State Farm Mutual Automobile Insurance v. Commissioner , 698 F.3d 357 ( 2012 )

In the
United States Court of Appeals
For the Seventh Circuit
No. 11-3478
S TATE F ARM M UTUAL A UTOMOBILE INSURANCE C OMPANY,
Petitioner-Appellant,
v.
C OMMISSIONER OF INTERNAL R EVENUE,
Respondent-Appellee.
Appeal from the United States Tax Court.
No. 5426-05—Joseph Robert Goeke, Judge.
A RGUED M AY 23, 2012—D ECIDED A UGUST 31, 2012
Before M ANION, R OVNER, and H AMILTON, Circuit Judges.
H AMILTON, Circuit Judge. This appeal presents two
distinct questions regarding the taxation of insurance
companies. Petitioner State Farm Mutual Automobile
Insurance Company has appealed from two rulings of
the United States Tax Court that were part of the same
case. One ruling concerns the tax treatment of bad-faith
punitive damage awards that have not yet been paid.
2 No. 11-3478
The other concerns the alternative minimum tax
regime — a complicated area of the tax code that high-
earning individuals and corporations must contend
with, made even more complicated here by the special
rules applicable to life insurance companies, especially
when they are part of larger insurance enterprises.
During the tax years relevant to this appeal, petitioner
State Farm was the tax filer for both the life insurance
and non-life (automobile, etc.) insurance subgroups
that make up State Farm. Petitioner filed consolidated
tax returns that covered both insurance subgroups, as
permitted by the tax code. In late 2004, respondent Com-
missioner of Internal Revenue determined deficiencies
in those returns for the tax years 1996 to 1999. State Farm
responded with a petition that raised seven issues, one
of which included a revised method for calculating its
alternative minimum tax liability. The revised AMT
calculations, State Farm argued, meant that rather than
owing about $75 million in additional taxes, it would
instead be entitled to some $500 million in additional
refunds. Five of the seven issues raised by State Farm
were settled, leaving only the AMT issue and one
other — which we call the loss reserve issue — for the
Tax Court to resolve. Both of those issues involve
events in tax years 2001 and 2002, which relate to State
Farm’s 1996 to 1999 tax returns via various carry-back
rules for crediting tax losses.
In 2010, the Tax Court ruled that State Farm should
not have included an adverse $202 million award of
compensatory and punitive damages for bad faith in
No. 11-3478 3
its insurance loss reserve for its federal income tax
returns for 2001 and 2002. 135 T.C. 543 (2010). We affirm
the Tax Court’s decision regarding the punitive dam-
ages portion of the award, though for reasons dif-
ferent from the Tax Court’s. Pending clearer guidance
about the recommended tax treatment of punitive damage
awards from the National Association of Insurance Com-
missioners (to whom Congress has commanded defer-
ence in this regard), we hold that punitive damages
should be treated as regular business losses that are
deductible when actually paid rather than deducted
earlier as part of insurance loss reserves. With regard to
the compensatory damages portion of the award, how-
ever, we agree with amici insurance associations and
reverse the Tax Court. Extra-contractual obligations
like the compensatory damages for bad faith have long
been included in insurance loss reserves, and clear guid-
ance from the NAIC, which the federal tax statutes essen-
tially incorporate for key details of taxing insurance
companies, supports that result.
In a prior phase of the same case, the Tax Court rejected
the method by which State Farm wanted to recalculate
its alternative minimum tax liability for tax years 2001
and 2002. 130 T.C. 263 (2008). State Farm’s newly pro-
posed method for computing this liability used one
number for Pre-adjustment Alternative Minimum
Taxable Income in one calculation, and another number
for Pre-adjustment Alternative Minimum Taxable
Income in another calculation. State Farm effectively
applied a statutory “loss limitation” rule in one place
but not in the other. The result of this new math would be
4 No. 11-3478
the creation from thin air of a virtual tax loss some
$4 billion larger than State Farm’s actual loss (which
was itself a whopping $5.3 billion) in the 2001 tax
year — and consequently more than $500 million in new
retroactive tax credits. We affirm the Tax Court’s rejec-
tion of State Farm’s unreasonable new interpretation of
the tax code. We find nothing in the text or purpose
of the alternative minimum tax statutes and regula-
tions to support math that uses two different values
for the same variable in adjacent calculations.
