Petition for Writ of Certiorari — Bankers Life & Casualty Co. v. United States

Supreme Court brief1998

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98 145 wi 16198

No. cc UF THE CLERK

In The

Supreme Court of the United States

October Term, 1997

BANKERS LIFE AND CASUALTY COMPANY,

Petitioner,

UNITED STATES OF AMERICA,

Respondent.

On Petition For Writ Of Certiorari

To The United States Court Of Appeals

For The Seventh Circuit

PETITION FOR WRIT OF CERTIORARI

Rosert F. Forrer

Counsel of Record

Gary H. K LIne

THomas E. CHomicz

Witson & McILvaInNe

500 West Madison Street

Suite 3700

Chicago, IL 60661-2511

(312) 715-5000

Counsel for Petitioner

COCKLE LAW BRIEF PRINTING CO., (800) 225-6964

OR CALL COLLECT (402) 342-2831

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QUESTIONS PRESENTED

Whether a Court, having concluded that the literal

language of an Internal Revenue Code provision is silent

on the issue presented in analyzing an interpretive Treas-

ury Regulation, may decline to analyze the provision’s

statutory context, design and structure to ascertain Con-

gressional intent under the first step of Chevron.

Whether under I.R.C. § 815 non-cash assets distrib-

uted by a life insurance company are to be measured at

their adjusted tax basis, thereby invalidating interpretive

Treas. Reg. § 1.815-2(b)(3), which provides a different and

inconsistent measure of such distributed assets.

PARTIES TO THE PROCEEDING

All the parties are named in the caption.

STATEMENT PURSUANT TO RULE 29.6

Bankers Life And Casualty Company is a corporation

wholly owned by Bankers Life Insurance Company of

Illinois, which, in turn, is a wholly owned subsidiary of

CIHC, Inc., which is a wholly owned subsidiary of Con-

seco, Inc., a publicly traded company listed on the New

York Stock Exchange. Bankers Life And Casualty Com-

pany has no nonwholly owned subsidiaries.

iii

TABLE OF CONTENTS

Page

GURPEPE PEEE WUMMEEUEIMAE Sos vccccscsescvcccenteces Bi

PARTIES TO THE PROCEEDING ............e0000- ii

STATEMENT PURSUANT TO RULE 29.6........... ii

RE GI PU REPO RAEI 00 RR voce kere ee dese cews Vv

A EOS eS dN Ce eda Sb vk odes cece twas 1

EE ee ie Ci en o4b5.0e bw eR eb CK SS aOR a oes oe 1

STATUTORY AND REGULATORY PROVISIONS

tian Cac eka yh vss Kee dbs bees aekss 2

PROS MRE GO BEES SALES occas cescesscecvceeses 2

REASONS FOR GRANTING THE PETITION....... 7

I. The Decision Below Conflicts With This

Court’s Decisions Establishing The Analytical

Framework For Determining The Validity Of

Treasury Regulations And Other Agency Reg-

eS ge ee oeee eo rere ee 8

Il. As A Result Of Its Misapplication Of The Chev-

ron Analysis, The Seventh Circuit Erroneously

Affirmed The District Court’s Judgment...... 13

I bcc Rd h Abba phew aphaesacaness ¢00s' 17

APPENDICES

Page

Opinion of the United States Court of Appeals for

the Seventh Circuit, dated April 17, 1998 ......... Al

Judgment of the United States Court of Appeals

for the Seventh Circuit entered on April 17,

ee RSE IES Pete iii oe pan rene aren rere arae A37

TABLE OF CONTENTS - Continued

Page

Memorandum Opinion and Order of the United

States District Court for the Northern District of

Illinois, Eastern Division dated March 22, 1996 ...A38

Judgment In A Civil Case entered by the United

States District Court for the Northern District of

Illinois, Eastern Division on March 22, 1996...... A63

Section 802 of the Internal Revenue Code of 1954,

Gis WIS os aos ce a Ak a eae A64

Section 815 of the Internal Reverue Code of 1954,

TI ooo os ea Ee eee Fh eee ea A66

Treasury Regulation § 1.815-2.................0005. A78

ahi

TABLE OF AUTHORITIES

Page

Cases

Atlantic Mutual Ins. Co. v. Commissioner, 118 S. Ct.

RN CRON wah 6 wie p ih 0 Wad sw kv Pekin ene 8, 10, 11

Brown v. Gardner, 513 U.S. 115 (1994)....>33..-00 3. 11

Chevron U.S.A. Inc. v. National Resources Defense

Council, Inc., 467 U.S. 837 (1984).............. passim

Dole v. United Steelworkers of America, 494 U.S. 26

on ER ER Tatar Si Fe aa he Crane Peleg 12

Fulman v. United States, 434 U.S. 528 (1978) ......... 10

Imperial General Life Ins. Co. v. Commissioner, 60

cE he a. SPP Seeger in bee ae my eins ere Spee gee 6

K-Mart Corp. v. Cartier, Inc., 486 U.S. 281 (1988) ..... 12

MCI Telecomm. Corp. v. American Tel. & Tel. Co., 512

Re ee TAOS SS ons soos bus hae ce week iweiseedsres 12

Regions Hosp. v. Shalala, 118 S. Ct. 909 (1998)........ 11

STATUTES

Me es AES CRIS oss ws he vedi s Sobek ace esene 1

28 U.S.C. § 1346(a)(1) (1988 & Supp. IV 1992)........ 2

Oe Nee Oe BET CRI in os oo sk oa uke cas cabins bivee ia 1

REGULATIONS

Treasury Regulation § 1.815-2(b)(3) (1961) ....... passim

TABLE OF AUTHORITIES - Continued

Page

OTHER AUTHORITY

I.R.C. § 346 (1982) (amended 1988)................45. 6

ILR.C. §§ 802 (1982) (repealed 1984)............. passim

LR.C. § 815 (1982) (amended 1988).............. passim

I.R.C. § 7805(a) (1982) (amended 1988 & Supp. IV

ROOD) ova cscs ase Ea as eh ek a Pe eas iS

Deficit Reduction Act of 1984, Pub. L. No. 98-369,

PETITION FOR WRIT OF CERTIORARI

Bankers Life And Casualty Company (hereinafter

“Bankers Life”) respectfully petitions for a writ of cer-

tiorari to review the judgment and opinion of the United

States Court Of Appeals For The Seventh Circuit in this

case.

OPINIONS BELOW

The opinion of the Seventh Circuit is reported at 142

F.3d 973 and is set forth in its entirety in the Appendix

hereto at Al. The memorandum opinion and order of the

United States District Court for the Northern District of

Illinois, Eastern Division, affirmed by the Seventh Circuit,

is unreported and is available on Westlaw as, Bankers Life

And Casualty Company v. United States; 1996 WL 137646,

79 A.F.T.R.2d 97-1726, and is set forth in its entirety in the

Appendix hereto at A38.

JURISDICTION

The decision below was issued by the Seventh Circuit

on April 17, 1998 and judgment was entered on that date.

Bankers Life did not file a petition for rehearing in the

Seventh Circuit. In accordance with 28 U.S.C. § 2101(c)

(1988), this Petition is filed within ninety days of the date

on which the judgment was entered. The jurisdiction of :

this Court is invoked under 28 U.S.C. § 1254(1) (1988).

STATUTORY AND REGULATORY

PROVISIONS INVOLVED

The relevant statutory provisions which applied dur-

ing the relevant period, I.R.C. §§ 802, 815 (1982) and

Treas. Reg. § 1.815-2(b)(3) are set forth in their entirety in

the Appendix hereto at A64, A66 and A78, respectively.

STATEMENT OF THE CASE

1. Proctedings Below

Bankers Life, a stock life insurance company, filed a

three-count complaint against the United States of Amer-

ica in August, 1993 for refund of federal income taxes and

interest as allowed by law with respect to its 1983 and

1984 tax years. Jurisdiction in the District Court was

based upon 28 U.S.C. § 1346(a)(1) (1988 & Supp. IV 1992).

The case was submitted to the District Court on stipu-

lated and unopposed facts and both parties moved for

summary judgment. The District Court denied Bankers

Life’s motions for summary judgment and granted

Respondent's cross-motions for summary judgment on all

counts. Bankers Life appealed as to two of the counts

and, during the pendency of the appeal, the parties set-

tled one of those counts.

The remaining substantive issue before the Seventh

Circuit was whether, under then § 815 of the Internal

Revenue Code,’ Bankers Life’s 1983 distribution of non-

1 All sections referenced are to the Internal Revenue Code

of 1954, as amended, and as in effect during the relevant period.

The section at issue here is a part of Subchapter L, which was

substantially ax-ended by the Deficit Reduction Act of 1984

cash real property to its shareholder was to be measured

for purposes of the so-called Phase III federal income tax

by the adjusted tax basis or the fair market value of those

non-cash assets. Treas. Reg. § 1.815-2(b)(3), issued pur-

suant to the general grant of authority in § 7805(a) (1982)

(amended 1988 & Supy. IV 1922) of the Jaterna! Revenue

Code, expressly required a fair market value measure.

Bankers Life contended that certain of the language of

§ 815, coupled with its context and the statutory structure

of § 815, and the underlying tax accounting principles

embodied in that structure, evidenced Congress’s intent

that adjusted tax basis be the measure and that, therefore,

the Regulation was invalid.

2. The Seventh Circuit’s Decision And Opinion

In affirming summary judgment in favor of Respon-

dent, the Seventh Circuit held that, bécause in its view

the literal wording of § 815 was “silent” (A34) on the

issue of the proper measure for the distributed assets, it

must defer to the Regulation if the Regulation’s result

had “some colorable support.” (A35) The Seventh Circuit,

in so limiting its analysis, chose not to analyze Bankers

Life’s arguments as to the context, design and structure of

§ 815 to determine first whether Congress itself had spo-

ken to the applicable measure for the distributed assets.

Rather, it relegated those arguments to the second step of

its analysis and then only in the context of whether those

arguments “robbed” the Regulation of its reasonableness.

(A34)

(Pub. L. No. 98-369, § 211, 98 Stat. 720). i.R.C. § 802 was repealed

and some of its language merged with I.R.C. § 801.

The Seventh Circuit so held notwithstanding its con-

clusion that this Court’s decision in Chevron U.S.A. Inc. v.

National Resources Defense Council, Inc., 467 U.S. 837 (1984)

provided the analytical framework within which the Reg-

ulation’s validity was to be determined.

3. Internal Revenue Code Sections 802 And 815

And The Regulation

Commencing in 1959 and throughout the relevant

period, Congress allowed stock life insurance companies

to defer from federal income taxation one-half of their

annual underwriting gains. The rationale for this deferral

was that, in view of the contingent nature of life insur-

ance claims, such deferred amounts constituted an appro-

priate cushion or reserve against long-term contingencies.

As part of the statutory structure providing this

deferral, Congress also developed a tax accounting sys-

tem which was designed to determine when the deferral

of such underwriting gain would end and when the so-

called Phase III federal income tax with respect to such

previously deferred income would become payable. The

foundation of this tax accounting system was the mainte-

nance by each life insurance company of two tax mem-

oranda accounts which corresponded to two general

types of income.

The tax memoranda account known as the poli-

cyholders surplus account (“PSA”), from a tax accounting

standpoint, reflected the life insurance company’s undis-

tributed deferred underwriting income. The other

account, the shareholders surplus account (“SSA”), from

a tax accounting standpoint, reflected undistributed

amounts that had already been taxed to the life insurance

company or were not taxable to the life insurance com-

pany in the first instance.

The amounts in each of these tax memorandum

accounts were accounted for (credited) at their adjusted

tax basis. Therefore, these tax memoranda accounts did

not include or reflect the unrealized appreciation in the

value of any of the life insurance company’s investment

assets.

Under then LR.C. § 815(a), a triggering event for the

end of the deferral was a distribution to shareholders,

which distribution was first “treated as” made “out of”

the SSA and then, to the extent of any excess, was

“treated as” made “out of” the PSA. (A66) Any such

subtraction from the PSA released into taxable income on

a dollar-for-dollar basis the deferred underwriting

income reflected in the PSA, which, under I.R.C.

§ 802(a)(1) and (b)(3) became subject to the so-called

Phase III tax (which in effect was the “regular” corporate

tax applied on a deferred basis to the deferred underwrit-

ing income). (A64-65) The underlying structure of this tax

accounting system reflected the principle that a distribu-

tion should not end the deferral if the distribution did not

change the fact that amounts at least equal to the deferred

underwriting income continued to be retained and con-

tinued to function as a reserve or cushion against long-

term contingencies.

After the expiration of the notice and comment

period, Treas. Reg. § 1.815-2(b)(3) was issued and pub-

lished in the Federal Register in January, 1961. Prior to

this case, the Regulation’s validity had never been adjudi-

cated and had been referenced in only one reported judi-

cial opinion.? The Regulation was never amended.

4. Undisputed Facts

The parties stipulated to the following undisputed

relevant facts. During 1983, Bankers Life distributed sub-

stantial real estate and real estate-related assets to its sole

shareholder, the John D. and Catherine T. MacArthur

Foundation, a charitable foundation, pursuant to a partial

liquidation under I.R.C. § 346 (1982) (amended 1988).

These distributed assets had an aggregate adjusted tax

basis of $209,650,747 and an aggregate fair market value in

excess of $875,000,000 — that is, these distributed assets

had unrealized appreciation of over $666,000,000. In 1983,

Bankers Life had a SSA of $241,014,695 and a PSA of

$154,434,319. If the aggregate adjusted tax basis were the

proper measure of the distribution and if, accordingly, the

unrealized appreciation element of the distribution were

not a subtraction from the SSA and PSA, then Bankers Life

would have had no reduction in its PSA and, therefore, no

1983 Phase III income and no 1983 Phase III tax liability.

Bankers Life, in accordance with Treas. Reg.

§ 1.815-2(b)(3), initially treated fair market value as the

measure of the distribution and, therefore, recognized the

full amount of its PSA as Phase III income. Subsequently,

2 In the sole case that referenced Treas. Reg. § 1.815-2(b)(3),

Imperial General Life Ins. Co. v. Commissioner, 60 T.C. 979 (1973),

the Tax Court specifically noted that the taxpayer had not

challenged its validity.

Bankers Life timely filed a claim for refund based on its

belief that the Regulation was invalid and that the correct

measure of the 1983 non-cash distribution for purposes of

calculating the charge to Bankers Life’s SSA was the

distributed assets’ adjusted tax basis. This refund claim

was disallowed.%

REASONS FOR GRANTING THE PETITION

This case provides this Court with the timely oppor-

tunity to provide the lower courts with clear direction as

to the proper application of the Chevron two step analysis

in cases involving interpretive Treasury Regulations and,

indeed, in all cases involving a challenge to the validity

of a regulation issued by a department or agency.

The first question presented relates to the fundamen-

tal nature and scope of the required analysis in determin-

ing whether, under Chevron’s first step, Congress has

spoken to the particular issue. According to the Seventh

Circuit, an examination of the underlying statutory

design, structure and context is not part of that analysis.

In so holding, the Seventh Circuit has abandoned the

settled province and duty of the judiciary to say what the

law is. Furthermore, the Seventh Circuit has so broadly

defined the second step of the Chevron analysis as to

3 Pursuant to the aforementioned partial settlement, the

parties agreed that Bankers Life’s recovery is now limited to

interest for ten months on the 1983 Phase III tax it paid plus

interest on such interest as allowed by law.

make a finding of regulation invalidity virtually impossi-

ble. The Seventh Circuit’s decision, therefore, should be

reviewed not merely to correct an erroneous decision but

also to re-establish promptly the vital role of the judiciary

in determining the validity of an agency’s or depari-

ment’s regulations.

The Decision Below Conflicts With This Court’s Deci-

sions Establishing The Analytical Framework For

Determining The Validity Of Treasury Regulations And

Other Agency Regulations And Rules.

In Chevron, this Court established a two part analyti-

cal framework to be used by courts in determining the

validity of a regulation. The first step requires, in addi-

tion to reviewing the literal language of the statute, an

examination of the context in which the statutory lan-

guage was enacted and the design and structure of the

statute to determine first whether Congress has spoken to

the particular issue. Only after a court has so analyzed the

context, design and structure of the statute and only after

it has concluded that Congress did not speak to the issue

presented, may a court then apply the second part of the

Chevron test; that is, whether “the agency’s answer is

based on a permissible construction of the statute.” 467

U.S. at 843.

Subsequent to Chevron, a controversy described by

the Seventh Circuit as a “free-fire zone of judicial

debate,” ensued over whether the two part Chevron anal-

ysis applied to interpretive Treasury Regulations. (A9)

That question was resolved this term in Atlantic Mutual

Ins. Co. v. Commissioner, 118 S.Ct. 1413 (1998) wherein this

Court cited Chevron as supplying the required first step

analytical framework in an interpretive Treasury Regula-

tion validity case. Bankers Life had so contended

throughout this litigation. The Seventh Circuit ultimately

agreed. (A21-23)

The Seventh Circuit, however, applied that analysis in

a manner which conflicts not only with Chevron itself but

also with this Court’s decisions in numerous post-Chevron

cases. These decisions reiterate that the first step includes

an intensive examination of the context in which the

statutory language was enacted and its underlying statu-

tory structure and design to determine whether Congress

has spoken to the particular issue.

