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E. Treatment of Losses and Interest on Deposits in Insolvent Financial Institutions (Sec. 905 of the Act and secs. 165 and 451 of the Code) 30

Prior Law

Under prior law, a loss experienced by a taxpayer with respect to a deposit in a financial institution was treated in the same manner as any other bad debt loss. Deduction of the loss was generally allowable only in the year in which it is determined, based on all the facts and circumstances, that there was no prospect of recovery. Unless the deposit in the financial institution was created or acquired in connection with a trade or business of the taxpayer, any loss on the deposit constituted a short-term capital loss (sec. 166(d)). An individual taxpayer generally may deduct short-term capital losses only to the extent of $3,000 plus his capital gains for the year (sec. 1211).

Reasons for Change

The Congress believed that the circumstances surrounding deposits in financial institutions are different from the circumstances surrounding other debts owed to a taxpayer. Depositors in financial institutions often use such accounts for temporary safekeeping of funds that are needed for food, rent, and other essential items, rather than for investment. In most cases, these funds are deposited with the expectation that they may be withdrawn on demand. The Congress believed that an individual should be allowed an election to deduct the loss arising from the insolvency of a financial institution at the time that the loss becomes reasonably estimable. Moreover, it felt that the loss is better viewed as a casualty loss than as a short-term capital loss, and should receive the same treatment as a casualty loss for Federal income tax purposes.

In addition, the Congress believed that interest that is credited to a depositor's account in an insolvent financial institution that, due to the institution's insolvency, cannot be withdrawn, should not be includible in the depositor's income (or deductible by the institution) until the interest is subject to withdrawal.

Losses on deposits

Explanation of Provision

The Act allows qualified individuals to elect to deduct losses on deposits in qualified financial institutions as casualty losses in the

30 For legislative background of the provision, see: H.R. 3838, as reported by the House Committee on Ways and Means on December 7, 1985, sec. 805; H.Rep. 99-426, pp. 596-597; H.R. 3838, as reported by the Senate Committee on Finance on May 29, 1986, sec. 803; S.Rep. 99-313, pp. 291-292; and H.Rep. 99-841, Vol. II (September 18, 1986), pp. 291-292 (Conference Report).

year in which the amount of such loss can be reasonably estimated.31 A qualified individual is any individual other than an owner of one percent or more of the value of the stock of the institution in which the loss was sustained, an officer of such institution, and certain persons related to such owners and officers. Relatives of one-percent owners and officers who are not considered as qualified individuals are siblings (whether by whole or half blood), spouses, aunts, uncles, nephews, nieces, ancestors, and lineal descendants. Other persons are considered to be related to a one-percent owner or officer if they are a related persons under the provisions of section 267(b).

A qualified financial institution is any commercial bank (as defined in sec. 581), any thrift institution (as defined in sec. 591), any insured credit union, or any institution similar to the above which is chartered and supervised under Federal or State law. A deposit for the purposes of this provision is any deposit, withdrawable certificate, or withdrawable or repurchasable share of or in a qualified financial institution.

The amount of loss to be recognized in any year under the election is the difference between the taxpayer's basis in the deposit and the amount which is a reasonable estimate of the amount that will eventually be received with regard to such deposit.32 A reasonable estimate of the amount that will eventually be received might, for example, be based on a determination by an agency having regulatory authority over the financial institution as to the percentage of total deposits that the institution (or its insurer) is likely to honor. If the recognized loss is later recovered, the taxpayer must include the amount thereof in income in the year of such recovery, under normally applicable tax benefit principles.

The election under this provision constitutes an election of a method of accounting with respect to all losses on deposits in the same institution, and may be revoked only with the consent of the Commissioner of Internal Revenue. If the election is made, no bad debt deduction is permitted under section 166.33

Interest on frozen deposits

The Act also provides that, in certain circumstances, interest earned by a qualified individual on a deposit in a qualified financial institution is not includible in the depositor's taxable income even though credited to the depositor's account.34 Interest on a

31 It is anticipated that a technical amendment will be made permitting the taxpayer an alternative election to treat the loss as an ordinary loss under section 165(c)(2) of the Code. This election will be available only if no portion of the deposit is insured under Federal law, and the deduction will be limited in amount to $20,000 for any taxable year ($10,000 in the case of a separate return by a married individual) minus the amount of any insurance proceeds that can reasonably be expected to be received with respect to the deposit. Such an amendment was included in the versions of H. Con. Res. 395 which passed the House and the Senate in the 99th Congress.

32 Although basis includes any interest credited to a depositor's account where such interest has been included in income, it does not include any interest on frozen deposits the recognition of which has been deferred under section 451(f) as added by the Act.

33 The failure of a taxpayer to claim a loss under this provision in the year in which such loss can first be reasonably estimated will not preclude the taxpayer from claiming such loss in a later year, either under this election or as a bad debt under section 166.

34 The terms "qualified individual" and "qualified financial institution" have the same meanings as under section 165(1), relating to the treatment of losses on deposits.

"frozen deposit" is includible in the depositor's income only to the extent the interest has been actually withdrawn during the calendar year or is subject to withdrawal (disregarding any penalties for premature withdrawal of time deposits). A frozen deposit is one not subject to withdrawal at the end of the calendar year because of the bankruptcy or insolvency (or threatened bankruptcy or insolvency) of the financial institution, or because of any requirement imposed by the State in which the institution is located by reason of the bankruptcy or insolvency of one or more financial institutions in the State.

