Odomirok.26-Taxes

This chapter on taxation is all potentially outdated because of the new tax law passed by Congress effective for tax-year 2018. If I were on the exam committee, I would not ask any taxation questions until Odomirok has been updated. A new version of Odomirok (dated 2019) is being released for the 2019.Fall exam, and it seems pointless to ask detailed taxation questions from the 2014 version of Odomirok. (You should probably still study it though.) There are tons of formulas.

  Forum

Study Tip

The Feldblum.Discount reading covers the same material as the last section of this reading, chapter 26 of Odomirok. There is only 1 exam problem from the Feldblum reading and you can pretty much answer it using what you know from Odomirok. In other words, I don't think you need to spend much time on Feldblum.Discount. You can take a quick peek but it is very detailed, and it is being removed from the syllabus for the 2019.Fall sitting anyway.

BattleTable

Based on past exams, the main things you need to know (in rough order of importance) are:

• income tax calculation
• SAP income calculation, both pre-tax and post-tax
• tax basis income, tax rates, discounting loss reserves for tax purposes

reference	part (a)	part (b)	part (c)	part (d)
E (2018.Spring #14)	tax basis income: - calculate
E (2017.Fall #21)	income tax: - calculate
E (2016.Fall #19)	tax rate: - various income types	taxable income: - from SAP income	income tax: - calculate
E (2016.Spring #18)	discounting reserves: - for tax purposes	SAP income: - calculate pre-tax value	federal tax: - identify missing info
E (2015.Spring #17)	income tax: - calculate 1
E (2013.Fall #18)	SAP income: - calculate	bond/stock allocation: - considerations

¹ There's a little trick in this problem that's glossed over in the examiner's report. See A Few Old Exam Problems at the bottom of this article for an explanation.

Full BattleQuiz You must be logged in or this will not work.

  Forum

In Plain English!

Tax-Basis Income

When I was first writing this article, one of our beta-testers wrote to me asking when I'd be finished the material on taxes because she found it very confusing. I felt her pain. It isn't that Odomirok is badly written, per se, but they make you sift through all kinds of extraneous information to get to what you really need to know. I wish they would just clearly lay out 2 or 3 different types of problems with the formula alongside. Unfortunately they don't do that.

Anyway, let's start by looking at the following exam problem. It demonstrates a few of the important formulas and it isn't too hard. It asks you to calculate the tax-basis income. Don't try to solve it for now - Alice's solution is presented in the next section.

E (2018.Spring #14)

The first question that popped into my mind was:

Question: what is tax-basis income and how is it different from "normal" SAP income

• tax-basis income is SAP or statutory income with a few adjustments:

   ==> EP is adjusted with a revenue-offset

   ==> losses (or reserves) are discounted

The concept of discounting is already familiar, but let's take a closer look at the revenue-offset term. (If you want, you can glance ahead at the TBEP formula which is given in the next section.)

Question: briefly describe the IRS's revenue offset procedure as it applies to tax-basis income

• in SAP, acquisition costs not deferred so the insurer would incur a loss
• the insurer would then be entitled to a future tax refund on this loss
• but the IRS wanted to simplify the process: instead of a refund, the IRS reduces UEP liability by 20% for all insurers

(assumes the acquisition cost ratio is 20% for all lines for all insurers)

mini BattleQuiz 1 You must be logged in or this will not work.

Calculating the Tax-Basis Income (Easier Version)

Let

TBI = Tax-Basis Income

TBEP = Tax-Basis EP

InvInc = Investment Income

TBIL = Tax-Basis Incurred Loss

then

TBI    =    TBEP    +    InvInc    –    TBIL

where the right-hand-side terms TBEP and TBIL can each be calculated two different ways:

TBEP    =    EP    +    20% x chg(UEP)    =    WP    –    80% x chg(UEP)

TBIL    =    PL    +    chg(LD)    =    IL    –    chg(reserve discount)

Side Note:

The formula for TBEP doesn't look like it matches the above description of revenue-offset, but it amounts to the same thing:

==> the TBEP formula increases the statutory EP by 20% of the chg(UEP)

Alice's solution to (2018.Spring #14):

Solution to 2018.Spring #14

And here's a practice problem:

1 practice problem like 2018.Spring #14

The quiz has a practice template for this problem. (In the next section, we'll look at a slightly harder version of calculating TBI.)

mini BattleQuiz 2 You must be logged in or this will not work.