We review the Tax Court’s findings of fact for clear error
and its conclusions of law de novo. Freda v. Comm’r of
Internal Revenue, 656 F.3d 570, 573 (7th Cir. 2011). Both the
loss reserve and the alternative minimum tax issues
here presented legal questions for the Tax Court to decide
based on facts that were stipulated by the parties. Conse-
quently, our review is plenary. Because the two chal-
lenged rulings of the Tax Court are entirely separable,
and in fact were resolved in separate opinions more
than two years apart, we treat them separately below.
I. The Loss Reserve Issue
Insurance companies maintain loss reserves in their
annual statements and are allowed to take tax deduc-
tions for reasonably estimated insurance losses even
before those losses are actually paid out to claimants. See
26 U.S.C. § 832(b)(5). This special tax treatment, which
also requires discounting estimated future losses to
present value, helps to relate income from insurance
premiums in a given tax year to the expected claim ex-
No. 11-3478 5
penses (losses) on those same insurance contracts,
which may not actually be paid until years later. The
rule avoids time-value distortions that would arise if
companies had to pay taxes immediately on profits
from premiums but were allowed only years later to
deduct claim expenses that reduced those profits. The
rule is unique to the insurance industry, and the losses
that can be so deducted are defined by statute and regula-
tion.
Under section 832(b)(5), deductible “losses incurred”
must be “on insurance contracts” and can include
“unpaid losses on life insurance contracts plus all unpaid
losses (as defined in section 846).” Id. Deductible losses
incurred do not include ordinary business expenses,
which can be deducted only when actually paid. See 26
U.S.C. § 461(h) (requiring ordinary deductions to be
taken in the tax year in which “economic performance”
occurs). Deductible losses incurred must “represent a
fair and reasonable estimate of the amount the com-
pany will be required to pay,” and deductions can be
disallowed if deemed unreasonable. 26 C.F.R. § 1.832-4(b).
This statutory definition of “losses incurred,” like many
statutory definitions, requires interpretation — here to
determine whether compensatory and/or punitive
damages arising from bad faith claims are properly
included in deductible loss reserves before they are
actually paid. Because of the way Congress drafted
section 832, our ordinary interpretive tools are supple-
mented by guidance from the National Association
of Insurance Commissioners, which plays an unusual if
not unique role in filling in the details of federal tax law.
6 No. 11-3478
Section 832 requires that an insurance company’s
“gross income” — which includes “premiums earned on
insurance contracts during the taxable year less losses
incurred and expenses incurred” — be “computed on the
basis of the underwriting and investment exhibit of the
annual statement approved by the National Association
of Insurance Commissioners.” 26 U.S.C. § 832(b); Sears,
Roebuck & Co. v. Comm’r of Internal Revenue, 972 F.2d
858, 866 (7th Cir. 1992). The NAIC is an organization
of state insurance regulators that develops and promul-
gates accounting standards for insurance companies.
States require insurance companies domiciled within
their borders to file annual statements. Many states,
including Illinois (State Farm’s domicile here), require
those annual statements to conform to NAIC’s ac-
counting instructions. By enacting section 832 with its
reference to the NAIC-approved statement, Congress
has similarly compelled use of the NAIC instructions
for federal tax purposes. Sears, Roebuck, 972 F.2d at 866
(“State insurance commissioners’ preferences about
reserves thus are not some intrusion on federal tax
policy; using their annual statement is federal tax law.”).
As in Sears, Roebuck, we consider the NAIC’s promulgated
views when determining whether punitive damages
and extra-contractual liabilities should be included in
loss reserves that correspond to deductions under
section 832.
In 2001 and 2002, State Farm included a $202 million
adverse judgment in its loss reserve and claimed a tax
deduction for it as a discounted unpaid loss under sec-
tion 832(b)(5). The judgment was part of the long-running
No. 11-3478 7
Campbell litigation in Utah, which began with a fatal
auto accident in 1981 and eventually led to a “bad-faith”
jury verdict in 1996 — one related to State Farm’s
handling of the claim. The award was reduced by the
trial court in 1998 and then reinstated by the Utah
Supreme Court in 2001. As reinstated, the award
included $1 million in compensatory damages, $145 million
in punitive damages, $55.2 million in interest, and
$800,000 in fees, totaling $202 million. State Farm
appealed to the United States Supreme Court, but in the
meantime, it included the $202 million in its loss
reserve and took corresponding tax deductions for this
still-unpaid judgment.
