Part III. Administrative, Procedural, and Miscellaneous

Differential Earnings Rate for Mutual Life Insurance Companies

Notice 98–19

This notice publishes a tentative determination under § 809 of the Internal Revenue Code of the “differential earnings rate” for 1997 and the rate that is used to calculate the “recomputed differential earnings amount” for 1996. (The latter rate is referred to in this notice as the “recomputed differential earnings rate” for 1996.) These rates are used by mutual life insurance companies to calculate their federal income tax liability for taxable years beginning in 1997.

BACKGROUND

Section 809(a) provides that, in the case of any mutual life insurance company, the amount of the deduction allowable under § 808 for policyholder dividends is reduced (but not below zero) by the “differential earnings amount.” Any excess of the differential earnings amount over the amount of the deduction allowable under § 808 is taken into account as a reduction in the closing balance of reserves under subsections (a) and (b) of § 807. The “differential earnings amount” for any taxable year is the amount equal to the product of (a) the life insurance company’s average equity base for the taxable year multiplied by (b) the “differential earnings rate” for that taxable year. The “differential earnings rate” for the taxable year is the excess of (a) the “imputed earnings rate” for the taxable year over (b) the “average mutual earnings rate” for the second calendar year preceding the calendar year in which the taxable year begins. The “imputed earnings rate” for any taxable year is the amount that bears the same ratio to 16.5 percent as the “current stock earnings rate” for the taxable year bears to the “base period stock earnings rate.”

Section 809(f) provides that, in the case of any mutual life insurance company, if the “recomputed differential earnings amount” for any taxable year exceeds the differential earnings amount for that taxable year, the excess is included in life in

surance gross income for the succeeding taxable year. If the differential earnings amount for any taxable year exceeds the recomputed differential earnings amount for that taxable year, the excess is allowed as a life insurance deduction for the succeeding taxable year. The “recomputed differential earnings amount” for any taxable year is an amount calculated in the same manner as the differential earnings amount for that taxable year, except that the average mutual earnings rate for the calendar year in which the taxable year begins is substituted for the average mutual earnings rate for the second calendar year preceding the calendar year in which the taxable year begins.

The stock earnings rates and mutual earnings rates taken into account under § 809 generally are determined by dividing statement gain from operations by the average equity base. For this purpose, the term “statement gain from operations” means “the net gain or loss from operations required to be set forth in the annual statement, determined without regard to Federal income taxes, and ... properly adjusted for realized capital gains and losses. . . .” See § 809(g)(1). The term “equity base” is defined as an amount determined in the manner prescribed by regulations equal to surplus and capital increased by the amount of nonadmitted financial assets, the excess of statutory reserves over the amount of tax reserves, the sum of certain other reserves, and 50 percent of any policyholder dividends (or other similar liability) payable in the following taxable year. See § 809(b)(2), (3), (4), (5) and (6). Section 1.809–10 of the Income Tax Regulations provides that the equity base includes both the asset valuation reserve and the interest maintenance reserve for taxable years ending after December 31, 1991.

Section 1.809–9(a) of the regulations provides that neither the differential earnings rate under § 809(c) nor the recomputed differential earnings rate that is used in computing the recomputed differential earnings amount under § 809(f)(3) may be less than zero.

As described above, the differential earnings rate for 1997 and the recomputed differential earnings rate for 1996 affect the income and deductions reported by

mutual life insurance companies on their federal income tax returns for the 1997 taxable year.

Data necessary to determine the tentative differential earnings rate for 1997 and the tentative recomputed differential earnings rate for 1996 have been compiled from returns filed by mutual life insurance companies and certain stock life insurance companies. The Internal Revenue Service is currently examining these returns. This examination will not be completed before the March 16, 1998, due date for filing 1997 calendar year returns.

NOTICE OF TENTATIVE RATES

This notice publishes a tentative determination of the differential earnings rate for 1997 and of the recomputed differential earnings rate for 1996. This notice also publishes a tentative determination of the rates on which the calculation of the differential earnings rate for 1997 and the recomputed differential earnings rate for 1996 are based. The final determination of these rates is expected to be published before September 1, 1998.

