed by section 831.

Section 1.832-5(a) of the Income Tax Regulations provides that, for purposes of section 172 of the Code, "gross income" means gross income as defined in section 832(b)(1) and the allowable deductions are those allowed by section 832(c) with the exceptions and limitations set forth in section 172(d).

Section 832(d) provides that nothing in section 832 shall permit the same item to be deducted more than once.

In Rev. Rul. 68-60, 1968-1 C.B. 322, the Service considered the application of the alternative tax on capital gains in a situation involving abnormal insurance losses. It was concluded that section 832(c)(5) of the Code does not convert a capital loss into an ordinary loss but, instead, provides a current deduction against taxable income for capital losses that otherwise would be carried forward and treated as a short-term capital loss under section 1212.

As described above, section 832(c)(5) of the Code provides a specific rule for the carryback and carryforward of losses from capital assets sold or exchanged in order to obtain funds to meet abnormal insurance losses. This rule, which reduces that net capital loss for a taxable year, was enacted to prevent capital losses which were actually used to reduce taxable income in a given year from being used [178] again in a carryback or carryforward year. The net capital loss is not reduced either by capital losses which did not qualify as losses on sales to meet abnormal losses because such losses were in excess of the amount of abnormal losses (section 832(c)(5)(B)) or by capital losses which did qualify as losses on sales to meet abnormal losses but which did not reduce taxable income in the year of the loss (section 832(c)(5)(A)).

The allowance of a deduction under section 832(c)(5) of the Code for capital losses on sales to obtain funds to meet abnormal losses could be interpreted as having the effect of creating or increasing a net operating loss in taxable years in which such losses exceed the company's taxable income (computed without regard to gains or losses from sales or exchanges of capital assets). The allowance of a net operating loss carryback or carryforward deduction in addition to the capital loss carryback or carryforward deduction allowed by section 1212 would violate the double deduction prohibition of section 832(d). Thus the net operating loss deduction must be disallowed. To disallow the capital loss carryback or carryforward deduction rather than the net operating loss deduction would render meaningless the section 835(c)(5)(A) limitation, reverse the basic ordering rule of section 835(c)(5) that capital losses must first reduce capital gains for a taxable year before reducing ordinary income for that year, and conflict with the assumption of the legislative history that carryforwards of capital losses on sales to meet abnormal losses would be used in future years against capital gains and the holding of Rev. Rul. 68-60 that section 832(c)(5) does not convert a capital loss into an ordinary loss.

Although losses on sales to meet abnormal insurance losses in excess of taxable income do not create or increase a net operating loss, these losses should not lose their character as abnormal insurance losses when carried back or forward to other taxable years simply because these losses cannot be used against income in the year in which incurred. The special treatment provided for abnormal insurance losses, which would otherwise be treated as capital losses, occurs because of the lack of control over the timing of the sale of the assets. See S. Rep. No. 1631. Thus, although abnormal insurance losses are considered net capital losses in a carryover period, these net capital losses retain their character as abnormal insurance losses in the carryback or carryforward years.

HOLDING
Losses on capital assets sold or exchanged to meet abnormal insurance losses, as defined in section 832(c)(5) of the Code, in excess of capital gains are deductible in the year incurred to the extent of taxable income. Losses on sales to meet abnormal insurance losses in excess of taxable income become a net capital loss carryback or carryforward. Losses on sales to meet abnormal insurance losses retain their character when carried back or forward and must first be offset against capital gains in the carryback or carryforward year before being deducted against taxable income.