In 2003, though, the Supreme Court reversed the puni-
tive damages portion of the award and remanded for
reconsideration of the amount. See State Farm Mut. Auto.
Ins. Co. v. Campbell, 538 U.S. 408 (2003). State Farm then
reduced its loss reserve for the 2003 tax year and paid
taxes on the resulting increase in net income. After recon-
sideration in Utah courts, State Farm’s final liability from
the Campbell bad-faith verdict was about $17 million.1
1
Because of interest, varying discount rates, and the time
value of money, State Farm’s removal of the Campbell judgment
from its reserve (and resulting higher taxes) in 2003 did not
perfectly balance its prior inclusion of the judgment in that
reserve (and resulting deductions carried back to prior
years). We will spare the reader the actual calculations, but
the issue is not moot because, State Farm asserts, a decision
(continued...)
8 No. 11-3478
The Campbell award included compensatory damages
and punitive damages, both stemming from bad faith
in handling a claim rather than from an insured risk
covered by the underlying insurance contract, such as
the auto accident itself. A bad-faith lawsuit asserts that
the insurance company breached one of the implied
terms or special duties that the law recognizes as
arising from insurance contracts. Amici insurance associa-
tions inform us that the insurance industry refers to
compensatory liabilities that arise from these implied
terms as “extra-contractual obligations.” Without ex-
planation, the Tax Court treated compensatory and
punitive damages together and then held that the
analysis of Sears, Roebuck did not apply to these extra-
contractual losses. We believe this was a twofold error.
As discussed below, our Sears, Roebuck holding was
broad and its rationale applies here. Also, because of
differences in the NAIC’s guidance regarding punitive
damages and compensatory damages in bad-faith
cases, they should not be treated the same under Sears,
Roebuck. Compensatory damages for bad faith are
clearly within the NAIC guidance concerning what
should be included in loss reserves, but so far that guid-
ance has not been extended to punitive damage awards.
We address them separately.
1
(...continued)
on the loss reserve issue will have a net effect on the order of
$7 million to $8 million.
No. 11-3478 9
A. Compensatory Damages for Bad Faith
Based on information provided by the parties and
amici here, “extra-contractual obligations” seems to be
a broad category as used by the insurance industry —
one that may include a number of different kinds of
liability, such as losses above policy limits, fees and
costs, interest or consequential damages from delayed
payment of claims, and mental distress damages for
improper claim handling. We use the phrase here to
denote only the $1 million in bad-faith compensatory
damages, and interest thereon, included in the Campbell
judgment. We need not and do not attempt to define
the full scope of the extra-contractual obligations
category or decide on the proper tax treatment of other
kinds of liability potentially included in it. The question
we address here is whether the compensatory damages
portion of the Campbell bad-faith judgment is a
deductible loss incurred on an insurance contract that
could be deducted before it was paid. We conclude
that it is, and we reverse the contrary decision of the
Tax Court.
The statutory language we interpret here is part of a
series of nested definitions that require the reader to
follow a long trail similar to a scavenger hunt, aided by
added italics. Section 832(a) states that the insurer’s
“taxable income” equals “the gross income as defined in
subsection (b)(1) less the deductions allowed by subsec-
tion (c).” 26 U.S.C. § 832(a). “Gross income” is defined
in turn as:
the combined gross amount earned during the taxable
year, from investment income and from underwriting
10 No. 11-3478
income as provided in this subsection, computed on
the basis of the underwriting and investment exhibit
of the annual statement approved by the National
Association of Insurance Commissioners.
§ 832(b)(1). This is the first reference to use of the
NAIC annual statement. “Underwriting income” in turn
includes “the premiums earned on insurance contracts
during the taxable year less losses incurred and expenses
incurred.” § 832(b)(3). “Losses incurred” are defined as
losses incurred during the taxable year on insurance
contracts computed as follows:
(i) To losses paid during the taxable year, deduct
salvage and reinsurance recovered during the
taxable year.
(ii) To the result so obtained, add all unpaid losses
on life insurance contracts plus all discounted unpaid
losses (as defined in section 846) outstanding at the end
of the taxable year and deduct all unpaid losses on
life insurance contracts plus all discounted unpaid
losses outstanding at the end of the preceding
taxable year. . . .