Calculating the Tax-Basis Income (Harder Version)

We're going to build on the formulas from the previous section. The following exam problem is a harder version of the the tax problem. Take a quick look but don't try to solve it yet:

E (2017.Fall #21)

There were 2 things that made this problem harder:

• the calculation of InvInc required you to know details of how certain bonds and stockholder dividends are taxed
• you were asked to calculate IT (Income tax) which is an extra step (the previous problem asked only for TBI, the Tax-Basis Income, not the actual tax)

We'll examine these 2 items below, but first note the basic corporate tax rate of 35%. This percentage is applied directly to TBI (if TBI = $100 then IT = $35) but there are many, many adjustments. Most of these are not discussed in Odomirok.

Question: describe the tax adjustments to bonds and stockholder dividends

• proration of tax-exempt municipal bonds

   ==> add 15% of interest income to TBI

• proration of DRDs (Dividends-Received-Deductions) for stockholder dividends (let D = Dividend Income)

   ==> depends on the relationship between the corporation paying the dividend & the corporation being taxed

   ==> a certain portion (either 20% or 30%) is fully taxable, then the remainder '(80% or 70%) has 15% of its value taxed

ownership of taxed corporation	paying corporation is...	% of D subject to tax	TBI is adjusted by
> 80%	controlled	0%	no adjustment (dividends are 100% exempt)
20% → 80%	affiliated	20%	[ 20% + (80% x 15%) ] x D = 32% x D
< 20%	unaffiliated	30%	[ 30% + (70% x 15%) ] x D = 40.5% x D

• Example: Suppose D = $1,000 (D = Dividend Income)

• dividend-paying corporation is controlled:

   ==> adjust TBI by $0

• dividend-paying corporation is affiliated:

   ==> adjust TBI by $320

• dividend-paying corporation is unaffiliated:

   ==> adjust TBI by $405

These taxable amounts are then multiplied by the standard corporate tax rate of 35% to obtain the actual tax.

For the exam problem mentioned at the beginning of this section, Alice's solution lays out all the formulas you need. Side note: The solution involves something called RIT (Regular Taxable Income) which is the tax obtained by multiplying TBI (Tax-Basis Income) by the standard corporate tax rate of 35%. But big corporations are crafty and their accountants often use loopholes to reduce the tax owed. For this reason, the IRS has come up with something called AMIT (Alternative Minimum Income Tax). If AMIT is greater than RIT, then the company must pay the AMIT amount.

Alice's solution to (2017.Fall #21):

Solution to 2017.Fall #21

And here are 3 practice problems. They are all the same except for the ownership percentages. This illustrates the interplay between the ownership percentage and the AMIT. See below for a comparison table.

3 practice problems like 2017.Fall #21

Here's an observation based on these 3 practice problems that could be part of a great exam question. Notice how the overall tax liability drops as the ownership percentage increases. Note also that were it not for the AMIT, this insurer's tax bill would be even lower, much lower. That's why the AMIT exists! (numbers are rounded)

ownership percentage	RIT	AMIT	final tax
10%	2,048	2,024	2,048 ← RIT
55%	1,791	1,988	1,988 ← AMIT
90%	824	1,850	1,850 ← AMIT

Now, here's the first of 2 great exam questions related to this idea:

Alice's Great Question #1: for (2017.Fall #21), recalculate the tax given ownership percentages of 10% and 90%, and complete the table below

The results for 50% ownership were from the original exam problem. I will give a permanent shout-out to the first person to to email the correct answers for 10% and 90%. (email: info@battleacts.ca)

ownership percentage	RIT	AMIT	final tax
10%			← ?
50%	100.73	104.99	104.99 ← AMIT
90%			← ?

And here's the second great question:

Alice's Great Question #2: discuss the tax implications for the above insurer given different levels of ownership percentages

• the insurer's tax liability is inversely related to the ownership percentage (if ownership goes up, tax goes down, although note there are only 3 different ownership levels)
• this inverse relationship may not always be true (although it was true for the 2 examples above)

If you own the company then it kind of sucks to get stuck with the AMIT, but there is a silver lining.

Question: what happens when AMIT is greater than RIT for a particular year

• the difference (AMIT – RIT) can be carried forward indefinitely
• this means that if in a subsequent year, AMIT is less than RIT (so that the company pays taxes of RIT) they can reduce their taxes using amounts carried forward from previous years

This is a pretty easy concept that comes up in part (c) of:

E (2016.Fall #19)

Give it a try. You'll figure it out.

mini BattleQuiz 3 You must be logged in or this will not work.

