Taxation of Insurance Companies
Like all businesses, insurance companies are subject to federal, state, and local taxes. However, states and localities impose special premium taxes on the premiums written within their jurisdiction. Additionally, because insurance companies are subject to statutory accounting rules, the federal government enacted special rules for calculating the income of insurance companies.
State Premium Taxes
State premium taxes are a type of sales tax assessed on insurance gross premiums. Insurance companies must pay the tax, but they pass their cost on to their customers. Originally used as a means of protecting domestic insurers from foreign (out-of-state) insurers, other states retaliated by enacting their own premium taxes on foreign insurers. To attract greater investments in the state, states may also offer investment credits for investing in the state or deductions for the number of employees employed in the state.
Although states are generally forbidden from enacting discriminatory laws affecting interstate commerce, the Supreme Court has held, in Western & Southern Life Insurance Company v. State Board of Equalization, 451 U.S. 648 (1981), that the McCarran-Ferguson Act, which leaves the regulation and taxation of insurance companies to the states, removes the Commerce Clause restriction, thus allowing the states to tax insurance products without regard to its effects on interstate commerce. Although states may tax foreign insurers more than domestic insurers, the Supreme Court has ruled that such discrimination is only permissible if there is a rational basis for the discrimination. [Metropolitan Life Insurance Co. v. Ward, 470 U.S. 869 (1985)]
The state premium taxes are a percentage of the premiums paid by the insured. The maximum state premium tax is 4%, while the most common percentage is 2.5%. However, some municipalities may also impose a premium tax, which would be added to the state tax.
Insurance companies pay corporate tax only in the state in which they are domiciled, but premium taxes are collected by every state in which premiums are written. This premium tax is assessed at a rate equal to the greater of the tax rate in the domicile state or the state in which the premium was written. The tax base is the amount of the written premiums minus any returns of premiums or dividends paid to policyholders.
Most states also have retaliatory taxes, designed to equalize the assessed taxes on foreign insurers so that they do not have an advantage over domestic insurers. Hence, insurance companies will pay the greater of the tax rate of its domicile or the tax rate in the state in which the premium was written.
Beside the requirement that a discriminatory tax have a rational basis, retaliatory premium taxes also limit discrimination. A retaliatory tax is the percentage difference between the tax rate of the domicile and the foreign tax rate of the state in which the premium is written. For instance, Tennessee has a premium tax rate of 2.25%, while Georgia has a foreign tax rate 4.75%. Without the retaliatory tax, a Georgia company would be able to sell insurance in Tennessee and pay only the 2.25% rate, while a Tennessee company selling policies in Georgia would have to pay the foreign rate of 4.75%. However, because of the retaliatory tax, the Georgia company selling insurance in Tennessee would have to pay an additional 2.5% premium tax on top of the 2.25% domestic rate, which would equalize the tax rate paid by the Tennessee company doing business in Georgia and the Georgia company doing business in Tennessee. A consequence of this premium tax system is that the lowest tax rate paid by an insurance company will be the tax rate of its domicile. While the insurance company may pay a higher rate in other states, the rate will never be lower than the rate of its domicile. Hence, insurance companies tend to domicile in states with the lowest premium tax rate.
States also charge companies, insurance agents and brokers licensing fees, which must be paid before a company or an insurance salesperson can sell insurance within the state.
Originally, the purpose of these taxes was to fund the state insurance department. However, like many government taxes, many of them in the form of fees, the revenue collected exceeds what is necessary to fund the original purpose of the tax, thereby becoming 1 of the many hidden taxes enacted by governments. Indeed, one reason why the states fear the federal government regulation of insurance is that they will also take away the power of the states to tax insurance products, since the power to regulate is often viewed as necessary and sufficient for the power to tax.
Federal Income Taxes
Insurance companies pay federal income taxes, like any other for-profit businesses. However, special rules apply to insurance companies, depending on type of insurance that they sell. The main difference is how taxable income is determined.
Life Insurance Companies
Life insurance companies are subject to the regular corporate tax rates on their life insurance company taxable income (LICTI), which is gross income minus deductions. Gross income includes premiums, decreases in reserves, and investment income. Deductions include incurred expenses, death benefits, policyholder dividends, increases in certain reserves, and other deductions. Increases in reserves can be deducted, but, since 1984, deductible reserves cannot exceed statutory reserves, which are determined by state law.
Federal law also requires that policy acquisition expenses be capitalized, meaning only a certain percentage can be deducted each year. Because 1st year commissions and life insurance policies generally exceed the amount of premiums collected in the 1st year, the life insurance company generally suffers an underwriting loss in the 1st year on new policies. Nonetheless, these sizable commissions must be amortized over a 120-month period. However, new insurance companies can amortize the 1st $5 million of policy acquisition expenses over a 5-year period instead of the usual 10-year period. The amortization of policy acquisition expenses reduces LICTI initially, but will yield higher income in later years.
Life insurers with less than $500 million in assets are also allowed a small company deduction, where 60% of the 1st $3 million in LICTI can be deducted. This deduction is reduced 15% of the excess of the tentative LICTI exceeding $3 million, thus phasing out completely when the LICTI reaches $15 million.
Property and Liability Insurers
The Tax Reform Act of 1986 altered the computation of income due to statutory accounting requirements for property and liability insurance companies and also for some health organizations. Only 80% of the increase in the unearned premium reserve is deductible in any given year. Loss reserves must also be discounted based on the federal midterm rate, to reflect the time value of money. Both incurred losses and increases in loss reserves can be deducted annually but is also subject to the federal midterm discount rate. Because increases in loss reserves are deductible, decreases in loss reserves, also discounted by the federal midterm rate, must be included as income. The deduction for incurred losses is reduced by 15% of tax-exempt interest and deductible dividends earned by the property and liability insurer, thereby reducing the tax savings of tax-exempt interest and deductible dividends by 15%.