§ 832(b)(5). Finally, section 846 defines “discounted
unpaid losses,” with exceptions not relevant here, as “the
unpaid losses shown in the annual statement filed by
the taxpayer.” 26 U.S.C. § 846(b)(1).2
2
It makes no difference for our purposes whether an unpaid
loss is treated as a subtraction from gross income under
(continued...)
No. 11-3478 11
Both section 832(b)(1) and section 846 (which became
effective after the events underlying our decision in
Sears, Roebuck) refer to the NAIC-approved annual state-
ment as the source of the unpaid losses used in cal-
culating gross income. Underwriting income, which
includes losses incurred, must be computed based on
the annual statement. Any doubt about whether the
unpaid losses (included in those losses incurred) are
also to be computed according to the annual statement
is resolved by the specific reference to that state-
ment in section 846. We agree with State Farm that the
NAIC-approved annual statement provides the rule
for computing deductible loss reserves under sec-
tion 832, at least where the NAIC has in fact provided
a rule.
The other key interpretive point is that whatever
unpaid losses are, they must be “on insurance con-
tracts.” The parties disagree about whether the word “on”
refers only to claim losses on insured risks, or means
something like “related to” insurance contracts — and
therefore also includes losses on State Farm’s handling
of claims. At least with regard to compensatory damages
in bad-faith lawsuits, the NAIC’s guidance resolves
this otherwise tricky dispute.
2
(...continued)
§ 832(b)(1) or as a deduction under § 832(c)(4). The code is
clear that taxpayers may choose either treatment so long as
they do not double-count a loss as both a subtraction and
a deduction. The deduction paragraph refers to the same
definition for losses incurred. See 26 U.S.C. § 832(c)(4) (re-
ferring to § 832(b)(5)).
12 No. 11-3478
The Commissioner argues that the Campbell judg-
ment was not a loss on an insurance contract because it
did not relate to an insured risk covered by the contract,
but was, as the Tax Court held, a liability incurred
because of State Farm’s own misconduct in handling
the Campbell claim. Because the loss did not arise out of
a contemplated risk but instead from torts committed
by State Farm, the Commissioner argues, it is not suf-
ficiently tied to the insurance contract to fall under
the definition in section 832(b)(5). The Commissioner
focuses on the punitive damages portion of the award,
noting that such damages are intended to punish fraud,
not to compensate for breach of contract.
State Farm argues that the bad-faith tort liability ex-
pressed in the Campbell judgment arose directly from
implied terms in the insurance contract. In many states
such contracts are interpreted to include duties of
good faith and fair dealing by insurers, and so any re-
sulting bad-faith tort judgments are necessarily tied to
the existence of an insurance contract. Depending on
state law, an insured might have tort claims that
require a showing of breach of an express or implied
contract term, or might have claims for both contractual
breach of implied terms and tortious breach of implied
duties arising from the same facts. See, e.g., Logan v.
Commercial Union Ins. Co., 96 F.3d 971, 979-80 (7th Cir.
1996) (discussing Indiana law); see also Beck v. Farmers
Ins. Exchange, 701 P.2d 795, 799-800 (Utah 1985) (discussing
the relation between contract and tort theories of liability
under Utah law, and distinguishing between third-
party and first-party insurance); Campbell v. State Farm
No. 11-3478 13
Mut. Auto. Ins. Co., 840 P.2d 130, 139 (Utah App. 1992)
(early decision in Campbell litigation saga). State Farm
points out that without an insurance contract from
which to imply terms and duties, there could be no bad-
faith Campbell judgment.3
Without guidance from the NAIC, this would be a
close question. Both sides advance some credible argu-
ments, and the statutory language itself is not helpful
with the meaning of the phrase “on insurance contracts”
as applied to this question. We might just as easily read
the phrase broadly to mean “related to” or “arising
from” insurance contracts as read it more narrowly to
mean “concerning contractually allocated risks.” But the
NAIC has already provided clear guidance that supports
State Farm’s position: compensatory damages for
“bad faith” should be included in unpaid loss reserves
in annual statements — and consequently qualify as de-
ductible losses per section 832.
3
The Commissioner attempts to draw a line between bad-
faith actions that arise from contracts and those that sound in
tort, but this distinction would have the unhappy effect of
making the interpretation of the “on insurance contracts”
language in a federal statute depend (and vary) based on
subtle differences in states’ common law of bad-faith claims.