The Seventh Circuit began its Chevron analysis by

acknowledging its own ambivalence over the scope of the

first step (A24), and by then concluding that the Seventh

Circuit “seem(s) to lean toward” reserving consideration

of legislative history and “other appropriate factors”

(such as the design of the statute as a whole) to the

second step. (A24) It then held:

With that said, however, we reiterate Chevron’s

fundamental dictate that a court must not “sub-

stitute its own construction of a statutory provi-

sion for a reasonable interpretation” by the

agency in question. (A25) (emphasis added)

In doing so, the Seventh Circuit quoted language from

Chevron having no bearing on this Court’s application of

the first step in Chevron. 467 U.S. at 844.

This misreading of Chevron led the Seventh Circuit

into its primary error — limiting its first step inquiry

solely to whether the literal wording of § 815 spoke to the

issue of the proper measure of the amount of a non-cash

assets. Citing this Court’s pre-Chevron decision in Fulman

v. United States, 434 U.S. 528 (1978), the Seventh Circuit

held:

Even more fundamentally, the plain language of

the statute simply fails to address the question

of valuation. In other words, the statute is silent

on this question. In Fulman, the Supreme Court

faced a similar situation in which “while obvi-

ously some rule of valuation must be applied,

Congress . . . failed expressly to provide one.”

434 U.S. at 533. Here, too, Congress failed to

expressly provide a.method of valuation.

Because the statute is silent, we should not

attempt to infer a method of valuation under the

guise of determining the plain meaning of the

provision. (A34)

As a result, the Seventh Circuit examined Bankers

Life’s arguments as to the structure and design of § 815

solely in the context of determining, under the second

step of the Chevron test, whether these arguments

“robbed” the Regulation of its reasonableness (A34)

rather than in the context of whether the plain meaning

of the underlying statutory provisions required adjusted

tax basis as the proper measure of a distribution.

This abbreviated Chevron first step stands in stark

contrast to this Court’s analysis in Atlantic Mutual,

decided shortly after the Seventh Circuit’s decision in this

case. In Atlantic Mutual this Court, noting that the statu-

tory term “reserve strengthening” was not defined in the

Code, nonetheless explored whether its “plain meaning”

could be discerned either from its having an established

meaning in the property-casualty industry or from the

term’s prior use in life insurance tax legislation. Only

after concluding that neither industry usage nor prior

legislation provided the “plain meaning” advanced by

the taxpayer did the Court proceed to the Chevron second

step; that is, whether the Treasury Regulation represented

a reasonable interpretation of the statute. 118 S.Ct. at

1417-1418.

The Seventh Circuit’s approach is also inconsistent

with this Court’s decisions applying Chevron in non-tax

cases. In these cases, this Court has repeatedly under-

taken a thorough examination of the language, context,

design and structure of the statute at issue in order to

determine, first, whether Congress had spoken to the

issue.

For example, in Regions Hosp. v. Shalala, 118 S.Ct. 909

(1998), this Court referred to the “now familiar” formula-

tion of the Chevron test and its required use by the courts

of traditional tools of statutory construction to first deter-

mine Congress’ intent, including an examination of other

provisions of the statute and focusing on the relevant

context.

In Brown v. Gardner, 513 U.S. 115 (1994), this Court

reiterated that the meaning of statutory language, plain

or not, depends on context. This Court in this case under-

took a detailed analysis of the language of the particular

section of the Veterans Administration Act, dictionary

definitions, the context of that language, textual cross

references to other parts of the Act and consideration of

the “incongruity” in the application of words. Ultimately

this Court held that “the text and reasonable inferences

from it give a clear answer against the Government and

that, as we have said is, ‘the end of the matter.’ ” Id. at

556.

So too in MCI Telecomm. Corp. v. American Tel. & Tel.

Co., 512 U.S. 218 (1994), this Court in resolving the par-

ties’ dispute over the meaning of the phrase “modify any

requirement” in § 203(b)(2) of the Telecommunications

Act underscored that the meaning should be discerned

not simply from dictionary definitions but also from con-

textual indications. Id. at 227. This Court also took into

account the enormous importance to the “statutory

scheme” of the tariff filing provision at issue. The Court

ultimately concluded: “But our estimations, and the Com-

mission’s estimations, of desirable policy cannot alter the

meaning of the Federal Communications Act of 1934.”

In Dole v. United Steelworkers of America, 494 U.S. 26

(1990), this Court emphasized that with respect to a chal-

lenge to a regulation, the reviewing court must first “try

to determine congressional intent, using traditional tools

of statutory construction.” Id. at 35. This Court then went

on to state that in addition to focusing on the statutory

language a court must look to the structure of the under-

lying statutory scheme and “the provisions of the whole

law, and to its object and policy.” Id. at 35 [quoting from

Massachusetts v. Marsh, 490 U.S. 107 (1989) and Pilot Life

Insurance Co. v. Oedeaax, 481 U.S. 41, 51 (1987).]

In K-Mart Corp. v. Cartier, Inc., 486 U.S. 281 (1988),

this Court emphasized that in determining whether a

challenged regulation is consistent with the statute it

implements, the reviewing court must ascertain the stat-

ute’s plain meaning by looking to the particular statutory

language at issue and the language and design of the

statute as a whole. Id. at 291.

In erroneously applying an abbreviated first step of

Chevron, the Seventh Circuit eschewed this Court’s direc-

tives as to the role of the judiciary in reviewing agency

and department regulations and so expansively defined

the second part of the Chevron test as to make a finding of

regulation invalidity a virtual impossibility. Such an

expansive view of “judicial deference” not only estab-

lishes an erroneous precedent in the Seventh Circuit but

also adds further confusion as to the correct application

of the Chevron analysis. Prompt correction of this error is

of particular importance in cases addressing the validity

of Treasury Regulations which repeatedly require resolu-

tion of the tension between Congress’ power to tax and to

establish tax policy and its I.R.C. § 7805(a) directive to the

Treasury Department to adopt “all needful rules and

regulations for the enforcement of” the income tax provi-

sions of the Code.

Because of its misapplication of the two step Chevron

analysis, the Seventh Circuit erroneously upheld the val-

idity of Treasury Regulation § 1.815-2(b)(3) and affirmed

the judgment of the District Court.

As A Result Of Its Misapplication Of The Chevron

Analysis, The Seventh Circuit Erroneously Affirmed

The District Court’s Judgment

Throughout the proceedings below, Bankers Life con-

sistently advanced several distinct arguments which,

when applied under the Chevron first step, evidenced

Congress’ intent that the adjusted tax basis measure be

utilized for non-cash distributions under § 815. Those

arguments centered around the statutory language of

§ 815, fundamental principles of tax accounting that are

consistently applied throughout the Internal Revenue

Code, certain fundamental principles that are embodied

in the statutory scheme, legislative history and consis-

tency of results.

These arguments included, among other arguments,

the following:

1. Treas. Reg. § 1.815-2(b)(3) was inconsistent with

the distribution “out of” language of § 815. An element,

such as unrealized appreciation, could not be distributed

“out of” the SSA or PSA if it had never been included or

reflected in the SSA or PSA.

2. The underlying statutory provisions established a

debits and credits tax accounting system. A debits and

credits system of accounting inherently embodies the rule

that there must be uniformity between debits and credits

— that is, debits and credits must be based on or reflect

the same measure and an item cannot be a debit item in a

tax accounting system if the item cannot be a credit item.

Because credits to the SSA and PSA corresponded to, and

reflected, adjusted tax basis, distributions, which consti-

tuted debits to these accounts, must also reflect adjusted

tax basis and not fair market value as required by the

Regulation. Because the unrealized appreciation element

of the distributed assets was not a credit to the SSA or the

PSA, the distribution of this element could not have been

a debit to these accounts.

cere

3. The effect of interjecting the Regulation’s fair

market measure into the Phase III tax accounting system

was to create a result which was in direct conflict with

the following underlying principles which were embod-

ied in the statutory Phase III tax accounting system:

(a) The underlying statutory scheme ensured

that if a distribution did not change the fact that

amounts at least equal to the deferred under-

writing income continued to be retained and

continued to function as a reserve or cushion

against long-term contingencies, the deferral

would not end.

(b) The underlying statutory scheme ensured

that items that should not be taxed — because

such items had previously been taxed or were

not taxable in the first instance - would not be

subject to the Phase III deferred tax and would

not be a trigger event for the Phase III tax. (The

unrealized appreciation of the distributed assets

was an item that was not taxable in the first

instance.)

The Seventh Circuit rejected the first argument in its

first step Chevron analysis largely on the basis of its

construction of the “treated as” language in § 815 without

examining the reasons, based on the underlying statutory

structure, that the “treated as” language had to be

included in § 815.

In analyzing Bankers Life’s second argument, based

on settled tax accounting principles inherent throughout

the Code, the Seventh Circuit in applying the second step

of Chevron, concluded:

And Bankers Life certainly demonstrates that

the regulation conflicts with the methods of con-

ventional taxation. But conflicts do not equal

irrationality. The IRS may adopt regulations that

produce unusual results, so long as those results

have some colorable support. As Chevron itself

explained, an agency may choose among con-

flicting policies. See 467 U.S. at 845. Further-

more, as the government argues, because of the

singularity of the Phase III system, any conflicts

with regular taxation do not mean very much.

(A35) (emphasis added)

Neither the Seventh Circuit nor Respondent cited any

authority — linguistic, legislative or otherwise - that Con-

gress intended § 815 to be interpreted in a manner that

would conflict with methods of conventional taxation

that were embodied throughout the Code and in the

Phase III system. The Seventh Circuit, rather than consid-

ering such inconsistency as a primary, if not determina-

tive, factor in discerning Congress’ intent as to the

measure of a distribution under the first part of the

Chevron analysis, brushed the conflict aside under the

second part of the Chevron analysis as “not being equal

(to) irrationality.” (A35)

The Seventh Circuit did not even address the third

argument set forth above based on cardinal principles

that were embodied in the underlying statutory structure

and design.

By granting this petition, this Court will be posi-

tioned to correct the Seventh Circuit’s underlying deci-

sion, and this Court will be able to nip in the bud the

Seventh Circuit’s entirely erroneous view that statutory

i eee aerate et

context, design, and structure are not relevant to the

application of the first part of the Chevron analysis.

CONCLUSION

For the foregoing reasons, the petition for a writ of

certiorari should be granted.

Dated: July 15, 1998

Respectfully submitted,

Rosert F. Forrer

Counsel of Record

Gary H. Kune

THomas E. CHomicz

Witson & MclILvaine

500 West Madison

Suite 3700

Chicago, IL 60661-2511

(312) 715-5000

Counsel for Petitioner

EEE TORO yA PL REE OE EOLA Ue A A Ne th

In the

United States Court of Appeals

for the Seventh Circuit

No. 96-2260

Bankers Lire AND CaAsuALTY COMPANY,

Plaintiff-Appellant,

Unrrep STATES OF AMERICA,

Defendant-Appellee.

Appeal from the United States District Court

for the Northern District of Illinois, Eastern Division.

No. 93 C 4739 — Paul E. Plunkett, Judge.

ARGUED Fesruary 20, 1998 — Decipep Apri 17, 1998

Before Cummincs, Kanne, and Evans, Circuit Judges.

Evans, Circuit Judge. Upon first glance, this lawsuit

seems overly ambitious. Bankers Life and Casualty Com-

pany invites us to invalidate a seemingly straightforward

and long-standing Treasury regulation. The insurance

company’s bold argument makes sense in light of one

crucial fact: Bankers Life seeks a tax refund of $71 million

plus interest from 1983. In effect, Bankers Life is betting

on a long shot. It must know its chances of winning are

slim, but the huge potential payoff apparently justifies

the effort.

In a nutshell, Bankers Life attacks the validity of

: Treasury Regulation § 1.815-2(b)(3). The regulation had

been on the books for 22 years — since the end of the

Eisenhower Administration — at the time it was applied to

Bankers Life. The regulation measured the value of a life

insurance company’s distribution of real property to its

shareholders according to market value — rather than

adjusted basis - for the purpose of determining whether

the distribution triggered a tax on previously untaxed

income. The district court, after upholding the validity of

the regulation, granted summary judgment in favor of the

government, and Bankers Life, on this appeal, asks us to

reverse the judgment.

As one might expect in a case involving the inter-

pretation of the tax code and its accompanying regula-

tions, a certain amount of dry exposition is necessary to

lay out the controversy. This story begins with the death

of John D. MacArthur, the owner of Bankers Life and

Casualty, in 1978. MacArthur’s death invoked the terms

of a trust agreement that transferred ownership of the

insurance company to the John D. and Catherine T. Mac-

Arthur Foundation (a name well-known to public televi-

sion and radio audiences). In 1983, because of legal limits

on the foundation’s ability to hold corporate stock, see

IL.R.C. § 4943(c)(6), the insurance company transferred

some of its real estate holdings to the foundation as a

distribution to the sole shareholder. Eventually, in 1984,

the foundation divested itself of Bankers Life by selling

the company to the ICH Corporation. This case focuses

on the amount of tax owed by Bankers Life because of the

1983 distribution of real estate assets. The fair market

value of these real estate holdings was a whopping $875

million. Their aggregate adjusted tax basis, however, was

just under $210 million. The difference between the two

valuations results in a $71 million tax differential.

The distribution invoked the arcane rules for taxation

of life insurance company income. See United States v.

Atlas Life Ins. Co., 381 U.S. 233, 235 n.2 (1965) (describing

the life insurance taxation system); Continental Bankers

Life Ins. Co. v. Commissioner, 93 T.C. 52, 60 (1989) (same).

For our purposes, matters are even more obscure because

Congress changed these rules in 1984.! See Tax' Reform

Act of 1984, Pub. L. No. 98-369, §§ 211-24, 98 Stat. 494. In

any event, under these complex rules, life insurance com-

panies paid taxes in three distinct “phases.” Under

“Phase I” taxation, an insurance company paid a tax on

the lesser of either its gain from investment or its gain

from investment and underwriting. See I.R.C. § 802(b)(1).

Under “Phase II” taxation, an insurer paid taxes on one-

half of the amount by which the gain from underwriting

exceeded the gain from investment. See I.R.C. § 802(b)(2).

In effect, Phases I and II taxed the insurance company’s

income — except for the remaining one-half of the gains

from underwriting. This remaining income received spe-

cial deferred taxation — “Phase III” taxation — the general

subject of this case. The law required the insurance com-

pany to keep a running tally of this Phase III income and

to pay a tax on the money when the company issued

certain distributions to its shareholders. See I.R.C.

§ 802(b)(3).

1 Thus, unless otherwise noted, all citations to the Internal

Revenue Code and Treasury regulations are to the statutes and

regulations in effect in 1983 — namely, the 1954 I.R.C.

gat ee

In order to keep track of the Phase III income and

determine when it owed taxes on the money, the revenue

code required insurance companies to maintain two sets

of bookkeeping entries, or, in IRS parlance, “tax return

memorandum accounts.” The first of these accounts — the

“shareholders surplus account” (“SSA”) — recorded the

amount of accumulated after-tax earnings from Phase I

and II income. See I.R.C. § 815(b). The second account -

the “policyholders surplus account” (“PSA”) — recorded

the amount of accumulated Phase III income. See I.R.C.

§§ 802(b)(3), 815(c).

The laws allowed an insurance company to distribute

its Phase I and II after-tax earnings to its shareholders

without consequence. Accordingly, whenever a life

insurer issued a distribution, it deducted the amount of

the distribution from the SSA without tax consequences.

This made complete sense because the company already

paid Phase I and II taxes on this money. If, however, the

distribution exceeded the amount of money recorded in

the SSA, the laws treated the excess amount of the distri-

bution as a transfer of Phase III income and required the

insurance company to pay Phase III taxes. Thus, the

insurer deducted the excess from the PSA and paid a

Phase III tax on this amount. See LR.C. § 815.2

2 Strictly speaking, the 1984 tax reforms did not abolish all

remnants of the three-phase structure. The new laws

grandfathered existing PSA accounts. The 1984 statutes

man iated that life insurers maintain existing PSA accounts, see

I.R.C § 815(d) (1984), and pay a tax on “the amount of direct and

indirect distributions . . . to shareholders from such account,”

see I.R.C. § 815(a)(2) (1984).

| eae ne eas nae ean Se SNe nr ate anno erenn nt rue wnnuoerr

To sum up, a life insurance company could have

distributed its after-tax earnings (the amount of money in

the SSA) without paying any additional tax. But when the

company dipped into the previously untaxed earnings

(the amount of money in the PSA) to make a distribution,

it paid the Phase III income tax. In other words, the laws

allowed the life insurance company simply to avoid pay-

ing taxes on a big chunk of its income until it distributed

that income to the shareholders.

Why did life insurance companies receive this

unusual treatment?? The Senate Finance Committee dis-

cussed the matter when it enacted the Life Insurance

Company Income Tax Act of 1959 which established the

three-phase tax structure. See Pub. L. No. 86-69, 73 Stat.

112. According to the committee report, Phase III taxation

addressed the “long-term nature of life insurance con-

tracts” by allowing the company to keep one-half of the

annual underwriting gain as “a desirable ‘cushion’ for

special contingencies which may arise.” S. Rep. No.

86-291, at 26 (1959). The report explained that underwrit-

ing gains may appear as income under an annual tax

system when, in fact, these gains merely serve to fulfill

life insurance contracts down the road. See id.; see also

H.R. Rep. No. 86-34, at 1, 15 (1959). The special deferred

tax treatment adjusted for the conflict between a tax code

3 The three-phase tax structure was not really a special deal

won by effective lobbying. On the contrary, the scheme enacted

a total income approach — taxing revenues from both investment

and underwriting. Previously, life insurers paid taxes only on

investment revenue. See S. Rep. No. 86-291, at 20-21 (1959).

based on annual income and the timetable of the insur-

ance business in which income remains uncertain until

actuarial predictions come to life (or death, as the case

may be).

