Insurer may deduct state-mandated medical education payment

Plain-English summary

A medical malpractice insurer was required by state law to transfer part of its reserve to a state fund supporting graduate medical education. The insurer expected the programs to increase the number and quality of medical professionals, expand its potential customer base, and reduce malpractice claims, while nonpayment could jeopardize its continued operations in the state. The IRS ruled that the payment was an ordinary and necessary business expense deductible under IRC § 162(a). It also ruled that the payment did not acquire, create, enhance, or facilitate an intangible asset and therefore did not have to be capitalized under IRC § 263(a).

Ruling snapshot

• Question: Is the insurer's state-mandated payment deductible as a business expense, and can it avoid capitalization?
• Outcome: Approved. The payment is deductible under IRC § 162(a) and is not required to be capitalized under IRC § 263(a).
• Key authorities: IRC §§ 161, 162(a), 263(a); Treas. Reg. §§ 1.162-1(a), 1.263(a)-4

Full text (IRS public release)

Internal Revenue Service Department of the Treasury
Washington, DC 20224

Number: 201724012 Third Party Communication: None
Release Date: 6/16/2017 Date of Communication: Not Applicable
Index Number: 162.00-00
Person To Contact:
---------------------------------------------- --------------------, ID No. ------------------
----------------------------------- Telephone Number:
-------------------------------------- ----------------------
------------------------ Refer Reply To:
CC:ITA:B02
--------------------------------------------------- PLR-128539-16
Date:
March 13, 2017

              TY: -------

Legend

Association = --------------------------------------------------------------------------------
State = ---------
State Fund = ---------------------------------------------------------------------------------------------------

Payment = -------------------------------------------------------------------------------
Reserve = ------------------------------------------------------------------------------------------------------

Statute 1 = -----------------------------------------------------------------------------------------------------

Statute 2 = -----------------------------------------------
Statute 3 = --------------------------------------------------
Statute 4 = -------------------------------------------------------------------------------
Year 1 = -------
Year 2 = -------
Year 3 = -------
Year 4 = -------
Year 5 = -------
Year 6 = -------
Date 1 = ---------------------------
Fund 1 = ---------------------------------------------------------------------
Fund 2 = --------------------------------------------------------------------------
X = ------------------
Y = ---------------
Z = ------------------

Dear -------------:

PLR-128539-16 2

This responds to a letter dated September 13, 2016, submitted on behalf of Association
requesting rulings concerning the Payment by Association to the State Fund.

RULINGS REQUESTED

(1) Whether the Payment by Association to the State Fund is deductible as an ordinary
and necessary business expense under § 162(a) of the Internal Revenue Code.

(2) Whether the Payment by Association to the State Fund is not capitalized under
§ 263(a).

FACTS

Taxpayer represents that the facts are as follows:

Association is a non-stock insurance company created by State Statute 1 enacted in
Year 1, in response to the need for additional medical malpractice insurance providers
in State. Under State Statute 2, with minor exceptions, every insurer authorized to write
liability insurance on a direct basis within State is required to be a member of
Association. Association writes medical malpractice insurance for medical service
providers and nursing homes in State. The issuance of these insurance contracts is the
only business of Association. Association is regulated by the State Department of
Insurance. Association is not owned by State and is not a part of State. Association is
a taxable insurance company. Since Year 4, Association has each year reported
taxable income pursuant to § 832.

As directed by Statute 3, Association’s after-tax operating profits (except those
attributable to insurance issued to nursing homes and assisted living facilities) are
added to its surplus Reserve.

Fund 1 was initiated in Year 2 with each policyholder annually paying into Fund 1 an
amount that was proportionate to each premium payment for liability insurance
purchased through Association as determined by an advisory committee to Association.
Contributions to Fund 1 have not been made since Year 3 as the Fund 1 balance has
been deemed to provide sufficient cushion against adverse experience. Fund 1 is not
property of State.

Any operating deficit sustained by Association is recouped by a contribution from
Fund 1 until it is exhausted and next, if necessary, by an assessment on the
policyholders and then on the members of Association.