Insurance companies would have to conduct a fifty-state
survey to determine whether the state where each lawsuit
arose called the suit a contract case (based on an implied good-
faith term), or a tort case (based on an implied duty of
good faith), or both. But this is a distinction without a real
difference relevant to the question whether an unpaid
loss should be deductible or not.
14 No. 11-3478
The NAIC publishes an Accounting Practices and
Procedures Manual that includes a number of
Statements of Statutory Accounting Principles, which
are promulgated by action of the entire membership.
SSAP Number 55 applies to “Unpaid Claims, Losses,
and Loss Adjustment Expenses” that are included in
loss reserves in the approved annual statement. Unfortu-
nately, SSAP Number 55 is not significantly clearer
than the statutory “on insurance contracts” language on
this issue — it uses the language “losses relating
to insured events.” But in 2004, the NAIC issued an
authoritative “interpretation” (INT 03-17) clarifying this
precise question. The interpretation states: “Insurers are
sometimes parties to lawsuits known as extra con-
tractual obligations lawsuits; these include ‘bad faith’
lawsuits.” Such lawsuits “arise out of the handling” of
claims. The NAIC interpretation concludes: “Claims
related extra contractual obligations losses and bad
faith losses shall be included in losses.” We could not
ask for a clearer statement of the NAIC’s view
regarding the inclusion of compensatory bad-faith dam-
ages in loss reserves. Although the INT 03-17 interpreta-
tion of SSAP Number 55 was released after State
Farm’s decision to include the Campbell judgment in its
loss reserves, it provides persuasive evidence that State
Farm’s prior interpretation of NAIC guidance was
correct with regard to the compensatory damages. (As
explained below, however, SSAP Number 55 and INT 03-17
both state they do not apply to punitive damages.)
The Tax Court did not fully treat this NAIC guidance
because it did not consider our analysis in Sears, Roebuck
No. 11-3478 15
controlling regarding the extra-contractual losses at
issue here. The court reasoned that Sears, Roebuck con-
cerned “estimated insured losses and this case is about
extracontractual losses.” Nothing about our analysis in
Sears, Roebuck indicates that its reasoning was so lim-
ited. The point was that section 832(b)(5) defers to the
NAIC accounting rules. Sears, Roebuck applies here. See
972 F.2d at 866 (rejecting arguments for treating subsec-
tion (b)(5) losses differently and noting that they are
part of the subsection (b)(1) income calculation, which
refers to the annual statement.) The Tax Court believed
that the Campbell judgment was not “on” an insurance
contract under section 832(b)(5), so it need not look at
the NAIC guidance. This was the wrong approach. In
the linked chain of definitions we described above, Con-
gress referred to the NAIC annual statement above
(section 832(b)(1)) and below (section 846) the allegedly
exclusionary “on insurance contracts” language. Congress
commanded use of the NAIC instructions to compute
underwriting income, and then clarified in section 846
that what the NAIC says is an unpaid loss for
annual statement purposes controls for tax purposes, as
well. There is nothing unreasonable about the NAIC’s
interpretation that some extra-contractual losses are
appropriately treated as unpaid losses on insurance
contracts and included in section 832(b)(5) unpaid loss
reserves.
Amici insurance associations offer a persuasive
policy reason to support this result for compensatory
damages. Underwriting income is a key factor that in-
surance companies and regulators use to assess capital
16 No. 11-3478
requirements. It is also used as an input for the compli-
cated ratemaking and rate approval processes. By tying
the computation of unpaid loss reserves for tax purposes
to the annual statement used for these other purposes,
Congress has allowed insurance companies to main-
tain just one set of books. We can see no reason to
overturn the settled practice of the insurance industry
in this area.4
For these reasons, we reverse the Tax Court’s ruling with
regard to the compensatory damages portion of the
Campbell judgment. Compensatory damages in bad-
faith lawsuits against insurers are included in unpaid
loss reserves under authoritative NAIC annual state-
ment guidance, and are thus properly included in de-
ductible unpaid losses under section 832.
B. Punitive Damages for Bad Faith
Punitive damages are another matter. The NAIC guid-
ance we relied upon above regarding compensatory
damages does not apply to punitive damages. To begin
4
Amici also inform us that under prior NAIC guidance,
insurance companies included extra-contractual obligations
in their loss reserves either as section 832(b)(5) losses or as
section 832(b)(6) loss adjustment expenses. Both losses and
loss adjustment expenses go into deductible loss reserves.