Congress reasoned that when a life insurance com-

pany made a distribution so large that it dipped into the

PSA, then the company no longer needed a big reserve

for a rainy day. As the Senate committee explained, “If

the insurance company itself decides to distribute these

amounts to stockholders, it has demonstrated that this

cushion is no longer needed.” S. Rep., supra, at 26. Thus, a

distribution larger than the SSA triggered the Phase III

tax.

So far, we have explained one part of tne mechanism

the IRS used to calculate Phase III taxes. We still need

more information to determine the amount of tax. The

missing link is the method for valuing the distribution. To

determine the value of a distr oution for purposes of

Phase III taxation, the IRS relied on a regulation — Treas-

ury Regulation § 1.815-2(b)(3) — developed under its gen-

eral authority to promulgate necessary rules. See I.R.C.

§ 7805(a). Before issuing this regulation, the IRS followed

full notice and comment procedures. Treasury Regulation

§ 1.815-2(b)(3) provided that certain noncash distribu-

tions would be measured by fair market value:

Except in the case of a distribution in cash

and as otherwise provided herein, the amount

to be charged to the special surplus accounts

referred to in subparagraph (1) of this para-

graph with respect to any distributions to share-

holders (as defined in section 815(a) and

paragraph (c) of this section) shall be the fair

market value of the property distributed, deter-

mined as of the date of distribution. However,

for the amount of the adjustment to earnings

and profits reflecting such distributions, see sec-

tion 312 and the regulations thereunder. For a

special rule relating to the determination of the

amount to be charged to such special surplus

accounts in the case of a distribution by a for-

eign life insurance company carrying on a life

insurance business within the United States, see

section 819(c)(1) and the regulations thereunder.

If we put some real world numbers to all of this

abstract tax talk we can see why Bankers Life has a bone

to pick with the IRS. In 1983 Bankers Life had an SSA of

$241,014,695 and a PSA of $154,434,319. The real estate

assets it distributed to the foundation, as we noted ear-

lier, had a fair market value of over $875 million but an

aggregate adjusted basis of only $209,650,747. Pursuant to

Treasury Regulation § 1.815-2(b)(3), Bankers Life valued

the distribution at fair market value. As a result, the life

insurance company depleted its SSA and emptied its PSA

~ paying Phase III taxes on the entire amount of the PSA.

After computation of various adjustments, Bankers Life

ended up paying a Phase III tax of $70,750,058.

Incidently, another abstruse twist in the tax laws

prevented the IRS from just requiring Bankers Life to pay

Phase I and II taxes on the distribution under the normal

rule that when a corporation distributes appreciated

property to shareholders, the corporation must recognize

the gain. That obscure convolution in the tax code was

the General Utilities doctrine (from General Utilities &

Operating Co. v. Helvering, 296 U.S. 200 (1935)) -— “was”

because Congress extinguished the doctrine with the 1986

tax reforms. See Tax Reform Act of 1986, Pub. L. No.

99-514, 100 Stat. 2085. The General Utilities doctrine pro-

vided that a corporation did not pay normal tax on a

noncash distribution. Bankers Life made sure that this

exception to the norm applied — it sought and received a

private letter ruling that the 1983 distribution did not

give rise to a taxable event for purposes of Phase I or

Phase II taxation. See Private Letter 8540070 (July 10,

1985). (Bankers Life also received permission from Illinois

regulators to make the distribution as an “extraordinary

dividend” under state insurance law.) If Bankers Life had

followed the current tax law regarding noncash distribu-

tions, it would have paid Phase I and II taxes on the

appreciation, then included the after-tax gain in the SSA

as a credit, and simultaneously entered a debit reflecting

the full value of the distribution to the foundation.

In any event, Bankers Life predictably examined the

enormous Phase III tax payment very closely. Not sur-

prisingly, the company concluded that Treasury Regula-

tion § 1.815-2(b)(3) conflicted with the tax code. Bankers

Life argues that the tax code required the IRS to value

distributions at aggregate adjusted basis — rather than fair

market value — for purposes of calculating Phase III tax.

According to Bankers Life, the IRS should have valued

the distribution at just under $210 million, an amount

lower than the balance of the SSA. The SSA would have

absorbed the entire distribution and Bankers Life would

not have deducted any amount from the PSA. Thus,

under this approach, Bankers Life would have owed no

Phase III tax at all.

Consequently, Bankers Life filed for a refund seeking

a return of the Phase III tax plus interest since 1983. The

IRS stood by its regulation and disallowed the claim.

Bankers Life then filed this lawsuit. Because the parties

did not dispute the facts, the district court (Judge Paul E.

Plunkett) needed to determine only the validity of Treas-

ury Regulation § 1.815-2(b)(3). On March 22, 1996, Judge

Plunkett upheld the regulation and granted summary

judgment in favor of the government. Bankers Life now

appeals. We review de novo. See Bell Fed. Sav. & Loan Ass'n

v. Commissioner, 40 F.3d 224, 226 (7th Cir. 1994).

Before explaining Bankers Life’s substantive argu-

ments or the government's responses, we need to cover

the basic structure of a challenge to a tax regulation.

Essentially, we must determine the degree of deference

owed to a Treasury Regulation issued under I.R.C.

§ 7805(a) with notice and comment procedures. This

seemingly simple inquiry leads us into a free-fire zone of

judicial debate over the proper level of judicial deference

to various IRS interpretations of the revenue laws. The

basic question is whether Chevron deference (from Chev-

ron U.S.A., Inc. v. Natural Resources Defense Council, Inc.,

467 U.S. 837 (1984), and its progeny) applies to tax regula-

tions. See, ¢.g., Central Pa. Sav. Ass'n v. Commissioner, 104

T.C. 384, 390-91 (1995) (discussing the “checkered career”

of Chevron deference in the tax arena), supplemented by, 71

T.C.M. (CCH), 1996 WL 165489 (Apr. 10, 1996). In addi-

tion to the debate in the case law, the topic has generated

heated scholarly commentary. See Ellen P. Aprill, Muffled

Chevron: Judicial Review of Tax Regulations, 3 Fl. Tax Rev. 51

(1996) (describing and advocating a fusion of Chevron and

National Muffler, 440 U.S. 472 (1979)); Paul L. Caron, Tax

Myopia Meets Tax Hyperopia: The Unproven Case of Increased

Judicial Deference to Revenue Rulings, 57 Ohio St. L.J. 637

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(1996) (critiquing attempts to apply discrete levels of

deference to tax interpretations); John F. Coverdale, Court

Review of Tax Regulations and Revenue Rulings in the Chev-

ron Era, 34 Geo. Wash. L. Rev. 35 (1995) (arguing for

distinct levels of non-Chevron deference for each type of

tax interpretation); Linda Galler, Judicial Deference to Reve-

nue Rulings: Reconciling Divergent Standards, 56 Ohio St.

L.J. 1037 (1995) (attempting to provide a hierarchy of

uniformly applied levels of deference for tax interpreta-

tions).

Unfortunately, we walk into this melee without very

much help from the parties. Bankers Life inexplicably

urges us to evaluate its challenge to Treasury Regulation

§ 1.815-2(b)(3) under what many commentators would

consider the highly deferential Chevron standard. Frus-

tratingly, the government neglects to address the appli-

cability of Chevron deference. Therefore, before resolving

this issue, we need some background information on the

different forms of IRS interpretation and the correspond-

ing degrees of deference.

The IRS interprets the tax code in four significantly

different ways: (1) regulations issued pursuant to a speci-

fic directive from Congress, (2) regulations issued under

the IRS’s general authority to interpret the tax laws, (3)

revenue rulings, and (4) private letter rulings. Each of

these categories often receives different deference from

the courts. While the first three categories constitute

interpretations of general applicability, letter rulings

apply only to the parties who specifically request them.

Neither the courts nor the IRS may rely on letter rulings

as precedent. See I.R.C. § 6110(j)(3) (1988); Treas. Reg.

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§ 301.6110-7(b) (West 1998); cf. Fox Valley & Vicinity Con-

str. Workers Pension Fund v. Brown, 897 F.2d 275, 280 n.2

(7th Cir. 1990) (en banc). At the other end of the spectrum

from letter rulings are regulations issued under specific

grants from Congress. The tax code contains a myriad of

specific congressional instructions regarding rulemaking.

See Coverdale, supra, at 52 (estimating the number of

specific grants at over 1000 and providing examples).

Pursuant to the Administrative Procedures Act (“APA”),

the IRS issues these rules with full notice and comment.

See 5 U.S.C. § 553 (1994). In the middle, between letter

rulings and specific authority regulations, are general

authority regulations and revenue rulings. The IRS issues

general authority regulations under its power to “pre-

scribe all needful rules and regulations.” See I.R.C.

§ 7805(a) (1994). While the IRS takes the position that

regulations issued solely under this general authority do

not require notice and comment, the agency nevertheless

usually follows full notice and comment procedures. See

First Chicago NBD Corp. v. Commissioner, __ F.3d ___, 1998

WL 28113, *2 (7th Cir. Jan. 28, 1998). In contrast, the IRS

does not follow notice and comment procedures for reve-

nue rulings. Revenue rulings typically contain the IRS’s

interpretation of how the law applies to a set of hypo-

thetical facts. Revenue rulings do not have broad applica-

tion like regulations, but the IRS does consider them

authoritative and binding. See Rev. Proc. 95-1, § 2.05

(codified at Treas. Reg. § 601.201 (West 1998)); Rev. Proc.

89-14, § 7.01 (codified at Treas. Reg. § 601.601 (West

1998)).

Revenue rulings receive the lowest degree of defer-

ence — at least in this circuit. In First Chicago, we held that

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revenue rulings deserve “some weight,” __ F.3d __,

1998 WL 28113, at *2, and are “entitled to respectful

consideration, but not to the deference that the Chevron

doctrine requires in its domain,” id. at *1 (citations omit-

ted). In other circuits this question has generated incon-

sistent rulings ranging from Chevron deference to no

deference. See Coverdale, supra, at 81-84 (citing cases);

Galler, supra, at 1059-74 (citing cases).

Determining the level of deference accorded to regu-

lations is more difficult. Initially it may appear that we

can resolve the problem by resorting to the APA’s distinc-

tion between legislative and interpretive regulations. See

5 U.S.C. § 553(b)(3)(A) (1994). Administrative law

scholars usually treat legislative regulations as rules of

full legal effect - they create new legal duties binding on

the parties and the courts and, therefore, require full

notice and comment procedures. Interpretive rules, on

the other hand, only clarify existing duties and do not

bind; thus, they do not require notice and comment. In

the tax world, however, these terms and classifications

seem to provide more confusion than clarity. Tax experts

refer to specific authority regulations as “legislative” and

to general authority regulations as “interpretive.” The

confusion arises because the “interpretive” designation

does not mesh with the characteristics of the IRS’s gen-

eral authority regulations. While the IRS calls its general

authority regulations interpretive, the agency promul-

gates them according to the same formal procedures it

employs for its specific regulations. Moreover, both the

specific authority and general authority regulations, cre-

ate duties and have binding effect. See Aprill, supra, at

55-56; Coverdale, supra, 48-50.

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If this legislative versus interpretive distinction held

up for tax regulations, we could apply the simple rule

described in Hanson v. Espy, 8 F.3d 469 (7th Cir. 1993). In

that case, we explained the distinction between nontax

legislative and interpretive regulations and said that

Chevron applied to legislative regulations only. See id. 472

n.3. General tax regulations seem to carry the force of

law, they are developed according to notice and com-

ment, and they have the imprimatur of a congressional

delegation of authority. In substance, general tax regula-

tions fall short of being full legislative regulations only

because the congressional delegation is general rather

than specific. This distinction, however, may not have

any effect at all on the standard of deference because

Chevron itself dealt with a regulation promulgated under

an arguably general grant of authority to the EPA under

the Clean Air Act. See Coverdale, supra, at 50. Further-

more, Chevron stated that its framework applied to

implicit congressional delegations as well as to specific

and explicit directives. See Chevron, 467 U.S. at 844.4

In any event, courts uniformly give tremendous def-

erence to regulations issued under a specific directive

from Congress. In fact, some courts give these regulations

the same force as statutes, focusing only on whether the

4 Chevron arguably, therefore, altered the understanding of

a line of Supreme Court cases often applied to “interpretive” tax

regulations. See National Muffler Dealers Ass'n v. United States,

440 U.S. 472 (1979); Rowan Co. v. United States, 452 U.S. 247

(1981); United States v. Vogel, 455 U.S. 16 (1982). These cases all

distinguished between regulations issued under specific grants

of authority (full deference) and regulations issued under

general grants of authority (less deference).

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agency promulgated the regulation properly within its

scope of authority. See Coverdale, supra, at 53 (citing

cases). We basically follow the same approach. In Gehl Co.

v. Commissioner, 795 F.2d 1324 (7th Cir. 1986), we

explained that “a court’s main focus in examining a legis-

lative regulation issued under a specific statutory author-

ity ‘is whether the interpretation or method is within the

delegation of authority.’ ” Id. at 1329 (quoting Rowan Co.

v. United States, 452 U.S. 247, 253 (1981)). One commenta-

tor suggests that this level of deference accords even

greater respect to the IRS’s views than Chevron. See Cov-

erdale, supra, at 55. We leave that hypothesis for another

day.

Where then does all of this leave tax regulations

promulgated under general authority? The question

would be easier if the IRS did not employ notice and

comment rulemaking procedures — in other words, if

general authority tax regulations more truly resembled

interpretive regulations. In Atchison, Topeka and Santa Fe

Railway v. Pena, 44 F.3d 437 (7th Cir. 1994) (en banc), aff'd.

without discussion, Brotherhood of Locomotive Engineers v.

Atchison, Topeka and Santa Fe Railway, 516 U.S. 152 (1996),

we held that courts should accord only moderate defer-

ence to interpretive regulations issued without notice and

comment by an agency without general rulemaking

powers.> See id. at 442; see also Central Midwest Interstate

5 Because Atchison dealt with a regulation issued by an

agency that lacked an express authorization — either general or

specific — to promulgate rules, it seems unlikely that general

authority tax regulations would fall under Atchison’s rule of

moderate deference.

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Low-Level Radioactive Waste Comm'n v. Pena, 113 F.3d 1468,

1473 (7th Cir. 1997) (“we do not apply Chevron’s ‘rubber

stamp’ to interpretive rules”). As the Atchison court

explained:

Whatever degree of deference due these inter-

pretive rules is dictated by the circumstances

surrounding the agency’s adoption of its statu-

tory interpretation. “The weight given to an

agency interpretation depends on many factors,

including the validity of its reasoning, its consis-

tency with earlier and later agency pronounce-

ments and whether the administrative docu-

ment was issued contemporaneously with the

passage of the statute being interpreted.” Doe v.

Reivitz, [830 F.2d 1441, 1447 (7th Cir. 1987),

amended, 842 F.2d 194 (7th Cir. 1988)]. In short,

we look to “the thoroughness, validity, and con-

sistency of the agency’s reasoning.” Orrego v.

833 West Buena Joint Venture, 943 F.2d 730, 736

(7th Cir. 1991) (citing United States v. Markgraf,

736 F.2d 1179, 1184 (7th Cir. 1984)).

Atchison, 44 F.3d at 442.

In accord with its emphasis on the “circumstances

surrounding the agency’s adoption” of the regulation, the

Atchison court understood Chevron either to apply or not

to apply based on the extent to which an agency follows

full notice and comment rulemaking procedures. The

court explained that the notice and comment process

provides a critical component in our decision to grant

Chevron deference:

The principal rationale underlying [Chevron]

deference is that in this context the . gency acts

as a congressional proxy; Congress develops the

statutory framework and directs the agency to

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flesh out the operational details. But Congress

typically does not permit the agency to run free

in this endeavor; the Administrative Procedures

Act establishes certain procedures that the

agency must follow. Chief among them is the

notice-and-comment provision of the APA. 5

U.S.C. § 553. This rule-making process bears

some resemblance to the legislative process and

serves to temper the resultant rules such that

they are likely to withstand vigorous scrutiny. It

is this process that entitles the administrative

rules to judicial deference.

Id. at 441-42.

In this regard Atchison is not unique. For instance, in

Pennington v. Didrickson, 22 F.3d 1376 (7th Cir. 1994), we

explained “[w]e are mindful of our obligation to defer to

the interpretation of the agency whenever that interpreta-

tion can be said to embody a deliberate and considered

interpretation of the legislative intent.” Id. at 1383. When

an agency undertakes notice and comment procedures it

elevates the status of a regulation above mere interpreta-

tion. Similarly, in Doe v. Reivitz, 830 F.2d 1441, 1446-47

(7th Cir. 1987), amended, 842 F.2d 194 (7th Cir. 1988), we

characterized regulations promulgated with the full pan-

oply of procedures as “high powered” rules meriting

Chevron deference. Thus, in this circuit it appears that

rules developed pursuant to notice and comment pro-

cedures constitute full legislative regulations.

So, is there an answer to the question of whether we

give Chevron deference to general authority tax regula-

tions promulgated with notice and comment? At first it

might appear that we shut the door on that question in

Bell Federal Savings & Loan Ass'n v. Commissioner, 40 F.3d

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224, 226 (7th Cir. 1994). Unfortunately, that case does not

provide definitive closure.

In Bell Federal we considered an IRS regulation pro-

mulgated under the general authorization statute, I.R.C.