The tentative determination of the differential earnings rate for 1997 and the tentative determination of the recomputed differential earnings rate for 1996 that are published in this notice should be used by mutual life insurance companies to calculate the amount of tax liability for taxable years beginning in 1997 (in the case of companies that file returns before publication of the final determination of these rates) or to calculate the amount of estimated unpaid tax liability for taxable years beginning in 1997 (in the case of companies that are allowed an extension of time to file returns). Companies that file returns before publication of the final determination of these rates should file amended returns after the final determination of these rates is published. If there is a failure to pay tax for a taxable year beginning in 1997 and the failure is attributable to a difference between (a) the tentative determination of the differential earnings rate for 1997 and recomputed differential earnings rate for 1996 and (b) the final determination of these rates, then any such failure through September 15, 1998, will be treated as due to reasonable

March 30, 1998 24 1998–13 I.R.B.

rate in effect at the time of the distribution and then of income that is subject to progressively lower (or no) federal income tax rates in effect at the time of distribution. The same policy applies in the regulations under § 664 when different income tax rates apply to different groups of income within a category of the items described in § 664(b), such as short-term and long-term capital gains. Therefore, income from a group that is subject to a higher federal income tax rate is deemed distributed before other income from a group, within the same category, that is subject to a lower federal income tax rate.

The following example illustrates how this principle applies to capital gain distributions after TRA 1997. Assume for the 1998 taxable year, a CRT has undistributed long-term capital gain in each of the three groups of long-term capital gain, i.e., the 28-percent group, the 25-percent group, and the 20-percent group, and also has undistributed short-term capital gain. To the extent capital gains are deemed distributed for the 1998 taxable year, the shortterm capital gain is deemed distributed prior to any long-term capital gain. The long-term capital gain is deemed distributed in the following order: (1) the gain in the 28-percent group is deemed distributed prior to any other long-term capital gain; (2) the gain in the 25-percent group is deemed distributed prior to any gain in the 20-percent group; and (3) the gain in the 20-percent group is deemed distributed last of any long-term capital gain.

A trustee of a CRT will be required to report each group of long-term capital gain separately on the Form 5227, SplitInterest Trust Information Return. The trustee may use any reasonable method for determining the amount of each type of gain within a group that has been distributed when doing the required reporting or associated recordkeeping.

PRE-1997 LONG-TERM CAPITAL GAIN

As of January 1, 1997, many CRTs had undistributed long-term capital gains that the CRT properly took into account before January 1, 1997 (pre-1997 long-term capital gains). These pre-1997 long-term capital gains must be assigned to one of the three groups of long-term capital gains. Section 1(h) does not specifically assign pre-1997 long-term capital gains to

cause and will not give rise to any addition to tax under § 6651.

The tentative determination of the rates is set forth in Table 1.

Notice 98–19 Table 1 Tentative Determination of Rates To Be Used for Taxable Years Beginning in 1997

Differential earnings rate for 1997 . . 0 Recomputed differential earnings

rate for 1996 . . . . . . . . . . . . . . . . . . .0 Imputed earnings rate for

1996 . . . . . . . . . . . . . . . . . . . .15.669 Imputed earnings rate for

1997 . . . . . . . . . . . . . . . . . . . .13.813 Base period stock earnings

rate . . . . . . . . . . . . . . . . . . . . .18.221 Current stock earnings rate

for 1997 . . . . . . . . . . . . . . . . .15.254 Stock earnings rate for 1994 . . .11.437 Stock earnings rate for 1995 . . .17.087 Stock earnings rate for 1996 . . .17.238 Average mutual earnings rate

for 1995 . . . . . . . . . . . . . . . . .16.477 Average mutual earnings rate

for 1996 . . . . . . . . . . . . . . . . .16.225

Capital Gains and Charitable Remainder Trusts

Notice 98–20

This notice provides guidance on the ordering and taxation of distributions under § 664(b)(2) of the Internal Revenue Code from a charitable remainder trust (CRT) in light of the changes made to § 1(h) by the Taxpayer Relief Act of 1997 (TRA 1997). Pub. L. 105–34, § 311, 111 Stat. 788, 831. Section § 1(h) provides that the Treasury may issue regulations to implement the provisions of § 1(h) for passthrough entities. The Treasury Department and the Internal Revenue Service plan to issue regulations incorporating the guidance contained in this notice.

BACKGROUND

Generally, a CRT is a trust that provides for a specified distribution at least annually over a specified period to one or more noncharitable recipients (a CRT distribution), with the remainder interest in the trust held irrevocably for a charitable organization.

TRA 1997 amended § 1(h) to provide for new capital gain tax rates for noncorporate taxpayers. Notice 97–59, 1997–45 I.R.B. 7, explains that a noncorporate taxpayer’s long-term capital gains and losses are separated into three tax rate groups: (1) the 28-percent group, (2) the 25-percent group, and (3) the 20-percent group. The present notice uses these terms in explaining how a CRT characterizes its capital gain distribution for taxable years beginning on or after January 1, 1998. The definitions of net capital gain, net longterm capital gain or loss, and net shortterm capital gain or loss were not changed by TRA 1997. Like Notice 97–59, this notice takes into account the pending retroactive legislative corrections. H.R. 2676, 105th Cong., § 605(d) (1997).