Thus, the NAIC’s 2004 interpretation was merely choosing
one of two possible ways to categorize such obligations,
not breaking new ground over their inclusion in deductible
reserves.
No. 11-3478 17
with, the NAIC’s Statement of Statutory Accounting
Principles Number 55 states: “This statement does not
address liabilities for punitive damages.” Instead, punitive
damages are to be recorded in annual statements in
accordance with SSAP Number 5, but it addresses
whether to report unpaid punitive damages judgments
at all, not where to report these liabilities on annual state-
ments — whether in insurance loss reserves or in
ordinary operating reserves. The Commissioner argues
that SSAP Number 5 liabilities are generally reported as
ordinary operating losses. But as above, the SSAPs ap-
proved by the entire NAIC membership do not conclu-
sively resolve the statutory interpretation question
over punitive damages here. The relevant guidance is
at best ambiguous.
The INT 03-17 interpretation that guided our decision
on compensatory damages reaffirms that SSAP Num-
ber 55 does not apply to punitive damages and so is no
help here. State Farm asserts that punitive damages,
like the compensatory damages discussed above, fall
within the “claims related extra contractual obligations
losses and bad faith losses” language of interpretation
INT 03-17. In response, the Commissioner argues that
reading the interpretation this way would put the inter-
pretation in conflict with the guidance it interprets.
State Farm’s reading would include punitive damages
in loss reserves that are governed by guidance that dis-
avows its own application to punitive damages. We
agree with the Commissioner on this point.
To avoid this result, State Farm offered the testimony
of Norris Clark, who chaired the working group that
18 No. 11-3478
drafted the INT 03-17 interpretation. He testified that
the group meant for the “bad faith losses” language to
include punitive damages. If that is true, significant
time and expense could have been saved on this portion
of this appeal simply by saying explicitly in INT 03-17
that unpaid punitive damages go in deductible loss
reserves, even though SSAP Numbers 55 and 5 tend to
suggest otherwise. Given the actual texts of SSAP
Numbers 55 and 5 and INT 03-17, however, we cannot
accept the word of a paid witness — even one who was
involved in drafting the relevant interpretation — over
the clear implication in the guidance adopted by the
entire NAIC membership that punitive damages are to
be treated differently. Congress has provided that under-
writing income is to be “computed on the basis of the
underwriting and investment exhibit of the annual state-
ment approved by the National Association of Insurance
Commissioners.” 28 U.S.C. § 832(b)(1). We think that the
“approved by” language requires something with much
more weight than what a witness tells the court was
“really” meant. While we held in Sears, Roebuck, and
hold here, that this statutory language requires some
deference to the guidance promulgated by the NAIC,
that deference does not extend to an individual com-
missioner’s opinion attempting to resolve ambiguity in
the official guidance.5
5
Nor is our deference under Sears, Roebuck absolute. Other
circuits have rejected arguments that expense items are per se
deductible just because they are included in the relevant
(continued...)
No. 11-3478 19
We also note but do not attach significant weight to
the fact that various state regulators and outside
auditors approved State Farm’s 2001 and 2002 annual
statements — statements that included the Campbell
punitive damages award in the unpaid loss reserve.
State Farm has provided no evidence that the entities
in question addressed or engaged with the specific issue
now presented. Even if they had, we are not bound by
the section 832 statutory language to consider the views
of any auditor or regulator other than the NAIC as a
whole. For their part, amici insurance associations
here were content to stress the distinction between puni-
tive and ordinary extra-contractual obligations and
argue that whatever the result for punitive damages, we
should reverse the Tax Court on the compensatory dam-
ages, as we have.
Absent binding directives from the NAIC membership
for insurance companies to treat unpaid punitive
damages as deductible losses, the parties and amici
5
(...continued)
portions of the NAIC annual statement. See, Home Group, Inc. v.
Comm’r of Internal Revenue, 875 F.2d 377, 381 (2d Cir. 1989) (“An
accounting practice for bookkeeping purposes is not
necessarily what the Code allows for tax accounting purposes.”)
and Western Casualty & Surety Co. v. Comm’r of Internal Revenue,
571 F.2d 514, 517 (10th Cir. 1978). We need not opine whether
bad-faith punitive damages would conflict with the “on in-
surance contracts” statutory language in a future case if the
NAIC clearly directs that they be included in insurance
loss reserves on annual statements.