§ 7805(a), just like the regulation in this case. We weighed

whether to apply Chevron deference (as the Sixth Circuit

did in Peoples Federal Savings & Loan Ass'n v. Commis-

sioner, 948 F.2d 289, 304-05 (6th Cir. 1991)) or whether to

apply a more narrow traditional rule of deference to tax

regulations (as the Ninth Circuit did in Pacific First Fed-

eral Savings Bank v. Commissioner, 961 F.2d 800, 805-08 (9th

Cir. 1992)). The Bell Federal court opted for the traditional

rule apparently because it was more narrowly tailored to

tax regulations:

The proper test for the validation of a chal-

lenged regulation thus requires only that the

regulation issued by the Commissioner consti-

tute a reasonable implementation of Congress's

mandate. The Commissioner’s interpretation

need not be the only, or even the most, reason-

able interpretation possible as “[t]he choice

among reasonable interpretations is for the

Commissioner, not the courts.”

40 F.3d at 227 (quoting National Muffler Dealers Ass’n v.

United States, 440 U.S. 472, 488 (1979)). Bell Federal contin-

ued by explaining that courts should inquire into whether

the regulation “ ‘harmonizes with the plain language of

the statute, its origin, and its purpose.’” Id. (quoting

National Muffler, 440 U.S. at 477).

Bell Federal’s choice of the traditional rule appeared

eminently reasonable at the time. In Cottage Savings Ass'n

v. Commissioner, 499 U.S. 554, 560-61 (1991), the Supreme

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Court conspicuously did not cite Chevron and appeared to

apply the traditional rule of tax deference: “Because Con-

gress had delegated to the Commissioner the power to

promulgate ‘all needful rules and regulations for the

enforcement of [the Internal Revenue Code],’ 26 U.S.C.

§ 7805(a), we must defer to his regulatory interpretations

of the Code so long as they are reasonable.” Id. at 560-61

(citing National Muffler).

The Bell Federal court equivocated, however, on

whether there was any real difference between Chevron

and the traditional rule. Chevron upholds a regulation if

the agency based its interpretation on a permissible con-

struction of a statute, see 467 U.S. at 843, while the tradi-

tional rule validates the regulation if the agency

reasonably implemented Congress’s mandate. Noting

that “both approaches apply essentially the same test,”

the Bell Federal court stated that “the difference between

these two approaches is negligible at best — any regula-

tion which is ‘based upon a permissible construction’ of

an ambiguous statute will almost always ‘implement the

congressional mandate in some reasonable manner’ and

vice versa. .. . ” 40 F.3d at 227.

While Bell Federal’s hedging about the difference

between Chevron and the traditional rule gives us pause,

we hesitate to apply the traditional rule for another rea-

son. We think that the en banc decision in Atchison

reopened the door that Bell Federal seemed to have shut.

As Chief Judge Posner stated in First Chicago, “we con- |

sider [Chevron’s] application to interpretive rules issued

by the Treasury to be open in this circuit, since the

Treasury has decided to use the notice and comment

procedure for interpretive rules, though not required to

Al9

do so by statute.” ___ F.3d at __, 1998 WL 28113, at *2

(citation omitted).

Atchison explained that the notice and comment pro-

cedure was the sine qua non for Chevron deference.®

Because the IRS promulgates general authority regula-

tions through a notice and comment process, Atchison

militates forcefully in favor of according Chevron defer-

ence to those regulations. Thus, after Bell Federal, Atchison

altered the balance and tipped the scales in favor of

Chevron.”

6 Having described the fundamental importance of notice

and comment procedures, we note that courts could employ

other standards. In American Medical Ass'n v. United States, 688

F. Supp. 358 (N.D. Ill. 1988), aff'd. in part and rev'd in part, 887

F.2d 760 (7th Cir. 1989), the district court eschewed a brightline

rule and proposed distinguishing between legislative and

interpretive regulations based on whether the regulation

defined or gave “substantive content to language undefined in

the Code.” Id. at 364. Under this test, “the existence or

nonexistence of a precise statutory definition of the term later

elaborated on by the Treasury Regulation would mark the

watershed.” Jd. Thus, this district court advocated an

examination of “the nature of the reglation [sic], and not merely

the source of authority for its promulgation.” Id. at 365 (citing

Chamber of Commerce v. OSHA, 636 F.2d 464 (D.C. Cir. 1980)).

Other courts have observed that an agency’s interpretation

deserves diminished deference when it carries the indicia of a

litigating position. See Pennington, 22 F.3d at 1383. But cf. Amoco

Corp. v. Commissioner, __ F.3d __, 1998 WL 105480, at *9 (7th

Cir. Mar. 11, 1998) (explaining that the court should consider a

regulation “promulgated through notice-and-comment

rulemaking” even if the rule “bears the marks of a litigating

position.”).

7 We note the use of the traditional rule in Indianapolis Life

Insurance Co. v. United States, 115 F.3d 430, 436 (7th Cir. 1997).

A20

Furthermore, we think Bell Federal’s description of a

“negligible” difference between the approaches might

overstate the true extent of the divergence. Chevron held

that “a court may not substitute its own construction of a

statutory provision for a reasonable interpretation made

by the administrator of an agency.” 467 U.S. at 844. While

the two approaches articulate the level of deference dif-

ferently, they both come down to one operative concept —

reasonableness. Thus, Chevron and the traditional rule

constitute two different formulations of a reasonableness

test. There may be some subtle difference in the phrasing

of each framework, but we should be wary of attempts to

discern too many gradations of reasonableness. As we

explained in Boyce v. Fernandes, 77 F.3d 946 (7th Cir. 1996),

“human ability to make fine distinctions is limited.” Id. at

948 (describing the difficulty in distinguishing between

the inquiries into a police officer’s probable cause for an

arrest and whether that officer receives qualified immu-

nity). Viewed from this perspective at least, the supposed

gap between Chevron and the traditional rule is a distinc-

tion without a difference.

The Tax Court shares our suspicion that Chevron

merely repackages the traditional rule: “[W]e are inclined

to the view that the impact of the traditional, i.e., National

Muffler standard, has not been changed by Chevron but

has merely been restated in a practical two-part test with

subtle distinctions as to the role of legislative history and

the degree of deference to be accorded to a regulation.”

Central Pa. Sav. Ass'n v. Commissioner, 104 T.C. 384 (1995),

The Indianapolis Life court, however, did not weigh the

applicability of Chevron or the effect of Atchison.

A21

supplemented by 71 T.C.M. (CCH), 1996 WL 165489 (Apr.

10, 1996). Thus, as one might expect, other circuits and

the Tax Court apply Chevron to general authority tax

regulations. See, e.g., Western Nat'l Mut. Ins. Co. v. Com-

missioner, 65 F.3d 90, 93 (8th Cir. 1995); Redlark v. Commis-

sioner, 106 T.C. 31, 38-39 (1996).

This all leads us to the $64,000 question: If the defer-

ence test walks like Chevron and talks like Chevron, why

shouldn’t we just call it Chevron? Or, phrased differently,

if the two standards are the same, does our denomination

make any difference? Our answer lies with consistency.

While we do not doubt that “foolish consistency is the

hobgoblin of little minds, adored by little statesmen and

philosophers and divines,” Ralph Waldo Emerson, Self

Reliance, Essays: First Series (1841), we hope that our

emphasis on consistency does not qualify as foolishness.

On the contrary, consistency in the law forms the back-

bone of effective jurisprudence. See, e.g., Piper Aircraft

Corp. v. Wag-Aero, Inc., 741 F.2d 925, 937 (7th Cir. 1984)

(Posner, J., concurring) (“The most important function of

appellate review is to maintain the consistency of the law;

if consistency is not a desideratum, the argument for

appellate review is weakened.”). Because the APA

imposes uniform procedures on agencies that formulate

rules, there is some incentive for courts to apply a uni-

form framework for challenges to regulations developed

with notice and comment. A consistent approach might

help alleviate the tensions evident in the now-resolved

conflict between the Sixth Circuit and the Tax Court over

Chevron. See Peoples Fed. Sav. & Loan Ass'n v. Commissioner,

948 F.2d 289, 304-05 (6th Cir. 1991) (“[W]e conclude that

the Tax Court used the wrong standard to decide this

San crenata een eee

A22

case. Entirely ignoring Chevron ... the Tax Court

employed the standard in National Muffler Dealers which

seemed to allow a plenary review of the legislative his-

tory without the deference requirements found in Chev-

ron....”). More practically, our decision signals an effort

to move toward a resolution of the current circuit split on

the issue. Currently the Sixth Circuit accords Chevron

deference to all tax regulations. See Peoples Federal. Mean-

while, the Third and Fifth Circuits have rejected Chevron

for general authority tax regulations. See E.I. du Pont de

Nemours & Co. v. Commissioner, 41 F.3d 130, 135-36 & n.23

(3d Cir. 1994); Nalle v. Commissioner, 997 F.2d 1134,

1138-39 (5th Cir. 1993). Furthermore, we wish to avoid the

situation in the Third Circuit - divergent treatment for

notice and comment regulations depending on whether

they are tax or nontax rules. See Elizabeth Blackwell Ctr. for

Women v. Knoll, 61 F.3d 170, 182 (3d Cir. 1995) (applying

Chevron to a nontax interpretive regulation), cert. denied,

516 U.S. 1093 (1996). We see no reason that nontax regula-

tions issued with notice and comment should receive

Chevron deference while tax regulations promulgated

with the same procedures receive something different.

More importantly, in contrast to our foregoing anal-

ysis of the similarities between the traditional rule and

Chevron, there are some important differences. These con-

siderations also argue in favor of Chevron. Chevron is the

focus of ongoing development by the Supreme Court,

especially regarding the scope of the initial inquiry into

statutory meaning. See, e.g., National R.R. Passenger Corp.

v. Boston & Marine Corp., 503 U.S. 407, 417-18 (1992)

(reformulating the first step of Chevron analysis by focus-

ing on the plain language of the statute rather than the

A23

intent of Congress). We do not labor under the illusion

that Chevron will provide monolithic certainty for all

courts reviewing administrative rules - we recognize the

Court’s own inconsistency regarding Chevron. See Thomas

W. Merrill, Judicial Deference to Executive Precedent, 101

Yale L.J. 969 (1992) (explaining that “the Chevron frame-

work is used in only about half the cases that the Court

perceives as presenting a deference question”); see also

Thomas W. Merrill, Textualism and the Future of the Chev-

ron Doctrine, 72 Wash. U. L.Q. 351 (1994). We do hope,

however, that by employing a uniform framework for

challenges to administrative regulations we can better

stay abreast of the Court’s dictates.

We also favor Chevron because many courts contend

that the traditional rule accords less than Chevron defer-

ence to tax regulations. The Sixth Circuit, for instance,

characterizes National Muffler as allowing “plenary

review” contrasted with Chevron deference. See Peoples

Federal, 948 F.2d at 305. The Third and Fifth Circuits

believe that the traditional rule entitles a regulation to

“less deference” than under Chevron. See E.I. du Pont, 41

F.3d at 135 n.23; Nalle, 997 F.2d at 1139. As Atchison

explains, we owe full Chevron deference to a regulation

issued with the full deliberative procedures. Although we

acknowledge the gulf between the idealized Chevron and

the realized one, we do believe that the structure of

Chevron encourages a court to defer rather than to inter-

pret. We, therefore, prefer it.

Under Chevron deference we apply a two-step anal-

ysis: (1) We examine the text of the statute — in this case,

the relevant section of the tax code. If the plain meaning

of the text either supports or opposes the regulation, then

A24

we stop our analysis and either strike or validate the

regulation. But if we conclude the statute is either ambig-

uous or silent on the issue, we continue to the second

step: (2) We examine the reasonableness of the regulation.

If the regulation is a reasonable reading of the statute, we

give deference to the agency’s interpretation. See National

R.R. Passenger Corp., 503 U.S. at 417-18; Chevron, 467 U.S.

842-43.

While this circuit has examined legislative history

during the first step of Chevron, see Illinois EPA v. United

States EPA, 947 F.2d 283, 289 (7th Cir. 1991) (“To ascertain

the intent of the law, we must examine the plain meaning

of the statute at issue, the language and design of the

statute as a whole, and, where necessary, less satisfactory

indicia of congressional intent such as legislative history.”

(citations omitted)), we now seem to lean toward reserv-

ing consideration of legislative history and other appro-

priate factors until the second Chevron step, cf. Alex v. City

of Chicago, 29 F.3d 1235, 1239 (7th Cir. 1994) (“when

statutory meaning is clear with respect to the issue at bar

judicial inquiry normally should end without heed to the

embellishments of secondary materials like legislative

history”). In the second step, the court determines

whether the regulation harmonizes with the language,

origins, and purpose of the statute. While not dispositive,

a court may find various considerations informative -

these considerations might include the consistency of the

agency’s interpretation, the contemporaneousness of the

interpretation, and the robustness oi the regulation fol-

lowing congressional re-enactment of the underlying stat-

ute. Although we sometimes describe Chevron as a

“rubber stamp,” see Atchison, 44 F.3d at 442, we know that

A25

agencies occasionally act unreasonably. Given the scope

of the permissible inquiry under Chevron’s second step,

we believe that courts can rein in the excesses of unrea-

sonable administrative rulemaking. With that said, how-

ever, we reiterate Chevron’s fundamental dictate that a

court must not “substitute its own construction of a statu-

tory provision for a reasonable interpretation” by the

agency in question. 467 U.S. at 844.

At long last, then, we begin our examination of

Bankers Life’s challenge to Treasury Regulation

§ 1.815-2(b)(3) under the Chevron framework starting with

the tax code. Bankers Life seeks to show that the plain

meaning of the tax code required the IRS to value distri-

butions according to aggregate adjusted basis. Next, it

argues that the regulation unreasonably departed from

the harmony and order of the statutory scheme.

Bankers Life, of course, starts by parsing the lan-

guage of the code section that created the Phase III tax

system — I.R.C. § 815:

For purposes of this section and section

802(b)(3), any distribution to shareholders after

December 31, 1958, shall be treated as made -

(1) first out of the shareholders surplus

account, to the extent thereof,

(2) then out of the policyholders sur-

plus account, to the extent thereof, and

(3) finally out of other accounts.

I.R.C. § 815(a) (emphasis added). The insurance company

focuses on the meaning of the terms “distribution” and

“out of.” Their argument is that “an element cannot be

distributed out of an account unless the element had been

A26

included in the account.” Specifically, that SSA and PSA

never included the portion of the fair market value of the

1983 distribution attributable to unrealized appreciation.

Thus, the IRS should not have deducted the appreciation

“out of” the SSA or the PSA because the rules never

placed the appreciation into those accounts.

Or, phrased another way, the IRS could not have

distributed the fair market value out of the SSA and PSA

because “distribution involves the concept of being dis-

pensed from a ‘whole’ that only includes ‘parts’ within

that ‘whole,’ and a distribution, therefore, cannot include

elements that are not a part of the source of the distribu-

tion.” Even more basically, if we never put the apprecia-

tion in the boxes marked SSA and PSA, how could we

have taken the appreciation out of those boxes?

Bankers Life also focuses on the statute’s use of the

word “accounts.” Since § 815 referred explicitly to

“accounts,” logic dictates that it must have mandated

some standard form of accounting. The tax code gener-

ally employs uniform methods of debit/credit account-

ing. See, e.g., I.R.C. § 312(a)(3}) and Treas. Reg.

§ 13121(a)-(c) (employing credits/debits system and

adjusted basis to measure distributions out of a corporate

earnings and profits account during partial liquidation).

Since the SSA included only Phase I and II income - after-

tax gains — it could not have included unrealized appre-

ciation of assets. Thus, the statute could not have directed

the withdrawal of unrealized appreciation from the SSA

unless it also allowed for the simultaneous credit of the

after-tax gain from that appreciation to the account.

A27

These several arguments lead Bankers Life to the

conclusion that Treasury Regulation § 1.815-2(b)(3) defied

the statute. It defied the plain meaning of “distribution”

and “out of.” It defied fundamental principles of account-

ing evoked by the word “account.” Therefore, according

to Bankers Life, we should apply the first step of Chevron

and strike the regulation.

Moving beyond the language of the statute, Bankers

Life argues that the regulation constituted an unreason-

able interpretation of the code. Bankers Life backs up

statutory language argument about “accounts” with ref-

erence to the “regular” — as opposed to “phased” — taxa-

tion rules. The company explains that, normally,

unrealized appreciation inherent in an asset does not

become part of taxable income until the owner causes a

taxable event by selling or exchanging the asset. As

Bankers Life explains, the tax laws mark value with refer-

ence to basis, they do not “mark to market.” See Cottage

Sav. Ass'n v. Commissioner, 499 U.S. 554, 559 (1991); see also

Young v. Commissioner, 923 F.2d 719, 721 (9th Cir. 1991)

(stating that principles of taxation do not recognize unre-

alized gain or loss). Since, in this case, the tax laws did

not recognize a taxable event under Phase I or II taxation,

Bankers Life contends that § 815 could not have suddenly

marked to market and created a taxable event for pur-

poses of Phase III taxation alone.

The core of this argument is that by creating a taxable

event under Phase III rules the IRS impermissibly

imposed a debit without the corresponding credit. Under

the regular tax rules a taxable event imposes a tax burden

but also confers an accounting credit by adding after-tax

income to the SSA and/or the PSA. A distribution would

A28

then result in a debit —- but only after Bankers Life

received the benefit of the accounting credit. By comput-

ing the value of the 1983 distribution according to market

value, the IRS subjected Bankers Life to a debit without

ever having given it the corresponding credit. By creating

a taxable event solely under Phase III the IRS imposed the

detriment of a taxable event without the benefit. Return-

ing to credit/debit accounting principles, since the SSA

received no credit for the unrealized appreciation, the IRS

could not attempt to extract the unrealized appreciation

from the SSA.

