Taxation of Insurance Companies: Tax Court Ruling Limits Insurance Companies’ Use of the Annual-Statement Method of Accounting for U.S. Federal Tax Purposes

Sullivan & Cromwell LLP - November 15, 2010

On November 8, 2010, the U.S. Tax Court issued an opinion that limits the use of the annual statement method of accounting by insurance companies in determining their annual taxable income for U.S. federal tax purposes. In its opinion, State Farm Mutual Automobile Insurance Co. v. Commissioner (135 T.C. 26), the Tax Court ruled that amounts owed as punitive damages may not be deducted from taxable income as a loss under Code Section 832(b)(5) notwithstanding that such amounts may have been properly included as losses by the taxpayer on its annual statutory financial statements. Instead, the Court held that the annual statement method of accounting applies only to losses under the terms of an insurance contract, and not to “extracontractual” obligations, such as punitive-damages awards.