Discounting Loss Reserves for Taxes

This is the final section from chapter 26 of Odomirok and there is a lot of overlap with Feldblum.Discounting. Note however that Feldblum's reading is being removed from the syllabus for the 2019.Fall sitting. Does this mean the topic of discounting is less important than it was? In other words, do you still have to study this topic? Well, there's no way to predict. Sometimes readings that are being removed are tested heavily; sometimes not at all. My suggestion is that you get a basic understanding of discounting facts and calculations, but if I were studying for the exam, I would give it a lower priority.

First, let's recall our earlier discussion of discounting as it related to the Fair Value of the Liabilities. That was discussed in Chapter 23 Purchase GAAP. Discounting was component #2 of the Fair Value of the Liabilities. As a reminder, component #1 was future cash flows and component #3 was the risk margin. These components were asked on an exam question in 2017, so make sure you know them.

Anyway, the first paragraph in the discounting section in chapter 26 has another dumb bullet point list you have to memorize:

Question: what 3 components are required to calculate discounted loss reserves

• undiscounted loss reserves
• discount rate for that AY reserves to be discounted (use U.S. Treasury rate)
• payment pattern

Actually, that list is pretty obvious. If you simply know how to calculate the discounted reserves, you could come up with those components. We'll cover the calculations below, but there are a few more dull facts you have to know.

Question: where do you get these 3 components for discounting

• undiscounted loss reserves:

   - Schedule P, Part 1

   - note that Part 1 is net of tabular discount, but gross of nontabular discount (means that any tabular discount must first be eliminated to get the true undiscounted reserves)

• discount rate:

   - computed as a 60-month moving average of Federal midterm rates (for each AY)

• payment pattern: CHOICE!

   - option 1: use Schedule P, Part 1 from industry data (IRS does the calcs for you. Thanks IRS!)

   - option 2: use Schedule P, Part 1 from company data (there's a 2-year lag so the company's Annual Statement from 2018 would be used for AY 2020)

   - (For option 1, you have to keep the pattern for 5 years whereas for option 2, you have to update every year)

Aside from the actual discounting calculation, there's only 1 more thing that you might want to look at (then you can pretty much just skim Feldblum.Discounting in about 5 minutes.)

Question: why is the payment pattern derived from Schedule P, Part 1 instead of Part 3

• Part 3 may be skewed because it doesn't include adjusting/other expenses
• Part 3 is not audited (Part 1 is audited)
• Part 1 requires no judgment for the IRS method

Ok, we're finally at the fun part where we calculate the discount factor from Schedule P, Part 1 data. On the exam, this calculation is usually part of a bigger problem but the other parts of the problem are covered elsewhere so we'll focus here on the discount factor calculation. Once you have the discount factor, say it's 80.2% or something, you just multiply it by the undiscounted reserves, say that was $1,000, to get the discounted reserves of $802. Anyway, here's an exam problem where you have to calculate the discount factor. Below that, Alice has provided her own solution to the discounting calculation and then a few random practice problems.

E (2016.Spring #18)

Details of discounting calculation from above exam problem:

Solution to 2016.Spring #18 (discount calc only)

Random practice problems on calculating the discount factor:

4 discounting practice problems like 2016.Spring #18

mini BattleQuiz 4 You must be logged in or this will not work.

A Few Old Exam Problems

Here are a a few remaining exam problems for extra practice, but first here's a quick explanation of the trick in (2015.Spring #17):

• Part of the solution involves calculating RTI (or TBI).
• The standard formula is: TBI = TBEP + InvInc - TBIL
• You can calculate InvInc using the methods discussed above, but the trick involves getting the value for TBEP - TBIL
• You are not given TBEP. Instead you are given U/W profit. Recall the U/W profit formula from Chapter 8.

U/W profit

= EP - IL

= U/W profit + IL

also: TBEP = EP + 20% x chg(UEP)

and: TBIL = IL - chg(resv disc)

• Putting this all together gives:

TBEP - TBIL

= [ EP + + IL + 20% x chg(UEP) ] - [ IL - chg(resv disc) ]

= EP + 20% x chg(UEP) + chg(resv disc)

You can figure out the rest using the examiner's report.

mini BattleQuiz 5 You must be logged in or this will not work.

Full BattleQuiz You must be logged in or this will not work.

  Forum