To support its interpretation of § 815, Bankers Life

points to language in the Senate Finance Committee

report. The report described the SSA as containing

“amounts on which the tax has already been paid.” S.

Rep., supra, at 26. Since Bankers Life did not yet pay tax

on the appreciation element of the real property assets,

the SSA could not contain that element and the IRS could

not deduct the appreciation from the SSA.

Similarly, the report referred to the PSA as a “cush-

ion.” Since the statute did not allow Bankers Life to add

the appreciation element to the PSA, it never became part

of the “cushion.” Thus, § 815 could not have conceived of

Bankers Life relying upon the appreciation as part of its

special reserve. If the appreciation constituted a portion

of the Phase III income protected by special treatment,

then the law should have attributed that element to the

PSA.

Next, the company focuses on the issue of consis-

tency throughout the tax code. The insurer points to a

number of areas in which the tax laws treated the value of

A29

a distribution as the value of the adjusted basis rather

than the fair market value. See, e.g., Fulman v. United

States, 434 U.S. 528 (1978) (explaining that personal hold-

ing company dividends are charged to distributing com-

pany at fair market value); H.H. Robertson v. Commission-

er, 59 T.C. 53 (1972) (explaining that debits to foreign

subsidiary’s earnings and profits account were valued by

adjusted basis), aff'd, 500 F.2d 399 (3d Cir. 1974). The

regulation destroyed an otherwise harmonious measure-

ment of distributions by adjusted basis.

The company also explains the anomaly produced by

the difference between the treatment of cash, compared to

noncash, distributions. Because of the General Utilities

doctrine, noncash distributions resulted in no taxable

event at the corporate level. The regulation constituted a

brazenly impermissible end run around General Utilities -

an attempt by the IRS to create a Phase III taxable event

when no other rule would have imposed a tax.

These arguments lead Bankers Life to the conclusion

that, even if Treasury Regulation § 1.815-2(b)(3) did not

defy the plain meaning of the statute, it was fundamen-

tally unreasonable given the overall structure of the code.

It effectively created a taxable event without any support

from the tax law. And it defied the meaning of the statute

as revealed in legislative history.

The government responds with several arguments.

First, the government points, of course, to the plain lan-

guage of § 815. It notes that the statute stated that “any

distribution shall be treated as made” from out of the SSA

and PSA. I.R.C. § 815(a) (emphasis added). The use of

“treated as” overcomes any attempt to ascribe precise

A30

meaning to “distribute” and “out of” because “treated as”

presumed that someone must determine the proper treat-

ment of the distribution. The “treated as” language sug-

gested some level of abstraction, rather than the

withdrawal of a concrete asset deposited in a real

account. The government expands on this concept by

noting that the SSA and PSA were but memorandum

accounts, not real asset holding accounts. They constitu-

ted bookkeeping entries for the computation of tax, not

bank accounts.

This line of argument leads the government to the

conclusion that nothing in the controlling statute

explained how the IRS should value the distribution.

Under Chevron analysis, the government explains that the

statute was silent on the issue of valuation — the statute

contained a gap on this topic and the IRS filled that gap

by issuing Treasury Regulation § 1.815-2(b)(3).

The government also argues that “out of” did not

conclusively address the question of how to value distri-

bution. See Fulman, 434 U.S. at 534 (“out of . . . earnings

and profits” language in I.R.C. § 316 did not answer

question of how “distribution” is valued). The govern-

ment claims that “out of” created ambiguity. Thus, again,

the government argues that the statute left this question

for development by the IRS through regulation.

According to the government, therefore, Treasury

Regulation § 1.815-2(b)(3) did not defy the statute. The

government argues that the plain language of the statute

was either silent or ambiguous on the valuation of non-

cash distributions. Consequently, we must reach the sec-

ond step of Chevron analysis and decide whether the

A31

regulation constituted a reasonable interpretation of the

statute.

To debunk Bankers Life’s arguments about inconsis-

tencies, disparities, and anomalies, the government

explains that we cannot compare phased taxation to regu-

lar taxation. The government finds numerous references

in the Senate and House reports to the special tax treat-

ment afforded to life insurance companies under the

three-phase structure. Thus, because of the uniqueness of

the three-phase structure, the government argues that

there is simply no reason for conventional tax accounting

principles to apply to the calculation of Phase III taxes.

Congress created a unique tax structure and arguments

by analogy to conventional taxation shed no light on the

reasonableness of Phase III taxation.

The government also advances an argument based on

the regulation’s longevity and its survival in the face of

congressional re-enactment of the underlying statute.

This congressional acquiescence argument contends that

when a long-standing regulation survives substantial

changes to the underlying tax code, we should deem the

regulation to have tacit congressional approval and,

therefore, the effect of law. See Cottage Sav. Ass'n, 499 U.S.

at 561. At oral argument, the government attempted to

demonstrate congressional awareness of the regulation in

legislative history of the Tax Reform Act of 1969. The

government bolstered the re-enactment argument by

explaining that the IRS promulgated the regulation con-

temporaneously with the enactment of the three-phase

tax structure. See Atchison, 44 F.3d at 442 (listing contem-

poraneousness among the factors supporting a regula-

tion).

A32

Next, the government examines the legislative his-

tory of the statute to elucidate congressional intent and

shed light on the law’s meaning. Both the House and

Senate reports on the statute explained that Phase III

taxes applied when the life insurance company made

distributions to shareholders: “underwriting gains made

available to shareholders will be subject to the full pay-

ment of tax.” S. Rep., supra, at 13; H.R. Rep., supra, at 9.

Because Bankers Life could have sold the real estate

assets and realized gains, the IRS argues it properly

deducted this value from the SSA and PSA. In effect, the

potential income attributable to the appreciation element

constituted a reserve held by the company. The govern-

ment finds support for this line of reasoning in the

reports’ description of how Phase III taxation should treat

distributions of dividends: “where a life insurance com-

pany has distributed dividends to stockholders which are

in excess of previously taxed income, it becomes clear

that the company itself has made a determination that

additional amounts constitute income which was not

required to be retained to fulfill the policyholders’ con-

tracts.” S. Rep., supra, at 25; H.R. Rep., supra, at 15. The

government explains that when Bankers Life transferred

assets worth over $875 million to the foundation it clearly

signaled that it no longer needed an untaxed cushion of

$154 million (the amount in the PSA).

In other words, the concept of a cushion, or reserve,

embodied the idea of true value. A life insurance com-

pany would not let money in a reserve sit idly in a safety

deposit box. On the contrary, the company would invest

the money in hope of realizing a gain. Taking this argu-

ment to its logical conclusion, the government contends

A33

that, by conceiving of Phase III as a deferment mecha-

nism that created a special reserve fund, Congress

evinced an intent that Phase III taxation value distribu-

tions according to fair market value. Thus, congressional

intent embodied in the statute supported the regulation.

Finally, in response to Bankers Life’s arguments, the

government explains that the regulation did not create

taxable income. The entire logic of Phase III taxation

involved not the creation of taxable income, but instead

the release of taxable income from its special deferred

status. The taxable income came into being when the life

insurance company made gains from underwriting — the

tax code allowed the company to postpone the payment

of taxes on half of this income. The deduction of distribu-

tions from the memorandum accounts and the valuation

of those distributions constituted the methods used to

determine when to levy the tax on the Phase III income.

In other words, the regulation amounted to no more than

a mechanism to determine when and to what extent the

IRS should subject Phase III income to its normal tax.

When these arguments were tested in the district

court, Judge Plunkett concluded that Bankers Life failed

to meet its burden of showing the regulation to be

invalid. He reasoned that memo accounts did not neces-

sarily follow the same rules as real accounts. The judge

also concluded that, given the unique purpose of special

taxation, the regulation was not irrational.

We agree with the district court. Beginning with the

statutory language, we cannot glean enough from the

plain meaning to determine whether the statute supports

or condemns the regulation. The “treated as” language

A34

injects so much ambiguity into the meaning of the statute

that we cannot accept Bankers Life’s interpretation of

“distribution” and “out of” as controlling. The “treated

as” language makes it impossible to construe the

“accounts” as containing specific funds derived from

specific sources.

Even more fundamentally, the plain language of the

statute simply fails to address the question of valuation.

In other words, the statute is silent on this question. In

Fulman, the Supreme Court faced a similar situation in

which “while obviously some rule of valuation must be

applied, Congress . . . failed expressly to provide one.”

434 U.S. at 533. Here, too, Congress failed to expressly

provide a method of valuation. Because the statute is

silent, we should not attempt to infer a method of valua-

tion under the guise of determining the plain meaning of

the provision.

Moving to the second step of Chevron, Bankers Life

fares only a little better. Again, Fulman provides us with

guidance. The Fulman Court recognized the “logical

force” of the argument against the regulation in question.

See id. at 534. Logical force, however, did not carry the

day. The Court explained that “but for the Regulation, the

argument might well prevail.” Id. at 536. The Court con-

tinued: “[A]s we have indicated, the issue before us is not

how we might resolve the statutory ambiguity in the first

instance, but whether there is any reasonable basis for the

resolution embodied in the Commissioner’s Regulation.”

Id. Similarly, Bankers Life’s interpretation does not lack

logical force, but neither does it rob the regulation of its

reasonableness.

A35

The arguments over congressional intent as revealed

in the legislative history are in equipoise. The two sides

offer conflicting plausible interpretations of Congress's

purpose. And Bankers Life certainly demonstrates that

the regulation conflicts with the methods of conventional

taxation. But conflicts do not equal irrationality. The IRS

may adopt regulations that produce unusual results, so

long as those results have some colorable support. As

Chevron itself explained, an agency may choose among

conflicting policies. See 467 U.S. at 845. Furthermore, as

the government argues, because of the singularity of the

Phase III system, any conflicts with regular taxation do

not mean very much.

The government also carries the day on the question

of whether the regulation creates a taxable event. The

regulation merely provides the timing mechanism for the

release of Phase III income to taxation — the taxable event

occurred when the life insurer earned the Phase III

income. Thus, Bankers Life contentions about impermis-

sible marking to market also fail. The IRS did not mark to

market to measure the amount of Phase III income

earned, it used market value to measure the amount of

Phase III income released from its special deferred status.

While we find the government’s longevity and re-

enactment arguments informative, we choose not to place

too much weight on them or on the government's argu-

ment for the regulation’s validity based on its contem-

poraneity with the passage of the statute. See Smiley v.

Citibank (South Dakota), N.A., 116 S. Ct. 1730, 1733 (1996)

(“neither antiquity nor contemporaneity with the statute

is a condition of validity”). Arguments based on congres-

sional silence presume much. See Brown v. Gardner, 513

A36

U.S. 115, 120 (1994) (explaining that arguments based on

congressional silence and re-enactment lack persuasive

significance). Here, the government's stronger arguments

lie elsewhere.

In the end, the government offers a reasonable expla-

nation for the regulation given the origin and purpose of

the three-phase taxation scheme. In effect, the IRS

adopted a policy that attempted to limit the length of

time the insurance company could defer Phase III taxes.

Nothing in the three-phase scheme suggested that the IRS

could not constrain the benefit of deferment as narrowly

as possible. On the contrary, the scheme evinces an intent

to tax Phase III income upon large distributions to share-

holders. Treasury Regulation § 1.815-2(b)(3) did no more

than measure distributions of appreciated real property

in the largest manner possible. Because this is not unrea-

sonable given the purpose of the statute, we must AFrFirM.

A true Copy:

Teste:

Clerk of the United States Court of

Appeals for the Seventh Circuit

A37

United States Court of Appeals

For the Seventh Circuit

Chicago, Illinois 60604

JUDGMENT - WITH ORAL ARGUMENT

Date: April 17, 1998

BEFORE: Honorable WALTER J. CUMMINGS,

Circuit Judge

Honorable MICHAEL S. KANNE,

Circuit Judge

Honorable TERENCE T. EVANS,

Circuit Judge

No. 96-2260

BANKERS LIFE AND CASUALTY COMPANY,

Plaintiff-Appellant

UNITED STATES OF AMERICA,

Defendant-Appellee

Appeal from the United States District Court for the

Northern District of Illinois, Eastern Division

No. 93 C 4739, Paul E. Plunkett, Judge

The judgment of the District Court is AFFIRMED,

with costs, in accordance with the decision of this court

entered on this date.

(1061-110393)

A38

IN THE UNITED STATES DISTRICT COURT

FOR THE NORTHERN DISTRICT OF ILLINOIS

EASTERN DIVISION

BANKERS LIFE AND

CASUALTY COMPANY,

Plaintiff,

)

) No. 93 C 4739

)

Vv. )

)

Hon. Paul E. Plunkett

UNITED STATES OF

AMERICA,

Defendant.

MEMORANDUM OPINION AND ORDER

This tax refund case is before us on the parties’ cross-

motions for summary judgment. Plaintiff Bankers Life

and Casualty Company (“Bankers Life”) seeks tax

refunds for the years 1980, 1983, and 1984 on several

grounds, which defendant United States of America (the

“government”) opposes. For the reasons set forth below,

we grant the government’s motion and deny Bankers

Life’s motion on all counts.

Discussion

I. Standard

Rule 56(c) of the Federal Rules of Civil Procedure

allows us to grant summary judgment “if the pleadings,

depositions, answers to interrogatories, and admissions

on file, together with the affidavits, if any, show that

there is no genuine issue as to any material fact and that

the moving party is entitled to judgment as a matter of

A39

law.” In considering the evidence submitted by the par-

ties, we do not weigh it or determine the truth of asserted

matters. Anderson v. Liberty Lobby, Inc., 477 U.S. 242, 249

(1986). We ere to view all facts and draw all reasonable

inferences in the light most favorable to the non-moving

party. Transamerica Ins. Co. v. South, 975 F.2d 321, 327 (7th

Cir. 1992). Here, the parties have stipulated to the facts

necessary to resolve these motions.

Bankers Life has brought each of its three counts, for

refunds for tax years 1980, 1983, and 1984, on entirely

separate legal grounds. In addition, each presents a dif-

ferent factual scenario. Therefore, we address the facts

and the legal issues for each count separately.

II. Settlement of the Golbar Litigation (Count I)

A. Facts

On or about March 10, 1971, Bankers Life and four-

teen other lenders (collectively, the “lenders”) entered

into a stand-by “take-out” commitment (the “commit-

ment”) with Golbar Properties, Inc. (“Golbar”), to loan

Golbar or its assignee as permanent financing a total of

$45,000,000 upon the completion by Golbar of the con-

struction of a forty-four story office building in New York

City. (Stip. Facts, J 8.) Bankers Life’s portion of the loan

commitment was $5,000,000. (Id.) Golbar was to use the

commitment to obtain from Citibank N.A. a construction

loan to finance the construction of the building. (Id.) In

October 1974, the lenders, including Bankers Life, refused

to fund the loan on the grounds that Golbar had failed to

perform certain conditions precedent specified in the

commitment agreement. (See id., { 9.)

A40

In November 1974, Golbar sued the lenders, includ-

ing Bankers Life, in the New York state courts over their

refusal to fund the loan. (/d., { 10.) Bankers Life, among

others, filed a counterclaim. (Id., { 11.) On October 24, |

1979 the court entered a money judgment in the amount

of $6,495,000 in favor of Citibank N.A. (added as a plain-

tiff as Golbar’s assignee) and against Bankers Life and the

other lenders. (/d., {§ 12, 13.) The court also dismissed

the counterclaim. (Id., J 14.) On or about June 30, 1980,

while the judgment was on appeal, Bankers Life settled

the case for $4,545,455, which was just over ninety per-

cent of its original loan commitment. (Id., [ 15; Stip. Fact

Ex. 5, | 1.) as part of the settlement, Bankers Life received

a release from Citibank and the other plaintiffs in the

litigation, while it dismissed its counterclaim with preju-

dice and withdrew its appeal. (Id., { 26; Stip. Fact Ex. 5.)

Bankers Life filed its consolidated corporate federal

income tax return (Form 1120L) for tax year 1980 with the

Internal Revenue Service (“IRS”) on or about September

15, 1981. (Id., J 17.) On its return, it claimed the entire

settlement payment in the investment yield category on

Schedule A, line 9, as an investment expense item. (Id.,

{ 18.) When the IRS audited Bankers Life’s 1980 return,

the agent treated the settlement payment as belonging in

the gain or loss from operations category on Schedule E,

line 19, as an other deductions item. (Id., { 19.) The IRS

Appeals Office ultimately agreed to allow $1,326,291 of

the settlement payment as an interest expense deduction,

but the balance of $3,219,164 was reclassified as an “other

deduction” under section 809(d)(1) of the Internal Reve-

nue Code. (/d., J 20.) This resulted in an increase in

Bankers Life’s federal income tax for tax year 1980, which

A4l1

was assessed on November 28, 1988. (Id.) Bankers Life

paid the additional assessed tax on or before December 5,

1988. (Id., J 21.)

On May 26, 1989, Bankers Life filed two refund

claims, amending its 1980 tax return, for refund of the

additional assessed tax. (Id., | 22.) In one of the refund

claims, Bankers Life sought claimed the $3,219,164 as a

capital loss. (Id.) In January 1993, the IRS disallowed the

entire refund claim. (/d., J 23.)

Bankers Life, never discouraged, tried again to get a

favorable tax treatment of the Golbar settlement expense.