20 No. 11-3478
here have identified a number of compelling reasons not
to do so. First, punitive damage awards are typically
treated as rare, exceptional occurrences and are not
included in insurance ratemaking and rate approval
processes. Insurance loss reserves, however, are a
critical input for ratemaking, and potentially for other
regulatory formulas. Punitive damage awards that were
included in those loss reserves for purposes of recording
a tax deduction would then have to be backed out
for ratemaking. This seems both inconvenient and in-
dicative that punitive damages should instead be
treated as operating losses when actually paid.
Second, allowing insurance companies to take a tax
deduction for punitive damage awards before they
are actually paid does not serve the purpose of the
insurance-industry exception to the ordinary deduct-when-
paid rule. That exception is meant to avoid distortions
and “float” arising from the delay between receiving
premium income and paying claim expenses. But large
punitive damage awards can themselves be gross distor-
tions on any company’s balance sheet, and they are
even farther removed from legitimate claim expenses
than compensatory damages in bad-faith suits. Finally,
as State Farm’s own experience indicates, it can be
difficult to estimate reasonably, as the taxpayer must
per 26 C.F.R. § 1.832-4(b), “the amount the company
will be required to pay.” Punitive damage awards are
frequently reduced or overturned post-verdict, as with
the Campbell judgment and apparently at least one
other large judgment against State Farm in recent years.
See State Farm Br., n.7, noting reversal of a $1 billion
No. 11-3478 21
judgment (including punitive damages) in the Avery
class action in Illinois, which State Farm had not
reported as an unpaid deductible loss; see also BMW
of North America, Inc. v. Gore, 517 U.S. 559 (1996)
(ordering reduction in a punitive damage award that
was 500 times the compensatory damages); Anthony J.
Sebok, Punitive Damages: From Myth to Theory, 92 Iowa L.
Rev. 957, 971-72 (2007) (noting rarity and high reduction
rate on appeal of awards with high ratios of punitive
to compensatory damages), and sources cited therein;
Michael Rustad, The Closing of Punitive Damages’ Iron
Cage, 38 Loy. L.A. L. Rev. 1297, 1334-35 (2005) (noting
high reversal rate and close appellate scrutiny of
punitive damage awards); Catherine M. Sharkey,
Punitive Damages: Should Juries Decide?, 82 Tex. L. Rev. 381,
404-05 (2003); Neil Vidmar and Mary R. Rose, Punitive
Damages by Juries in Florida: In Terrorem and In Reality,
38 Harv. J. on Legis. 487, 506-07 (2001) (summarizing
empirical studies showing high reversal rates of puni-
tive damage awards); Samuel Issacharoff, Can There Be
a Behavioral Law and Economics?, 51 Vand. L. Rev. 1729,
1743 (1998) (recognizing close appellate scrutiny and
high reversal rate of punitive damage verdicts).
Companies, whether selling insurance, cars, or med-
ical devices, sometimes must report potential unpaid
liabilities to their shareholders and lenders, and must
set aside funds to account for judgments. The fact that
State Farm wanted to or needed to set aside money in
reserve to pay the $202 million Campbell judgment,
which in 2001 seemed likely to come due, does not mean
that its insurance loss reserve was the only or best
22 No. 11-3478
place to do so. Many ordinary business expenses,
in c lu d in g p o t en t ia l fe e s a n d lia b ilit ie s fr om
pending lawsuits, are disclosed and accounted for in
reserves — without triggering the special tax treatment
for insurance loss reserves of deduction before actual
payment of the underlying liability. See Brown v.
Helvering, 291 U.S. 193, 202 (1934) (noting the limited
number of deductible reserves authorized by tax law
and stating: “Many reserves set up by prudent business
men are not allowable as deductions.”). Companies
that need to account to their shareholders or lenders for
unpaid punitive damage awards may do so regardless
of the tax treatment of the reserves they set up.
We therefore affirm the result but not the reasoning
of the Tax Court with regard to the punitive damages
portion of the Campbell judgment. Our analysis of the
relevant statutory language in Sears, Roebuck does apply,
at least to the extent that deference to the NAIC could
be appropriate here. But the NAIC has not directed
insurers to include punitive damages in deductible
loss reserves before they are paid. Unlike compensatory
damages (as a component of ordinary extra-contractual
obligations), there is no evidence that the insurance
industry regularly includes punitive damages in de-
ductible unpaid loss reserves. The Tax Court properly
held that State Farm was not entitled to take a deduc-
tion for this portion of the Campbell judgment in 2001
and 2002.