Interest excluded under this provision is treated as credited to the depositor's account in the following calendar year, and is includible in that year (unless eligible under this provision for exclusion in that year). The Act also denies an interest deduction to the financial institution with respect to any interest on a frozen deposit excluded under this provision until such interest is includible in gross income.

Effective Date

The provision relating to losses on deposits is effective for taxable years beginning after December 31, 1982.35 The provision relating to exclusion of interest on frozen deposits by a depositor generally applies to taxable years beginning after December 31, 1982. However, the latter provision applies to taxable years beginning after that date and before January 1, 1987, only if the taxpayer elects to have it apply to all such years. In addition, interest paid or incurred by a financial institution on a frozen deposit that is attributable to the period beginning January 1, 1983, and ending December 31, 1987, is not subject to the limitation on deductibility imposed by this provision.

Revenue Effect

The provision is estimated to decrease fiscal year budget receipts by $3 million in 1987, $1 million in 1988, $1 million in 1989, $1 million in 1990, and $1 million in 1991.

35 It is anticipated that a technical amendment will be made under which the provision will be effective for taxable years beginning after December 31, 1981. Such an amendment was included in the versions of H. Con. Res. 395 which passed the House and Senate in the 99th Congress.

TITLE X-INSURANCE PRODUCTS AND COMPANIES

A. Insurance Policyholders

1. Interest on installment payments of life insurance proceeds (sec. 1001 of the Act and sec. 101(d) of the Code)1

Prior Law

Under prior and present law, amounts paid by an insurance company to the beneficiary of a life insurance contract by reason of the death of an insured individual generally are not includible in gross income. Under certain life insurance contracts, the insurer may agree to hold the amounts that it would otherwise pay on the death of the insured and pay such proceeds of the contract at a later date.

If the insurer pays the insurance proceeds to a beneficiary in a series of payments after the death of the insured, a prorated amount of each payment is treated as a nontaxable payment of the death benefit, and the remainder of the payment generally is includible in gross income. Under prior law, the first $1,000 received by a surviving spouse in any taxable year in excess of the amount treated as a payment of the death benefit was excludable from gross income.

In addition, under prior and present law, the amount held by an insurer with respect to any beneficiary is the amount that equals the value of the agreement, provided in the life insurance contract, to make payments at a date or dates later than the death of the insured. The value of such an agreement was determined as of the date of death of the insured and was discounted on the basis of the interest rate and mortality tables used by the insurer in calculating payments under the agreement. Under prior law, the mortality tables used by an insurer for purposes of valuing the agreement described above could distinguish among individuals on the basis of

sex.

Reasons for Change

The amount received by a beneficiary of a life insurance contract in excess of the prorated amount deemed to be a payment of the death benefit represents a payment made by the insurance company for the use of the beneficiary's money, i.e., the unpaid death benefit. Congress believed that this amount is comparable to interest paid by other financial institutions for the use of depositors' money and should be taxed in the same manner.

For legislative background of the provision, see: H.R. 3838, as reported by the House Committee on Ways and Means on December 7, 1985, sec. 1001; H.Rep. 99-426, p. 657; H.R. 3838, as reported by the Senate Committee on Finance on May 29, 1986, sec. 1001; S.Rep. 99-313, pp. 487488; and H.Rep. 99-841, Vol. II (September 18, 1986), pp. 338-339 (Conference Report).

Congress was also concerned that, if gender-distinct mortality tables were used, the tax system distinguished among individuals on the basis of sex in calculating the amount of any payment that is deemed to be attributable to a death benefit. In most cases under the Internal Revenue Code, gender-neutral mortality tables are prescribed by the Secretary of the Treasury. Congress found it appropriate to direct the Secretary to prescribe a similar gender-neutral table for purposes of valuing the delayed payment of a death benefit.

Explanation of Provision

Under the Act, all amounts paid to any beneficiary of a life insurance policy at a date later than the death of the insured are included in the beneficiary's gross income to the extent that the amount paid exceeds the amount payable as a death benefit. The special exclusion from the gross income of a surviving spouse of the first $1,000 in excess of the amount payable as the death benefit is repealed.

The Act also requires, for purposes of valuing the portion of any payment deferred beyond the death of the insured that is a nontaxable death benefit, that an insurer use mortality tables prescribed by the Secretary of the Treasury in regulations. Congress expects that such tables will not distinguish among individuals on the basis of sex. An insurer is not permitted to use its own mortality table in determining the portion of any payment attributable to a nontaxable death benefit. As under prior law, the insurer is permitted to use its assumed interest rate in calculating payments under the agreement.

The operation of this rule does not prevent an insurance company from making payments to beneficiaries based on its own mortality tables. Rather, the provision operates to specify the portion of any installment payment that is to be treated as a payment of an excludable death benefit and the portion attributable to interest that is includible in gross income.

Effective Date

The provision applies to amounts received with respect to deaths occurring after October 22, 1986, in taxable years ending after that date.

2. Treatment of structured settlement agreements (sec. 1002 of the Act and sec. 130 of the Code)2

Prior Law

Prior and present law exclude from gross income the amount of any damages received on account of personal injuries or sickness, whether by suit or agreement and whether as a lump sum or as periodic payments (Code sec. 104(a)(2)). The person liable to pay the

2 For legislative background of the provision, see: H.R. 3838, as reported by the House Committee on Ways and Means on December 7, 1985, sec. 1003; H.Rep. 99-426, p. 659; H.R. 3838, as reported by the Senate Committee on Finance on May 29, 1986, sec. 1002; S.Rep. 99-313, pp. 488490; and H.Rep. 99-841, Vol. II (September 18, 1986), pp. 339-340 (Conference Report).

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