It filed a claim for refund of federal income tax for tax

year 1983 (the “1983 refund claim”) on about December

30, 1991. (Id., J 28.) In the 1983 refund claim, it included

an amended 1983 tax return which reflected, among other

changes, a claim for refund of the $3,219,164 paid in

settlement of the Golbar litigation as a capital loss car-

ryforward for the 1983 tax year. (Id., { 29.) On or before

January 29, 1993, the IRS disallowed the 1983 refund

claim. (Id., { 31.)

At issue then in Count I is the proper tax treatment of

$3,219,164 paid in settlement of the Golbar litigation. If

that amount is treated as a capital loss carryforward, then

Bankers Life overpaid its 1983 federal income tax. The

parties have not agreed on the amount of the refund if

Bankers Life is successful on this claim, but Bankers Life

asserts that it would be approximately $900,000 to

$1,600,000.

A42

B. Analysis

Bankers Life asserts that the $3,219,164 should be

treated as a capital loss carryforward for two reasons.

First, it argues that its interest in the Golbar contract was

an interest in an executory contract which should prop-

erly be treated for tax purposes as a capital asset. It

reasons that the mutual releases given as part of the

settlement, together with the payment by Bankers Life,

constituted the equivalent of a sale or exchange of a

capital asset from Bankers Life’s standpoint.’ Alter-

natively, it contends that then-applicable section 1232 of

the Tax Code should apply to the settlement. Section 1232

provided that an amount received on the retirement of an

evidence of indebtedness of a corporation was to be

treated as an amount received in an exchange. Thus,

according to Bankers Life, the settlement transaction gave

rise to a capital loss because the “bottom line effect” of

settlement was the same as if Bankers Life had made a

cash transfer of the loan commitment amount followed

by its acceptance of only a partial repayment, accom-

panied by the parties’ mutual releases — a truly ingenious

argument.

The government remains unimpressed, arguing that

to determine the characterization of the payment, the

“origin of the claim” test requires that we examine the

pleadings, other court papers, and settlement documents

1 The government points out that Bankers Life never

executed a release in favor of the Golbar plaintiffs in connection

with the settlement, although it appears undisputed that

Bankers Life did forego an appeal.

A43

to determine the nature of the settlement payment. It

contends the documents show that the settlement pay-

ment did not consist of the sale or exchange of a capital

asset at a loss. First, it asserts that Bankers Life cannot be

said to have had a capital asset or even property within

section 1221 of the Tax Code because it did not have any

rights or “bundle of rights” to enforce based upon its

breach of the commitment which gave rise to the Golbar

litigation. Second, it argues that the release of Bankers

Life’s obligation did not amount to a sale or exchange

because Bankers Life did not receive anything besides the

release; rather, the settlement payment was merely the

satisfaction of a disputed obligation.

The fundamental issue is whether the loss resulting

from the settlement was a capital or an ordinary loss. As

the taxpayer seeking a refund, Bankers Life has the bur-

den of proof. Heublein, Inc. v. United States, 996 F.2d 1455,

1461 (2d Cir. 1993) (in refund suit, taxpayer has burden of

proving overpayment of tax and amount of refund).

Bankers Life has not met its burden. Its first premise —

that its loan commitment to Golbar was an executory

contract that constituted a capital asset - may well be

correct, but it has no bearing on the issue here. We

recognize that Bankers Life was to receive, pursuant to

the commitment, rights to an interest in the building in

exchange for loaning the $5,000,000. However, it does not

follow from this that any transaction relating to the com-

mitment, regardless of its nature, therefore constitutes a

capital gain or loss for tax purposes. Rather, the proper

characterization of a particular transaction, such as the

one which occurred here, depends upon the facts behind

it.

A44

In order for Bankers Life to prevail on this argument,

not only must the commitment be properly characterized

as a capital asset of Bankers Life, but its settlement of the

Golbar litigation must have involved a release of its own

rights which constituted a sale or exchange of the capital

asset. But, Bankers Life did not settle on the original loan

commitment; it settled on the money judgment awarded

to Citibank N.A. in the litigation, as the settlement papers

make clear. (Stip. Fact Ex. 5.) The money judgment extin-

guished Bankers Life’s rights under the commitment

agreement, and it constituted a debt or obligation of

Bankers Life, not a capital asset. The cases of Meisels v.

United States, 732 F.2d 132 (Fed. Cir. 1984), and Turzillo v.

United States, 346 F.2d 884 (6th Cir. 1965), upon which

Bankers Life principally relies, are inapposite, for neither

involved settlement on a money judgment. In addition, as

the government notes, to be a capital loss, Bankers Life

must have sold or exchanged a capital asset resulting in a

loss. But, in settling the Golbar litigation, Bankers Life in

effect purchased a release of its disputed obligations under

the commitment; it did not sell anything. If Bankers Life

had funded the loan commitment as promised but had

not received any interest in the building in return, and

had then settled with Citibank N.A., the settlement might

have been a capital loss. But that did not happen here.

Bankers Life’s second contention, that section 1232

requires that the loss be treated as a capital loss, as

equally farfetched. Its “bottom line analysis” posits the

tax treatment of a hypothetical transaction, not the one

which actually occurred. Bankers Life did not shell out

the original $5,000,000 loan as it had committed, and it

did not accept only a partial repayment. What it did was

A45

renege on the loan commitment and settle for a portion of

that amount only after it had been hit with a money

judgment greater than the value of the loan commitment.

It has cited us no authority for the proposition that,

regardless of the means used (i.e., the taxpayer’s actual

conduct), the tax treatment of this transaction should be

determined solely on the basis of the ends achieved.

The government has established that it properly

refused to treat the settlement payment of $3,219,164 as a

capital loss. Therefore, we grant the government’s motion

for summary judgment and deny Bankers Life’s motion

for summary judgment on Count I.

Ill. Distributions to the Foundation (Count ID

A. Facts

The Life Insurance Company Income Tax of 1959

established a three phase tax system for life insurance

companies, which remained in effect until the statute was

repealed in 1983. See generally Subchapter L of Internal

Revenue Code of 1954 (“I.R.C.”). Under this system,

“Phase I” taxable income was the lesser of the life insur-

ance company’s taxable investment income or its gain

from operations, which was roughly the sum of taxable

investment income plus underwriting gain. I.R.C.

§ 802(b)(1). “Phase II” taxable income was one half the

amount by which the gain from operations exceeded

taxable investment income. I.R.C. § 802(b)(2). Finally,

“Phase III” tax was imposed on the remaining one half of

the amount by which the gain from operations exceeded

taxable investment income; however, tax on this amount

was deferred by being credited for tax purposes to a tax

A46

return memorandum account called the “policyholders

surplus account” (the “PSA”). I.R.C. § 802(b)(3). This

excluded income was subject to taxation upon eventual

distribution to the shareholders, at which time the com-

pany’s Phase III tax obligation arose. See I.R.C.

§ 802(a)(1), 802(b)(3).

A life insurance company was also required to main-

tain for tax purposes another tax return memorandum

account, the “shareholders surplus account” (the “SSA”).

I.R.C. § 815(b). The SSA was essentially an accumulated

after-tax earnings account, which reflected accumulated

after-tax investment income and the accumulated after-

tax portion of the one half of underwriting gain that had

previously been taxed. See id. Distributions during a year

to shareholders were first subtracted from the SSA, and

then, to the extent of any excess, were subtracted from

the PSA. ILR.C. § 815(a). The subtraction from the PSA

released into taxable income some or all of the previously

untaxed income held in the PSA and triggered the “Phase

Ill” tax. I.R.C. § 802(b)(3).

At the time of the death of John D. MacArthur on

January 6, 1978, his Trust No. 1 held all of the capital

stock of Bankers Life.? (Stip. Facts, {J 34, 35.) Pursuant to

the terms of the trust agreement, that stock was required

to be distributed to The John D. and Catherine T. Mac-

Arthur Foundation (the “Foundation”). (Id. J 35.) This

was accomplished on December 1, 1978. (Id. { 36.)

2 Bankers Life was a stock life insurance company under

Subchapter L of the Internal Revenue Code at all relevant times.

A47

The Foundation, as a private foundation, was subject

to limitations relating to its holdings in a business corpo-

ration’s stock. (Id. { 37.) Under then-applicable Section

4943(c)(6) of the Internal Revenue Code, it was required

to divest itself of no less than eighty percent of the

Bankers Life capital stock within five years, or, in other

words, on or before November 30, 1983. (Id.) On Novem-

ber 30, 1984, the Foundation obtained an additional five

years in which to meet the divestiture requirements. (Id.

{ 43.)

On September 3, 1982, the Bankers Life board

adopted a plan of partial liquidation under which, during

1983, Bankers Life would distribute to the Foundation a

large number of real estate holdings held by Bankers Life

and its non-life insurance company subsidiaries. (Id.

q 44.) Six days later, the Foundation board ratified

Bankers Life’s adoption of the plan of partial liquidation.

(Id. J 45.)

On March 25, 1982, a request for a ruling as to certain

federal income tax consequences of the implementation

of the plan of partial liquidation was submitted to the

IRS. (Id. J 47.) The IRS issued its ruling on July 10, 1985,

in Letter Ruling 8540070. (Id.) In addition, because for

state law insurance purposes the plan of partial liquida-

tion involved payment to the Foundation by Bankers Life

of an “extraordinary dividend” as defined in the Illinois

Insurance Code, by letter of November 23, 1983, Bankers

Life sought authorization for such extraordinary divi-

dend from the Illinois Department of Insurance (the

“Department”). (Id. { 48.) The Department approved the

extraordinary dividend on December 30, 1983. (Id. { 49.)

A48

Bankers Life made the non-cash distributions of real

estate and real estate-related assets to the Foundation

pursuant to the plan of partial liquidation during calen-

dar year 1983. (Id. { 50.) It filed its consolidated corporate

federal income tax return (Form 1120L) for tax year 1983

with the IRS on or before September 17, 1984. (Id. J 51.)

Pursuant to that return, it paid federal income tax in the

amount of $95,923,210. (Id. | 52.)

With respect to its 1983 taxable year, Bankers Life had

an SSA of $241,014,695 and a PSA of $154,434,319. (Id.,

{I 59, 60.) In its 1983 return, in accordance with section

1.815-2(b)(3) of the Treasury Regulations, it reported the

distributions to the Foundation on the basis of the fair

market value of the assets distributed, which was in

excess of $875,000,000, in computing the subtractions

from its SSA and PSA. (/d., {¥ 56, 62.) Because the fair

market value of the assets distributed exceeded the

amount in its SSA, the excess was subtracted from its

PSA. (Id., { 65.) As a consequence, Bankers Life had to

report additional taxable income for 1983 in the amount

of $154,434,319, which resulted in a Phase III tax of

$71,039,787. (Id., § 57.) Bankers Life paid this tax with its

1983 return. (/d., J 58.)

Bankers Life filed a claim for refund for tax year 1983

in the amount of $72,324,865, plus interest (the “1983

refund claim”), on or before December 30, 1991. (ld.,

11 28, 68.) Of the total refund sought, $70,750,058 repre-

sented the Phase III tax it had paid as a result of the 1983

distribution of the non-cash assets, less subsequent

adjustments, plus interest. (Id., { 69.) In the 1983 refund

claim, Bankers Life contended that section 1.815.2(b)(3) of

the Treasury Regulations was invalid and that the non-

A49

cash distributions to the Foundation should have been

measured by their adjusted tax basis for purposes of

determining the amounts to be subtracted from its SSA

and PSA. (Id., { 70.) The adjusted tax basis of the non-

cash distributions was $209,650,747. (Id., J 61.) If the non-

cash distributions had been measured by their adjusted

tax basis, then Bankers Life would have owed no Phase

III tax in 1983. (Id., [J 64, 70.) The IRS disallowed the full

amount of the 1983 refund claim on or before January 29,

1993. (Id., J 71.) |

B. Analysis

Bankers Life contends that it is entitled a refund in

the amount of $70,750,058 in Phase III income tax it paid

for the taxable year ending December 31, 1983, on the

ground that Treasury Regulation § 1.815-2(b)(3) is invalid.

It argues that the regulation improperly requires that, in

charging distributions to shareholders against its SSA

and PSA, the amount to be charged is based on the fair

market value, rather than on the adjusted after tax basis,

of the property distributed. According to Bankers Life,

use of the fair market value improperly included unre-

alized appreciation.

Before we examine the regulation in question, we

consider our standard of review. Generally, Treasury reg-

ulations are entitled to great deference and must be sus-

tained unless unreasonable and plainly inconsistent with

the revenue statutes. Commissioner v. Portland Cement

Company of Utah, 450 U.S. 156, 169 (1981), They must be

upheld as long as they are found to “implement the

congressional mandate in some reasonable manner.”

A50

United States v. Cartwright, 411 U.S. 546, 660 (1973). The

precise standard applicable to a given regulation is deter-

mined by the source of the authority for the regulation,

which is one of two things. The source may be section

7805(a) of the Tax Code, which allows the Commissioner

of the Internal Revenue Service to “prescribe all needful

rules and regulations for the enforcement of this title,”

I.R.C. § 7805(a), or else it may be specific statutory grant

of authority. Gehl Co. v. Commissioner, 795 F.2d 1324, 1328

(7th Cir. 1986). The former is called an “interpretative”

regulation, and it is entitled to deference as a reasonable

interpretation of the congressional mandate to the extent

that “it harmonizes with the statute’s language, origin,

and purpose.” Id. at 1329. A regulation is harmonious

with a statute’s language even if “the statutory language

will support a contrary interpretation.” Id. (quoting

United States v. Vogel Fertilizer. Co., 455 U.S. 16, 26 (1982)).

The latter type of regulation is a “legislative” regulation,

and it is entitled to greater deference than an interpreta-

tive one. Id. at 1238.

The parties do not dispute that the regulation at

issue, section 1.815-2(b)(3), is interpretative. The regula-

tion states, in pertinent part,

Except in the case of a distribution in cash and

as otherwise provided herein, the amount to be

charged to the special surplus accounts referred

to in subparagraph (1) of this paragraph [the

SSA and the PSA] with respect to any distribu-

tions to shareholders (as defined in Section

815(a) and paragraph (c) of this section) shall be

the fair market value of the property distrib-

uted, determined as of the date of distribution.

AS1

Treas. Reg. § 1.815-2(b)(3). Bankers Life contends that it is

invalid because it is inconsistent with the underlying

statutcry provisions of the Code and the underlying stat-

utory scheme, which, it argues, require that the amount

to be charged be measured on its adjusted tax basis.

Bankers Life raises five arguments in support of its

position. First, it contends that the underlying Internal

Revenue Code provisions, section 815(a)(1) and section

815(b)(3)(A), provide that a distribution must be “out of”

the SSA in order to be a reduction from the SSA. How-

ever, the unrealized appreciation element in the assets

distributed in 1983 was not reflected in the SSA imme-

diately prior to the distribution, and the distribution was

not a taxable event which would have required that the

unrealized appreciation be added to the SSA. Therefore,

according to Bankers Life, the unrealized appreciation

was not a distribution “out of” the SSA.

Second, Bankers Life asserts that, under basic tax

accounting principles, credits and debits to a tax account

must be based on the same measure. Under the statutory

rules, amounts credited to the SSA are measured on an

adjusted tax basis, so that, absent evidence that Congress

intended otherwise, amounts debited from the SSA must

be measured on the same basis. But, the regulation

improperly measures the amount to be debited from the

SSA by its fair market value instead.

Third, Bankers Life argues that the Internal Revenue

Code requires that distributions be charged last to the

PSA (and first to the SSA). In this case, even after the

A52

distribution at issue, Bankers Life still held assets corre-

sponding to the amount in its PSA, so that no part of the

PSA can be deemed to have been distributed.

Fourth, Bankers Life asseris that it was Congress’

intent that the Life Insurance Company Income Tax Act of

1959 would not affect the general rules of taxation except

as specifically mandated by the statute. However, accord-

ing to Bankers Life, the fair market value rule of section

1.815-2(b)(3) results in a substantia! taxable gain which

would otherwise not have resulted fiom the distribution

under the then applicable tax laws.

Lastly, Bankers Life contends that the fair market

value rule is inconsistent with the rules applicable to

other tax areas in 1983 relating to the treatment of prop-

erty distributions from the standpoint of the distributing

corporation, which required that the property distribu-

tions be measured by adjusted tax basis. But, it argues,

there is no evidence that Congress intended that the rule

under section 815 of the Internal Revenue Code to be

different from the prevailing rule in other areas of the

Code.

The government defends Treas. Reg. § 1.815-2(b)(3)

on several grounds, of which we address only a few.

First, it contends that the regulation is valid as a reason-

able interpretation of the statute because the fair market

value rule is consistent with the “amount” language of

section 815 (which section, the goverrmment notes, says

nothing about adjusted tax basis). Moreover, section 815

requires that a distribution to shareholders “shall be

treated as” out of the SSA first and the PSA last, not that

the distribution actually comes from assets held in those

A53

accounts, which do not hold assets at all. Furthermore, it

argues, the regulation is consistent with the purpose

behind the three phase income tax for life insurance

companies, as set forth in the legislative history. Accord-

ing to the government, under the Life Insurance Com-

pany Income Tax Act of 1959, Congress viewed the tax

deferral mechanisra of Phases II and III as justified by the

difficulty, due to the long-term nature of life insurance

contracts, in ascertaining the underwrit'ng income of a

life insurance company on an annual basis. Accordingly,

Congress provided that the income tax be deferred on

half of what was apparently underwriting income in any

particular year. This tax deferral provided a cushion for

the long-term contingencies allegedly inherent in the life

insurance business. Consequently,

whe[n] a life insurance company - .- . distri-

bute[s] dividends to stockholders which are in

excess of the previously taxed income, it

becomes clear that the company itself has made

a determination that the additional amounts

constitute income which [is] not required to be

retained to fulfill the policyholders’ contracts.