During Year 5, the state legislature created a separate fund (Fund 2) for operating
profits from policies sold to nursing homes and assisted living facilities. Fund 2

PLR-128539-16 3

operates similar to Fund 1, but unlike Fund 1, Fund 2 is property of State. Amounts
paid to the State Fund from Fund 2 will not be deducted on Association’s Year 6 federal
income tax return and are not included in this private letter ruling request.

In Year 6, after determining there was a critical shortage of medical residents serving
the state, the State legislature enacted Statute 4 creating the State Fund to help support
graduate medical education. The sums in the State Fund are to be used to support
grants to hospitals and medical schools, inter alia, to provide graduate medical
education programs and create first-year residency positions. Under Statute 4,
Association’s Reserve, Fund 1, and Fund 2 are the primary funding sources for the
State Fund. As required by the legislation, on Date 1, Association paid $X to the State
Fund. Of this amount $Y was distributed from Fund 2 and is therefore not subject to
this private letter ruling request. Thus, Payment is $Z.

Improving the quality and accessibility of graduate medical programs in State provides
an economic benefit to the industry of medical practitioners and is expected to increase
the number of licensed medical professionals (potential customers of Association) within
State. Association expects that a better educated industry of medical professionals will
be less susceptible to medical malpractice claims. Since Association’s only business is
the issuance of insurance policies to medical professionals, the Payment to the State
Fund has a direct relationship to the industry in which Association operates. Notably,
the Payment is made with an expectation of financial return as the support for graduate
medical education will increase gross premium revenue and improve the underwriting
profit margins of Association. Also, Association can currently sell new policies and
renew current policies, though under Statute 4, the ability to sell new policies in the
future may be limited by State Department of Insurance.

LAW AND ANALYSIS

Ruling Request 1:

Section 162(a) provides, generally, that taxpayers may deduct all the ordinary and
necessary expenses paid or incurred during the taxable year in carrying on any trade or
business. See also § 1.162-1(a) of the Income Tax Regulations. In order to be
deductible under § 162, an expenditure must be (1) paid or incurred during the taxable
year, (2) related to carrying on a trade or business, and (3) ordinary and necessary for
the trade or business. Commissioner v. Lincoln Savings and Loan Ass'n, 403 U.S. 345,
352, 91 S. Ct. 1893, 29 L. Ed. 2d 519 (1971).

The term "ordinary" refers to an expenditure that is normal, usual, or customary.
Deputy v. du Pont, 308 U.S. 488, 495, 60 S. Ct. 363, 84 L. Ed. 416, 1940-1 C.B. 118
(1940). An expenditure may be ordinary if it is commonly and frequently incurred in the
type of business involved. Id. (citing Welch v. Helvering, 290 U.S. 111, 114, 54 S. Ct. 8,
78 L. Ed. 212, 1933-2 C.B. 112 (1933)).

PLR-128539-16 4

The term "necessary" means appropriate and helpful to the development of the
taxpayer's business. Commissioner v. Tellier, 383 U.S. 687, 689, 86 S. Ct. 1118, 16 L.
Ed. 2d 185 (1966) (quoting Welch, 290 U.S. at 113); Commissioner v. Heininger, 320
U.S. 467, 471, 64 S. Ct. 249, 88 L. Ed. 171, 1944 C.B. 484 (1943). A payment may be
appropriate and helpful to the development of a taxpayer's business if that payment is
mandated by a state governmental entity which confers upon the taxpayer the right to
conduct its business in that state. See Rothner v. Commissioner, T.C. Memo. 1996-
442.

In Rev. Rul. 95-32, 1995-16 I.R.B. 8, the Service ruled that payments by a public utility
as part of programs to promote energy conservation and energy efficiency were
business expenses that are deductible under § 162. These programs were aimed at
reducing electrical costs to the taxpayer’s customers, as well as addressing
environmental and societal concerns with the adverse environmental effects of
increased electrical generation. These programs also enabled the taxpayer to reduce
its future operating and capital costs.

The Payment by Association to the State Fund is deductible as an ordinary and
necessary business expense under § 162. The Payment is made with an expectation of
financial return as the support for graduate medical education will increase gross
premium revenue and improve the underwriting profit margins of Association. The
Payment to State Fund is a requirement of the laws of State, and failure to make the
Payment could jeopardize Association’s continued business operations in State. The
Payment is appropriate and helpful to Association’s business, and therefore, the
Payment is a necessary expense.

