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IRS reiterates doctrine of election limitations

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Tax Hot Topics newsletterThe IRS Office of Chief Counsel advised the agency’s Large Business & International division in a chief counsel advice memorandum (CCA 201939003) that a taxpayer could not amend its tax returns to change a statutory election it had made in Year 1 because the common law doctrine of election prohibited it.

The doctrine of election generally precludes a taxpayer from changing an election through an amended return, binding that taxpayer to its initial choice.

The facts of the CCA describe a consolidated group of companies, with some of the subsidiaries in the group being life insurance companies. On its Years 1, 2, and 3 tax returns, the taxpayer computed life insurance reserves on contracts for the subsidiaries in accordance with Section 807(d)(2), using the greater of the applicable federal interest rate (AFIR) or the prevailing state assumed interest rate (PSAIR) for the calendar year in which each contract was issued (Interest Rate A).

In 2018, however, the taxpayer filed amended returns for Years 1, 2, and 3 and tried to make elections under Section 807(d)(4)(A)(ii) to recompute the life insurance reserves on the contracts using the greater of the AFIR applicable to the first year of the current recomputation period or the PSAIR applicable to the calendar year in which each contract was issued (Interest Rate B). Under Section 807(d)(4)(A)(ii), a taxpayer may elect to recompute every five years the AFIR to be used in computing the reserves. The effect of the “new” elections by the taxpayer was to increase life insurance reserves, which would reduce taxable income. The taxpayer also attempted to file a protective election using Interest Rate B in its 2017 return, if the elections made on the amended returns were considered invalid.

Citing Pacific National Co. v. Welch, 304 U.S. 191 (1938), the CCA states that if a taxpayer initially had the right to choose one or more alternatives or inconsistent rights, and if nothing suggests the taxpayer could then change that initial choice after the filing due date, then the taxpayer is bound by that choice. The doctrine of election requires: (1) a choice between two or more alternatives; and, (2) an overt act by the taxpayer in communicating its choice to the IRS. Grynberg v. Commissioner, 83 T.C. 255 (1984). The reason why such elections are binding is to prevent administrative burdens, protect against revenue loss due to hindsight by a taxpayer, promote consistent accounting practice, and provide for fair and equitable tax administration, the CCA states, citing case law.

In the case of the taxpayer at issue in the CCA, the IRS stated that there are no explicit procedures for making an election under Section 807(d)(4)(A)(ii), and that in the absence of a deadline, the time for making an election is when a taxpayer is faced with the necessity of making the election or choice in computing taxable income on a tax return (see Bayley v. Commissioner, 35 T.C. 288 (1960). The statute and legislative history indicate that a life insurance company that makes an election under Section 807(d)(2)(A)(ii) must use the greater of AFIR for the fifth year after the year the contract is issued or the PSAIR for the year in which the contract is issued, in determining its reserves for the fifth through ninth years after the contract is issued. As a result, the election under Section 807(d)(2)(A)(ii) must be made no later than due date for the original return for the fifth year after a contract is issued. That is, according to the IRS, the first year the taxpayer is faced with the necessity of making the election or choice in computing taxable income on a tax return.

In this case, the taxpayer “communicated its free choice” to the IRS in electing Interest Rate A under Section 807(d)(2) on its returns for the fifth year after each contract was issued, and accordingly, the taxpayer cannot reverse that choice, the IRS stated in the CCA. Moreover, the doctrine of election supports preventing the taxpayer from changing its election to apply Interest Rate B because doing so would “invite accounting distortions leading to a loss of revenues.” For years beginning after Dec. 31, 2017, the AFIR and PSAIR are no longer used to determine life insurance reserves, due to the passage of the Tax Cuts and Jobs Act (TCJA). The effect of the change in law would have allowed the taxpayer, through the change in elections and the protective election in 2017, to offset income taxable at higher corporate tax rates pre-TCJA, and benefit from higher deductions, which would lead to disparate treatment and “reward hindsight,” according to the IRS.

The CCA reiterates the long-standing doctrine of election, which generally binds taxpayers to their initial elections when the law is not clear as to changes in elections. Taxpayers should carefully consider the impact of the election and its potential alternatives, especially if there are no procedures for changing the election after the due date for filing that return. Regulatory elections may be eligible for relief under Treas. Reg. Secs. 301.9100-1 through -3, which allow for late elections in cases where a taxpayer can prove it acted reasonably and in good faith, and the relief will not prejudice the government. Such relief is not available for statutory elections, like the one at issue in the CCA.  

In addition, the IRS Office of Chief Counsel has made it clear that it will consider a change in law, like the TCJA, in determining whether a taxpayer is acting with hindsight. Under Treas. Reg. Sec. 301.9100-3(b)(3)(iii), if specific facts have changed since the due date for making the election that make the election advantageous to a taxpayer, the IRS will ordinarily not grant relief. Accordingly, the passage of the TCJA makes an election advantageous to the taxpayer, the IRS will ordinarily not grant relief for such a late election.
 
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David Auclair
National Managing Principal
Washington National Tax Office
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Shamik Trivedi
Senior Manager
Washington National Tax Office
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