See 1959 Act S. Rep. No. 291, 86th Cong., Ist Sess. at 13,

reprinted in 1959-2 C.B. 770, 788.

Additionally, the government argues that Bankers

Life’s contentions are based upon a fundamental mis-

characterization of the nature of the SSA and the PSA.

Those accounts, its [sic] argues, do not hold any assets;

they are merely tax return memoranda accounts which

record, in the instance of the SSA, the amount of income

on which tax has already been paid and, in the instance of

the PSA, the amount of income upon which tax has been

A54

deferred. See 1959 Act S. Rep. No. 291, 86th Cong., Ist

Sess. at 13, reprinted in 1959-2 C.B. 770, 788-89. Thus, there

is nothing unreasonable about Treas. Reg. § 1.815-2(b)(3),

which measures the amount charged to the SSA and the

PSA by the fair market value of the assets distributed.

And, according to the government, it is immaterial that

the unrec.ized appreciation on the distributed assets was

never “in” the SSA, because Bankers Life was not taxed

' on the unrealized appreciation, only on the amount

charged against its PSA. On the same basis, the govern-

ment argues that there is no merit to Bankers Life’s

contention that amounts “credited” to the SSA are held

on an adjusted tax basis, because the SSA does not hold

assets at all.

The government responds to Bankers life’s third con-

tention by noting that it is nothing more than another

possible interpretation of the regulation. But, the govern-

ment points out, the choice among reasonable interpreta-

tions of the regulations lies with the Secretary of the

Treasury, not with Bankers Life or this Court. Hence,

unless Bankers Life shows that the Secretary’s interpreta-

tion is unreasonable, we must defer to it.

We do not address the government’s responses to

Bankers Life’s fourth and fifth contentions because we

need not reach them to resolve the issue before us. We

agree with the government that, however meritorious or

reasonable Bankers Life’s contentions may be, Bankers

Life has failed to meet its burden of showing that section

3 The government does not concede that Bankers Life’s

interpretation is reasonable. (Def.’s Br. at 33.)

A55

1.815-2(b)(3) is invalid.* Many of Bankers Life’s conten-

tion are founded upon a mischaracterization of the SSA

and the PSA as asset holding accounts rather than tax

return memoranda accounts. As a consequence, these

contentions do not establish either that the regulation at

issue is unreasonable and plainly inconsistent with the

revenue statutes or that it is not a reasonable interpreta-

tion of the congressional mandate in harmony with the

statute’s language, origin, and purpose. Rather, the gov-

ernment has adequately demonstrated that, given the

unique treatment of income tax issues for life insurance

companies under the Life Insurance Company Income

Tax Act of 1959, the fair market rule in section

1.815-2(b)(3) is reasonable and harmonizes with the lan-

guage, origin and purpose of section 815. Therefore, we

grant the government's motion for summary judgment

and deny Bankers Life’s motion for summary judgment

on Count I.

IV. The Section 338 Election (Count III)

A. Facts

As of January 1, 1984, the Foundation continued to

own all of the capital stock of Bankers Life. (Stip. Facts,

q 73.) At that time, Bankers Life’s assets consisted pri-

marily of assets used in its insurance operations and

4 We note for the record that we have not considered the

“expert” report of Bruce W. Foudree, submitted by the

government, because we consider it both unnecessary to our

understanding of the legal issues and inappropriate for

consideration on these motions, which we are deciding as a

matter of law.

A56

certain real estate interests which had not been distrib-

uted pursuant to the plan of partial liquidation. (Id.,

{ 74.)

On May 10, 1984, the Foundation executed a stock

purchase agreement with ICH Corporation (“ICH”), pur-

suant to which the Foundation sold all of the capital stock

of Bankers Life to ICH. (Id., J 75.) The sale closed on

October 30, 1984. (Id., | 79.)

On July 11, 1986, ICH filed with the IRS an election

under section 330(g) of the Internal Revenue Code. (/d.,

q 80.) ICH listed Bankers Life and each of Bankers Life’s

life insurance company subsidiaries as includable target

corporations in this election. (Id., J 80.) As a result of the

election, the taxable year of Bankers Life and its subsid-

iaries ended as of October 30, 1984. (Id., [ 81.)

On or before September 16, 1985, Bankers Life filed

its consolidated corporate federal income tax return

(Form 1120L) for the short tax period ending October 30,

1984. (Id., | 82.) At the same time, Bankers Life paid

cederal income tax in the amount of $20,119,900 pursuant

to that return. (/d., J 83.) It filed its consolidated corpo-

rate federal income tax return for its seven life insurance

company subsidiaries. (Id., {| 84.) As a result of the sec-

tion 338 election by ICH, Bankers Life reported on its

1984 short period tax return additional taxable income

pursuant to section 815(a)(2) of the Internal Revenue

Code-in-the-amount_of $38,705,072, resulting-in-a-federal———

income tax of $17,804,319. (Id., { 86.) Bankers Life paid

that tax when it filed its return. (/d., { 87.)

On or before December 30, 1991, Banker Life filed a

Form 1120X claim with the IRS for refund of federal

A57

income tax for the short tax period ended October 30,

1984, in the amount of $17,889,639, representing the 1984

federal income tax it paid which was attributable to the

aggregate amount of the PSAs of its life insurance com-

pany subsidiaries, as adjusted by the appeals settlement,

plus interest (the “1984 refund claim”). (Id., { 88.) On or

before January 29, 1993, the IRS disallowed the full

amount of the 1984 refund claim. (Id., { 89.)

B. Analysis

Before we reach the issues raised by Bankers Life in

support of their refund claizn, we consider the applicable

statutory scheme. In the Tax Reform Act of 1984, Con-

gress largely did away with the three phase tax scheme

for life insurance companies. However, for life insurance

companies which retained balances in their PSAs, direct

or indirect distributions to shareholders from their PSAs

still triggered Phase III tax liability under revised section

815 of the Internal Revenue Code. In other words,

In general the [1984 Act] eliminates any fur-

ther deferral with regard to income for 1984 and

later years. Although companies will not be able

to enlarge their policyholder surplus account

after 1983, they will not be taxed on previously

deferred amounts unless they are treated as dis-

tributed to shareholders or subtracted from the

policyholders surplus account [PSA] under rules

________ comparable to those provi nder the 1959

Act, but which reflect the basic changes in the

tax structure under the [1984 Act].

The [1984 Act] , -ovides that any direct or

indirect distribution to shareholders from an

A58

existing policyholders surplus account of a stock

life insurance company will be subject to tax at

the corporate rate in the taxable year of the

distribution. For these purposes, the term distri-

bution is intended to include actual ard con-

structive distributions. See Union Bankers Ins.

Co., 64 T.C. 807 (1975).

1984 Act H.R. Rep. No. 423, pt. 2, 98th Cong., 1st Sess., at

141011, reprinted in 1984 U.S.C.C.A.N. 697, at 1055. Addi-

tionally,

The statutory emphasis on taxing both direct

and indirect distributions from the poli-

cyholders’ surplus account was intended to be

construed broadly, whether or not there is a

distribution specifically within the meaning of

section 301 or 302. . . . There would be an

indirect distribution . . . whenever poli-

cyholders’ surplus account funds are used to

benefit the shareholders indirectly. . . .

When there are distributions from the poli-

cyholders’ surplus account, the amount of the

distribution (whether actual or deemed, or by

the indirect use of the amounts in the poli-

cyholders’ surplus account for the benefit of

shareholders), is taxed .. .

Staff of the Joint Committee on Taxation, 98th Cong., 2d

~~ Sess, General Explanation of the Revenue Provisions of the

Tax Reform Act of 1984 at 594 (1984).

Section 338(a) of the Internal Revenue Code, as in

effect in 1984, states, in pertinent part:

AS9

For purposes of tnis subtitle, if a purchasing

corporation makes an election under this sec-

tion . . . then, in the case of any qualified stock

purchase, the target corporation —

(1) shall be treated as having sold all of its

assets at the close of the acquisition date at

fair market value in a single transaction [to

which section 337 regarding certain com-

plete liquidations applies,] and

(2) shall be treated as a new corporation

which purchased all of the assets referred to

in paragraph (1) of the beginning of the day

after the acquisition date.

LR.C. § 338(a). Under this provision, a corporation that

elects, or is deemed to have elected, under this section

shall treat a qualified stock purchase as a purchase of

assets that the target corporation sold pursuant to a com-

plete liquidation under section 337. Then, the purchasing

corporation obtains a step-up in basis of the assets of the

target corporation, because it treats the stock acquisition

as an asset acquisition, see I.R.C. § 1012, even though no

liquidation of the target corporation actually occurs. The

target corporation is treated for federal income tax pur-

poses as an unrelated “new” corporation that now holds

the assets formerly held by the “old” corporation. LR.C.

§ 338(a)(2); Treas. Reg. § 1.338-2(d). In addition, because

under section 338(h)(3)(B), the “new” target corporation

of a corporation making a-section 338 election is deemed

to have purchased the stock of any of the “old” target

corporation’s subsidiaries, that purchase itself may be

eiigible for a section 338 election, whether actually

elected or deemed elected under section 338(e). See L.R.C.

A60

§ 339(h)(3)(B). In determining whether a section 338 elec-

tion results in a distribution for tax purposes, we must

look to section 815(f) of the 1959 Act, which is applicable

through incorporation by section 815(f) of the 1984 Act.

Section 815 defines “distribution” as “any distribution...

in... complete liquidation of the corporation. ...” I.R.C.

§ 815(f) (1983).

In this case, ICH made a section 338 election with

respect to both Bankers Life and its subsidiaries, and it

thus obtained a step-up in basis of both Bankers Life’s

and the subsidiaries’ assets. Consequently, Bankers Life’s

seven life insurance company subsidiaries were treated as

having sold all of their assets in a complete liquidation

pursuant to section 338(a)(1). For income tax purposes,

then, ICH’s section 338 election resulted in an indirect

distribution which triggered the Phase III tax.

Bankers Life asserts that ICH’s section 338 election

should not have been treated as a distribution to share-

holders from the SSAs and PSAs of Bankers Life’s seven

subsidiaries under section 815 so as to trigger Phase III

tax on those amounts. It argues that in fact none of the

seven subsidiaries made any direct or indirect distribu-

tion to their shareholders. Therefore, it argues, it is enti-

tled to a refund of the Phase III tax it paid based on the

alleged distributions.

The governments make two responses. First, it

asserts that Congress’ reference to the Union Bankers Ins.

Co. case in the House report is instructive. In that case,

the Tax Court held, among other things, that the “shall be

treated as a distribution” language of I.R.C. § 304(a)(2)

caused a constructive distribution from Union Bankers to

Aél

its controlling shareholder, General Insurance Investment

Co. (“General”), when Union Bankers’ subsidiary,

Bankers Service Life Insurance Co., purchased stock of

Union Bankers from General. According to the govern-

ment, Congress’ reference to this case indicates its intent

to include constructive distributions under Internal Reve-

nue Code provisions using terms such as “treated as” as

distributions within the meaning of section 815 of the

1984 Act. Second, it contends that its interpretation of the

“treated as” language is consistent with the legislative

intent to “construe broadly” the terms “direct or indirect

distributions.” Staff of the Joint Committee on Taxation,

98th Cong., 2d Sess., General Explanation of the Revenue

Provisions of the Tax Reform Act of 1984 at 594 (1984). And,

in this case, the amounts reflected in the seven subsid-

iaries’ PSAs benefited Bankers Life indirectly because the

deemed distributions in liquidation and resulting step-up

in bases entitled the subsidiaries to substantial future

deductions through amortization of intangible “insurance

in force” accounts.

We agree with the government that the section 338

election triggered Phase III tax liability because the elec-

tion required that the seven subsidiaries be considered as

having sold their assets in a complete liquidation, thus

triggering the distribution requirement of section 815(f).

The essence of Bankers Life’s argument is that an actual

_ distribution to shareholders from the seven subsidiaries’ —

PSAs must have occurred before Phase Ill tax liability

could be triggered. We fully recognize that no actual

distribution to shareholders of the seven subsidiaries

took place. But, as the House report on the 1984 Act

A62

makes clear, distribution means both actual and construc-

tive distributions. 1984 Act H.R. Rep. No. 423, pt. 2, 98th

Cong., Ist Sess., at 1410-11, reprinted in 1984 U.S.C.C.A.N.

697, at 1055. Here, the distribution was constructive,

rather than actual. Thus, Bankers Life’s argument that no

actual distribution occurred misses the mark.

Bankers Life has failed to show that it is entitled to

judgment as a matter of law on its 1984 refund claim,

while the government has demonstrated that it is. There-

fore, we grant the government’s motion for summary

judgment and deny Bankers Life’s motion for summary

judgment on Count III.

Conclusion

For the forgoing reasons, we grant defendant United

States of America’s motion for summary judgment and

deny plaintiff Bankers Life and Casualty Company’s

motion for summary judgment on all counts. This order is

final and appealable.

ENTER:

/s/ Ilegible

UNITED STATES

DISTRICT JUDGE

DATED: March 22, 1996

A63

United States District Court

NORTHERN DISTRICT OF ILLINOIS

Eastern Division

JUDGMENT IN A CIVIL CASE

BANKERS LIFE AND CASUALTY

COMPANY,

a ie CASE NUMBER: 93

Plaintiff C 4739

vs.

UNITED STATES OF AMERICA,

Defendant.

_ Jury Verdict. This action came before the Court for a

trial by jury. The issues have been tried and the jury has

rendered its verdict.

X Decision by Court. This action came to a hearing

before the Court. The issues have been heard and a

decision has been rendered.

IT IS ORDERED AND ADJUDGED that defendant,

United States of America’s motion for summary judgment

is granted. Plaintiff, Bankers Life and Casualty Com-

pany’s motion for summary judgment is denied on all

counts.

This order is final and appealable.

March 22, 1996 H. Stuart Cunningham

Date Clerk

mney

(By) Deputy Clerk

A64

§ 802. Tax imposed

(a) Tax imposed. -

(1) In general. - A tax is hereby imposed

for each taxable year on the life insurance com-

pany taxable income of every life insurance

company. Such tax shall consist of a tax com-

puted as provided in section 11 as though the

life insurance company taxable income were the

taxable income referred to in section 11.

(2) Alternative tax in case of capital

gains. — If for any taxable year any life insur-

ance company hés a net capital gain, then, in

lieu of the tax imposed by paragraph (1), there

is hereby imposed a tax (if such tax is less than

the tax imposed by such paragraph) which shall

consist of the sum of -

(A) a partial tax, computed as pro-

vided by paragraph (1), on the life insur-

ance company taxable income determined

by reducing the taxable investment income,

and the gain from operations, by the

amount of such net capital gain, and

(B) an amount determined as pro-

vided in section 1201(a) on such net capital

gain.

(b) Life insurance company taxable income

defined. — For purposes of this part, the term “life irisur-

ance company taxable income” means the sum of -

(1) the taxable investment income (as

defined in section 804) or, if smaller, the gain

from operations (as defined in section 809),

A65

(2) if the gain from operations exceeds the

taxable investment income, an amount equal to

50 percent of such excess, plus

(3) the amount subtracted from the poli-

cyholders surplus account for the taxable year,

as determined under section 815.

(Added Pub.L. 86-69, § 2(a), June 25, 1959, 73 Stat. 115,

and amended Pub.L. 87-858, § 3(b)(1), Oct. 23, 1962, 76

Stat. 1136; Pub.L. 88-272, Title II, § 235(c)(1), Feb. 26, 1964,

78 Stat. 126; Pub.L. 91-172, Title V, § 511(c)(1), Dec. 30,

1969, 83 Stat. 637; Pub.L. 94-455, Title XIX, § 1901(a)(95),

(b)(33)(E), Oct. 4, 1976, 90 Stat. 1780, 1801; Pub.L. 95-600,

Title III, § 301(b)(8), Nov. 6, 1978, 92 Stat. 2821.)

A66

§ 815. Distributions to shareholders

(a) General rule. —- For purposes of this section and

section 802(b)(3), any distribution to shareholders after

December 31, 1958, shall be treated as made -

(1) first out of the shareholders surplus

account, to the extent thereof,

(2) then out of the policyholders surplus

account, to the extent thereof, and

(3) finally out of other accounts.

(b) Shareholders surplus account. -

(1) In geneval. - Each stock life insurance

company shall, for purposes of this part, estab-

lish and maintain a shareholders surplus

account. The amount in such account on January

1, 1958, shal) be zero.

(2) Additions to account. - The amount

added to the shareholders surplus account for

any taxable year beginning after December 31,

1957, shall be the amount by which -

(A) the sum of -

(i) the life insurance company taxable

income (computed without regard to section

802(b)(3)),

(ii) in the case of a taxable year begin-

ning after December 31, 1958, the amount (if

any) of the net capital gain, reduced (in the

case of a taxable year beginning after

December 31, 1961) by the amount referred

” eee eer es

(iii) the deductions for dividends

received provided by sections 243, 244, and

A67

245 (as modified by section 809(d)(é)(B))

and the amount of interest excluded from

gross income under section 103, and

(iv) the small business deduction pro-

vided by section 809(d), (10), exceeds

(B) the taxes imposed for the taxable year

by section 802(a), determined without regard to

section 802(b)(3).