ADDITIONAL NETTING RULES

CRTs will be expected to follow the netting rules in Notice 97-59 when determining net short-term and net long-term capital gains. The rules in § 1.664–1(d)(1)(i)( b )( 2 ) and ( 3 ) of the Income Tax Regulations continue to apply in determining capital gains or losses carried forward to the succeeding taxable year.

GENERAL PRINCIPLES OF THE ORDERING RULE

Section 664(b) contains the ordering rule for determining the character of a CRT distribution in the hands of the recipient. The character of a CRT’s income is determined at the time the income is realized by the trust. Under § 664(b), the following ordering rule applies for determining the character of a distribution in the hands of the recipient: (1) first, as ordinary income to the extent of the trust’s ordinary income for the trust’s taxable year and its undistributed ordinary income for prior years, (2) second, as capital gain to the extent of the trust’s capital gain for the trust’s taxable year and its undistributed capital gain for prior years, (3) third, as other income to the extent of the trust’s other income for the trust’s taxable year and its undistributed other income for prior years, and (4) fourth, as a distribution of trust corpus.

The underlying policy in the ordering rule of § 664(b) and the existing regulations thereunder is that a CRT distribution is deemed to consist first of income that is subject to the highest federal income tax

1998–13 I.R.B. 25 March 30, 1998

one group of long-term capital gain. However, § 1(h) gives the Treasury broad regulatory authority to implement the provisions of § 1(h) for passthrough entities.

Pre-1997 long-term capital gains were characterized by the CRT based on the definitions of short-term and long-term capital gains applicable at the time the CRT sold a capital asset. CRTs have never been required to segregate these gains based upon the tax rate or holding period in effect at the time the gains were realized by the CRT. Thus, the undistributed pre-1997 long-term capital gains reflect gains realized when various tax rates and holding periods were in effect. Treasury will exercise its regulatory authority to treat undistributed CRT pre-1997 longterm capital gains as falling within the 20percent group.

1997 PRE-EFFECTIVE DATE LONGTERM CAPITAL GAINS

Long-term capital gains properly taken into account from January 1, 1997, through May 6, 1997, are covered by the rules in § 1(h) regarding pre-effective date gains. Under § 1(h), for the taxable year that includes May 7, 1997, gains and losses properly taken into account by the CRT for the

26 CFR 601.602: Tax forms and instructions.

Rev. Proc. 98–26

TABLE OF CONTENTS

PART A. GENERAL

portion of the taxable year before May 7, 1997, must be taken into account in determining long-term capital gain in the 28percent group. Because the taxable year for CRTs is the calendar year, long-term capital gains properly taken into account by a CRT from January 1, 1997, through May 6, 1997, are treated as long-term capital gains in the 28-percent group.

EXAMPLE ILLUSTRATING ORDERING AND CHARACTER RULES

The following example illustrates how these rules will apply to the 1998 taxable year. At the end of the 1998 taxable year, CRT X has no current or undistributed ordinary income and has the following net short-term and long-term capital gains:

Net short-term capital gain $ 5 Net long-term capital gain $50 By tax rate group:

28-percent group gain – $15 ($12 of gain recognized from 1/1/97 through 5/6/97; and $3 of gain recognized after 7/28/97 from an asset held for more than one year and less than 18 months) 25-percent group gain – $ 5 20-percent group gain – $30

($10 of gain recognized before 1/1/97) X makes a CRT distribution of $25 for the 1998 taxable year. The CRT distribution is deemed to have the following characteristics in the recipient’s hands:

Short-term capital gain $ 5 28-percent group gain $15 25-percent group gain $ 5 20-percent group gain $ 0 The undistributed 20-percent group gain of $30 is carried forward to 1999.

EFFECTIVE DATE

The proposed regulations when published will be effective for taxable years beginning on or after January 1, 1998. CRTs and their recipients, however, may rely on the rules in this notice for the 1997 taxable year.

DRAFTING INFORMATION

The principal authors of this notice are Mary Beth Collins and Jeff Erickson of the Office of Assistant Chief Counsel (Passthroughs and Special Industries). For further information regarding this notice contact Ms. Collins or Mr. Erickson on (202) 622-3070 (not a toll-free call).