Accordingly, based solely upon the information submitted we conclude that
Association's Payment to the State Fund is deductible as an expense under section
162(a).

Ruling Request 2:

Under § 161, if a cost is a capital expenditure, the capitalization rules of § 263 take
precedence over the deduction rules of § 162. Commissioner v. Idaho Power Co., 418
U.S. 1, 17, 94 S. Ct. 2757, 41 L. Ed. 2d 535 (1974). Therefore, a capital expenditure
cannot be deducted under § 162, regardless of whether the expenditure is ordinary and
necessary in carrying on a trade or business.

Section 263(a) generally prohibits deductions for capital expenditures. Section
1.263(a)-4 of the Income Tax Regulations provides rules for applying § 263(a) to
amounts paid to acquire or create intangibles.

PLR-128539-16 5

Section 1.263(a)-4(b)(1) provides that a taxpayer must capitalize: (i) an amount paid to
acquire an intangible, (ii) an amount paid to create an intangible, (iii) an amount paid to
create or enhance a separate and distinct intangible asset, (iv) an amount paid to create
or enhance a future benefit identified in the Federal Register or in the Internal Revenue
Bulletin as an intangible for which capitalization is required under this section, or (v) an
amount paid to facilitate the acquisition or creation of an intangible, whether the
taxpayer is the acquirer or the target.

Section 1.263(a)-4(b)(3)(i) provides that the term separate and distinct intangible asset
means a property interest of ascertainable and measurable value in money's worth that
is subject to protection under applicable State, Federal or foreign law and the
possession and control of which is intrinsically capable of being sold, transferred or
pledged (ignoring any restrictions imposed on assignability) separate and apart from a
trade or business. The Payment is not an amount paid to create or enhance a separate
and distinct intangible asset within the meaning of § 1.263(a)-4(b)(3).

Section 1.263(a)-4(b)(1)(i) provides that, in general, a taxpayer must capitalize amounts
paid to acquire an intangible as provided in § 1.263(a)-4(c). Association made the
Payment because State required that Association to make it. Association did not
acquire or purchase an intangible when it made the Payment. As a result, the Payment
does not constitute an amount paid to acquire an intangible within the meaning of
§ 1.263(a)- 4(b)(1)(i).

Section 1.263(a)-4(b)(1)(ii) provides that, in general, a taxpayer must capitalize an
amount paid to create an intangible described in § 1.263(a)-4(d). The Payment is not
one of the types of created intangibles that are listed in § 1.263(a)-4(d). Therefore, the
Payment is not a created intangible.

Also, the Payment was not made to create or enhance a future benefit identified in the
Federal Register or the Internal Revenue Bulletin. Further, the Payment was not made
to facilitate the acquisition or creation of an intangible. Therefore § 1.263(a)-4(b)(1)(iv)
and (v) do not apply to the Payment.

Accordingly, the Payment is not an intangible described in § 1.263(a)-4(b)(1) and is not
required to be capitalized under that section.

CONCLUSIONS

(1) The Payment by Association is deductible under § 162(a).

(2) Association is not required to capitalize the Payment under § 263(a).

Except as expressly provided herein, no opinion is expressed or implied concerning the
tax consequences of any aspect of any transaction or item discussed or referenced in

PLR-128539-16 6

this letter. Specifically, no opinion is expressed on whether Association is an insurance
company under § 832 or on what type of entity Association is under the rules of § 7701.
Also, no opinion is expressed on what is the proper year for deduction of the Payment
under § 461 or on whether the Payment is a tax under § 164.

This ruling is directed only to the taxpayer requesting it. Section 6110(k)(3) of the Code
provides that it may not be used or cited as precedent.

A copy of this letter must be attached to any income tax return to which it is relevant.
Alternatively, taxpayers filing their returns electronically may satisfy this requirement by
attaching a statement to their return that provides the date and control number of the
letter ruling.

The rulings contained in this letter are based upon information and representations
submitted by the taxpayer and accompanied by a penalty of perjury statement executed
by an appropriate party. While this office has not verified any of the material submitted
in support of the request for rulings, it is subject to verification on examination.

                                       Sincerely,



                                       David M. Christensen
                                       Assistant to the Branch Chief, Branch 2
                                       (Income Tax & Accounting)