(3) Subtractions from account. -

(A’ In general. - There shall be subtracted

from the shareholders surplus account for any

taxable year the amount which is treated under

this section as distributed out of such account.

(B) Distributions in 1958. - There shall be

subtracted from the shareholders surplus

account (to the extent thereof) for any taxable

year beginning in 1958 the amount of distribu-

tions to shareholders made during 1958.

(1) In general. - Each stock life insurance

company shall, for purposes of this part, estab-

lish and maintain a policyholders surplus

account. The amount in such account on January

1, 1959, shall be zero.

(2) Additions to account. - The amount

add: 2 to the policyholders surplus account for

any taxable year beginnirg after December 31,

1958, shail be the sum of -

(A) an amount equal to 50 percent of

the amount by which the gain from Opera-

tions exceeds the taxable investment

income,

A68

(B) the deduction for certain nonpar-

ticipating contracts provided by section

809(d)(5) (as limited by section 809(f)), and

health insurance and group life insurance

contracts provided by section 809(d)(6) (as

limited by section 809(f)).

(3) Subtractions from account. — There

shall be subtracted from the policyholders sur-

plus account for any taxable year an amount

equal to the sum of -

(d)

(A) the amount which (without regard

to subparagraph (B)) is treated under this

section as distributed out of the poli-

cyholders surplus account, and

(B) the amount by which the tax

imposed for the taxable year by section

802(a) is increased by reason of section

802(b)(3).

Special rules. —

(1) Election to transfer amounts from pol-

icyholders surplus account to shareholders sur-

plus account. -

(A) In general. — A taxpayer may elect

for any taxable year for which it is a life

insurance company to subtract from its poli-

cyholders surplus account any amount in

such account as of the close of such taxable

year. The amount so subtracted, less the

amount of the tax imposed with respect to

such amount by reason of section 802(b)(3),

shall be added to the shareholders surplus

account as of the beginning of the succeed-

ing taxable year.

A69

(B) Manner and effect of election. -

The election provided by subparagraph (A)

shall be made (in such manner and in such

form as the Secretary may by regulations

prescribe) after the close of the taxable year

and not later than the time prescribed by

law for filing the return (including exten-

sions thereof) for the taxable year. Such an

election, once made, may not be revoked.

(2) Termination as life insurance com-

pany. —

(A) Effect of termination. —- Except as

provided in section 381(c)(22) (relating to

carryovers in certain corporate readjust-

ments), if -

(i) for any taxable year the tax-

payer is not an insurance company, or

(ii) for any two successive taxable

years the taxpayer is not a life insur-

ance company,

then the amount taken into account under

section 802(b)(3) for the last preceding tax-

able year for which it was a life insurance

company shall be increased (after the appli-

cation of subparagraph (B)) by the amount

remaining in its policyholders surplus

account at the close of such last preceding

taxable year.

(B) Effect of certain distributions. — If

for any taxable year the taxpayer is an

insurance company but not a life insurance

company, then any distribution to share-

holders during such taxable year shall be

treated as made on the last day of the last

A70

preceding taxable year for which the tax-

payer was a life insurance company.

(3) Treatment of certain indebtedness. -—

If -

(A) the taxpayer makes any payment

in discharge of its indebtedness, and

(B) such indebtedness is attributable

to a distribution by the taxpayer to its

shareholders after February 9, 1959,

then the amount of such payment shall, for pur-

poses of this section and section 802(b)(3), be

treated as a distribution in cash to shareholders,

but only to the extent that the distribution

referred to in subparagraph (B) was treated as

made out of accounts other than the share-

holders and policyholders surplus accounts.

(4) Limitation on amount in poli-

cyholders surplus account. — There shall be

treated as a subtraction from the policyholders

surplus account for a taxable year for which the

taxpayer is a life insurance company the amount

by which the policyholders surplus account

(computed at the end of the taxable year with-

out regard to this paragraph) exceeds whichever

of the following is the greatest -

(A) 15 percent of life insurance

reserves at the end of the taxable year,

(B) 25 percent of the amount by which

the life insurance reserves at the end of the

taxable year exceed the life insurance

reserves at the end of 1958, or

premiums and other consideration taken

A71

into account for the taxable year under sec-

tion 809(c)(1).

The amount so treated as subtracted, less the

amount of the tax imposed with respect to such

amount by reason of section 802(b)(3), shall be

added to the shareholders surplus account as of

the beginning of the succeeding taxable year.

(5) Reduction of policyholders surplus

account for certain unused deductions. — If -

(A) an amount added to the poli-

cyholders surplus account for any taxable

year increased (or created) a loss from oper-

ations for such year, and

(B) any portion of the increase (or

amount created) in the loss from operations

referred to in subparagraph (A) did not

reduce the life insurance company taxable

income for any taxable year to which such

loss was carried,

the policyholders surplus account for the tax-

able year referred to in subparagraph (A) shall

be reduced by the amount described in the sub-

paragraph (B).

(6) Restoration of amounts distributed

out of policyholders surplus account. — Not-

withstanding any other provision of this sub-

chapter, no amount shall be subtracted from a

taxpayer’s policyholders surplus account with

respect to a distribution made during the last

month of the taxable year which, without regard

to this paragraph, would be treated in whole or

in part as a distribution out of the policyholders

surplus account, to the extent that amounts so

distributed are returned to the taxpayer no later

than the time prescribed by law (including

A72

extensions thereof) for filing the taxpayer’s

return for the taxable year in which the distribu-

tion was made. For purposes of this paragraph,

amounts returned to a taxpayer with respect to a

distribution shall be first applied to the return of

amounts which, without regard to this para-

graph, would have been treated as distributed

out of the policyholders surplus account. This

paragraph shall not apply if, at the time such

distribution was made, the taxpayer intended to

avail itself of the provisions of this paragraph

by having its shareholders return all or a part of

such distribution. Nothing in this paragraph

shall affect the tax treatment of the receipt of the

distribution by any shareholder, and the basis to

a shareholder of his stock in the taxpayer shall

not be increased by reason of amounts returned

under this paragraph to the extent that a divi-

dends received deduction or exclusion was

allowable in respect of the distribution of such

amount under any provision of this title.

(e) Special rule for certain mutualizations. —

(1) In general. —- For purposes of this sec-

tion and section 802(b)(3), any distribution to

shareholders after December 31, 1958, in acqui-

sition of stock pursuant to a plan of mutualiza-

tion shall be treated -

(A) first, as made out of paid-in capi-

tal and paid-in surplus, to the extent

thereof,

(B) thereafter, as made in two alloca-

ble parts -

(i) one part of which is made out

of the other accounts referred to in sub-

section (a)(3), and

A73

(ii) the remainder of which is a

distribution to which subsection (a)

applies.

(2) Special rules. -

(A) Allocation ratio. - The part

referred to in paragraph (1)(B)(i) is the

amount which bears the same ratio to the

amount to which paragraph (1)(B) applies

as -

(i) the excess (determined as of

December 31, 1958, and adjusted to the

beginning of the year of the distribution

as provided in subparagraph (B)) of the

assets over the total liabilities, bears to

(ii) the sum (determined as of the

beginning of the year of the distribu-

tion) of the excess described in clause

(i), the amount in the shareholders sur-

plus account, plus the amount in the

policyholders surplus account.

(B) Adjustment for certain distribu-

tions. — The excess described in subpara-

graph (A)(i) shall be reduced by the

aggregate of the prior distributions which

have been treated under subsection (a)(3) as

made out of accounts other than the share-

holders surplus account and the poli-

cyholders surplus account.

(f) Distribution defined. - For purposes of this sec-

tion, the term “distribution” includes any distribution in

redemption of stock or in partial or complete liquidation

of the corporation, but does not include —

| (1) any distribution made by the corpora-

tion in its stock or in rights to acquire its stock;

A74

(2) except for purposes of subsection (a)(3)

and subsection (e)(2)(B), any distribution in

redemption of stock issued before 1958 which at

all times on and after the date of issuance and

on and before the date of redemption is limited

as to dividends and is callable, at the option of

the issuer, at a price not in excess of 105 percent

of the sum of the issue price and the amount of

any contribution to surplus made by the original

purchaser at the time of his purchase; or

(3) any distribution after December 31,

1963, of the stock of a controlled corporation to

which section 355 applies, if such controlled

corporation is an insurance company subject to

the tax imposed by section 831 and if -

(A) control was acquired prior to Jan-

uary 1, 1958, or

(B) control has been acquired after

December 31, 1957 -

(i) in a transaction qualifying as a

reorganization under section

368(a)(1)(B), if the distributing corpora-

tion has at all times since December 31,

1957, owned stock representing not less

than 50 percent of the total combined

voting power of all classes of stock enti-

tled to vote, and not less than 50 per-

cent of the value of all classes of stock,

of the controlled corporation, or

(ii) solely in exchange for stock of

the distributing corporation which

stock is immediately exchanged by the

controlled corporation in a transaction

qualifying as a reorganization under

A75

section 368(a)(1)(A) or (C), if the con-

trolled corporation has at all times since

its organization been wholly owned by

the distributing corporation and the

distributing corporation has at all times

since December 31, 1957, owned stock

representing not less than 50 percent of

the total combined voting power of all

classes of stock entitled to vote, and not

less than 50 percent of the value of all

classes of stock, of the corporation the

assets of which have been transferred to

the controlled corporation in the section

368(a)(1)(A) or (C) reorganization;

(4) any distribution after December 31,

1966, of the stock of a controlled corporation to

which section 355 applies, if such distribution is

made to a corporation which immediately after

the distribution is in control (within the mean-

ing of section 368(c)) of both the distributing

corporation and such controlled corporation and

if such controlled corporation is a life insurance

company of which the distributing corporation

has been in control at all times since December

31, 1957; or

(5) any distribution after December 31,

1968, of the stock of a controlled corporation to

which section 355 applies, if such distribution is

made to a corporation which immediately after

the distribution is the owner of all the stock of

all classes of both the distributing corporation

and such controlled corporation and if, imme-

diately before the distribution, the distributing

corporation had been the owner of all of the

stock of all classes of such controlled corpora-

tion at all times since December 31, 1957.

ESSA EE OL TLR LTE

A76

Paragraphs (3), (4), and (5) shall not apply to that portion

of the distribution of stock of the controlled corporation

equal to the increase in the aggregate adjusted basis of

such stock after December 31, 1957, except to the extent

such increase results from an acquisition of stock in the

controlled corporation in a transaction described in para-

graph (3)(B). If any part of the increase in the aggregate

adjusted basis of stock of the controlled corporation after

December 31, 1957, results from the transfer (other than

as part of a transaction described in paragraph (3)(B)) by

the distributing corporation to the controlled corporation

of property which has a fair market value in excess of its

adjusted basis at the time of the transfer, paragraphs (3),

(4), and (5) also shall not apply to that portion of the

distribution equal to such excess.

(g) Certain distributions related to former subsid-

iaries. — If subsection (f)(5) applied to the distribution by

a life insurance company of the stock of a corporation

which was a controlled corporation -

(1) any distribution by such corporation to

its shareholders (after the date of the distribu-

tion of its stock by the life insurance company),

and

(2) any disposition of the stock of such

corporation by the distributee corporation,

shall, for purposes of this section, be treated as a distribu-

tion to its shareholders by such life insurance company,

until the amounts so treated equal the amount of the

distribution of such stock which by reason of subsection

(f)(5) was not included as a distribution for purposes of

this section.

A77

(Added Pub.L. 86-69, § 2(a), June 25, 1959, 73 Stat. 129,

and amended Pub.L. 87-790, § 3(b), Oct. 10, 1962, 76 Stat.

808; Pub.L. 87-858, § 3(b)(4), (e), Oct. 23, 1962, 76 Stat.

1137; Pub.L. 88-571, §§ 2, 3(a), 4(a), Sept. 2, 1964, 78 Stat.

857, 859; Pub.L. 90-225, § 4(a), (b), Dec. 27, 1967, 81 Stat.

733, 734; Pub.L. 91-172, Title IX, § 907(b), Dec. 30, 1969, 83

Stat. 715; Pub.L. 94-331, § 1(a), June 30, 1976, 90 Stat. 781;

Pub.L. 94-455, Title XIX, §§ 1901(b)(1)(O), (24), (33)(H),

1906(b)(13)(A), Oct. 4, 1976, 90 Stat. 1791, 1798, 1801,

1834.)

A78

§ 1.815-2 Distributions to shareholders. |

(a) In general. Section 815 provides that every stock

life insurance company subject to the tax imposed by

section 802 shall establish and maintain two special sur- |

plus accounts for Federal income tax purposes. These

special accounts are the shareholders surplus account (as

defined in section 815(b) and § 1.815-3) and the poli-

cyholders surplus account (as defined in section 815(c)

and § 1.815-4). To the extent that a distribution to share-

holders (as defined in paragraph (c) of this section) is

treated as being made out of the shareholders surplus

account, no tax is imposed on the company with respect

to such distribution. However, to the extent that a distri-

bution to shareholders is treated as being made out of the

policyholders surplus account, the amount subtracted

from the policyholders surplus account by reason of such

distribution shall be taken into account in determining

life insurance company taxable income under section

802(b).

(b) Priority system for distributions to share-

holders. (1) For purposes of section 815 (other than sub-

section (e) thereof relating to certain mutualizations) and

section 802(b)(3) (relating to the determination of life

insurance company taxable income), any distribution

made to shareholders after December 31, 1958, shall be

treated in the following manner:

(i) Distributions shall be treated as first being made

ovt of the shareholders surplus account (as defined in

section 815(b) and § 1.815-3);

(ii) Once the shareholders surplus account has been

reduced to zero, distributions shall then be treated as

——————

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being made out of the policyholders surplus account (as

defined in section 815(c) and § 1.815-4) until that account

has been reduced to zero; and

(iii) Finally, any distributions in excess of the

amounts in the shareholders surplus account and the

policyholders surplus account shall be treated as being

made out of other accounts (as defined in § 1.815-5).

(2) For purposes of subparagraph (1) of this para-

graph, in order to determine whether a distribution (or

any portion thereof) shall be treated as being made out of

the shareholders surplus account, policyholders surplus

account, or other accounts, the amount in such accounts

at the end of any taxable year shall be the cumulative

balance in such accounts at the end of the taxable year,

computed without diminution by reason of a distribution

(or any portion thereof) during the taxable year which is

treated as being made out of such accounts. For example,

on January 1, 1960, S, a stock life insurance company, had

$1,000 in its shareholders surplus account and $3,000 in

its policyholders surplus account. On November 1, 1960,

S distributed $4,000 to its shareholders. Under the provi-

sions of section 815(b)(2) and paragraph (b) of § 1.815-3,S

added $5,000 to its shareholders surplus account for the

taxable year 1960. Since the distributions to shareholders

during the taxable year 1960, $4,000, does not exceed the

cumulative balance in the shareholders surplus account

at the end of the taxable year, computed without diminu-

tion by reason of distributions treated as made out of

such account during the taxable year, $6,000 ($1,000 plus

$5,000), the entire distribution is treated as being made

out of the shareholders surplus account.

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(3) Except in the case of a distribution in cash and

as otherwise provided herein, the amount to be charged

to the special surplus accounts referred to in subpara-

graph (1) of this paragraph with respect to any distribu-

tions to shareholders (as defined in section 815(a) and

paragraph (c) of this section) shall be the fair market

value of the property distributed, determined as of the

date of distribution. However, for the amount of the

adjustment to earnings and profits reflecting such distri-

butions, see section 312 and the regulations thereunder.

For a special rule relating to the determination of the

amount to be charged to such special surplus accounts in

the case of a distribution by a foreign life insurance

company carrying on a life insurance business within the

United States, see section 819(c)(1) and the regulations

thereunder.

Except as otherwise provided in section 815(f) and sub-

paragraph (2) of this paragraph, the term “distribution”,

as used in section 815(a) and paragraph (b) of this sec-

tion, means any distribution of property made by a life

insurance company to its shareholders. For purposes of

the preceding sentence, the term “property” means any

property (including money, securities, and indebtedness

to the company) other than stock, or rights to acquire

stock, in the company making the distribution. Thus, for

example, the term includes a distribution which is con-

sidered a dividend under section 316, but is not limited to

the extent that such distribution must be made out of the

accumulated or current earnings and profits of the com-

pany making the distribution. For example, except as

otherwise provided in section 815(f) and subparagraph

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A8l

(2) of this paragraph, there is a distribution within the

meaning of this paragraph in any case in which a corpo-

ration acquires the stock of a shareholder in exchange for

property in a redemption treated as a distribution in

exchange for stock under section 302(a) or treated as a

distribution of property under section 302(d). For special

rules relating to distributions to shareholders in acquisi-

tion of stock pursuant to a plan of mutualization, see

section 815(e) and paragraph (e) of § 1.815-6.

(2) The term “distribution”, as used in section

815(a) and paragraph (b) of this section, does not (except

for purposes of section 815(a)(3) and (e)(2)(B)) include

any distribution in redemption of stock issued prior to

January 1, 1958, where such stock was at all times on and

after the date of its issuance and on and before the date of

its redemption limited as to the amount of dividends

payable and was callable, at the option of the issuer, at a

price not in excess of 105 percent of the sum of its issue

price plus the amount of contribution to surplus (if any)

made by the original purchaser at the time of his pur-

chase.

[T.D. 6535, 26 FR 542, Jan. 20, 1961, as amended by T.D.

7189, 37 FR 12793, June 29, 1972}

This is a copy of a public record, reproduced as it was published. It is not legal advice, and it may not be the version a court would rely on. Check the official source before you cite it.