No. 11-3478 23
II. The Alternative Minimum Tax Issue
We begin our discussion of the alternative minimum
tax issue raised by State Farm by commending the
careful and comprehensive opinion of the Tax Court on
the subject, which we affirm. 130 T.C. 263 (2008). We
adopt the result and reasoning of the court’s opinion,
though in deference to the trees we will not reprint it
here. Instead we will briefly explain the issue and the
dispositive factors behind our affirmance.
The alternative minimum tax was enacted in response
to the fairness concern that high-earning individuals
and corporations might otherwise escape significant tax
liability by employing an array of exemptions, deductions,
and credits. Calculation of alternative minimum tax
liability involves starting from ordinary taxable income,
then adjusting back a number of allowed reductions
in various ways. Through the alternative minimum
tax, Congress sought to address “instances in which
major companies have paid no taxes in years when they
reported substantial earnings.” See CSX Corp. v. United
States, 124 F.3d 643, 648 (4th Cir. 1997), quoting from
Senate Report No. 99-313 at 519. “Hence, the alternative
minimum tax was designed to eliminate situations
where corporations show substantial financial or book
income, and yet pay little or no taxes because their
taxable income is lowered by tax credits or deductions.” Id.
As we will see, State Farm rests its proposed calcula-
tion method on the idea that the alternative minimum
tax calculation seeks to better approximate “book in-
come” at all times for the sake of symmetry. But in fact
24 No. 11-3478
Congress sought to tie taxable income and book income
closer together for only a specific purpose — closing
loopholes that were perceived as unfair. State Farm’s
proposed calculation method is not sound. It would
produce highly artificial results, and would do so by
assigning different meanings to an identical phrase
where it appears in two consecutive subparagraphs of
the applicable Treasury regulation.
A. Alternative Minimum Taxation of Insurance Companies
We first provide some background on how the alterna-
tive minimum tax is calculated for an ordinary corpora-
tion. Internal Revenue Service Form 4626 also provides
a useful guide to the procedure. The starting point
for computation of alternative minimum tax is the com-
pany’s taxable income (or loss) before applying any
net operating loss deduction. Then the taxpayer must
apply a series of adjustments and preferences to that
number, which have the effect of adding back certain
deductions and deferred income. This leads to a
potentially larger number known to the cognoscenti as
the pre-adjustment Alternative Minimum Taxable
Income (pAMTI).
Next, the taxpayer must calculate its Adjusted Current
Earnings (ACE) according to 26 U.S.C. § 56(g). This cal-
culation starts from the pAMTI number and adds
back more adjustments. For example, certain tax-exempt
interest income is deductible from income in com-
puting ordinary income taxes but must be added back
in when computing ACE. Once the ACE is calculated,
No. 11-3478 25
an “ACE adjustment” is made to determine alternative
minimum taxable income. Section 56(g) provides that
the adjustment equals 75% of the amount of the ACE
that is greater than the pAMTI. Expressed as a formula:
ACE adjustment = 0.75 x (ACE – pAMTI). This ACE
adjustment ordinarily would be positive if the taxpayer
had income items subject to being added back, but it
can also be negative if the pAMTI number starts out
negative because of an overall operating loss. Once
the ACE adjustment is calculated, the taxpayer can
also carry forward leftover ACE adjustments from
prior years. Next, the pAMTI and the ACE adjustment
are added together, and the taxpayer can then apply
an alternative minimum net operating loss deduction
to arrive at the taxpayer’s Alternative Minimum
Taxable Income (AMTI). If the operating loss deduction
has not brought the AMTI below zero, the alternative
minimum tax is computed from the AMTI number.
As if this were not complicated enough, there are
special considerations and complications when the con-
solidated tax return is being filed by a taxpayer like
State Farm that operates both life insurance and non-
life insurance subgroups. Several tax statutes and reg-
ulations treat life insurance companies differently. Because
of those rules, income (or loss) of the life and non-
life subgroups cannot simply be added together for
purposes of filing a consolidated tax return, as is
possible for other types of parent companies. Specifically,
26 U.S.C. § 1503(c) limits how companies can use losses
in their non-life insurance subsidiaries to offset gains
26 No. 11-3478
in life insurance subsidiaries on consolidated returns.
This “loss limitation” rule has previously generated
confusion about which calculations must be performed
separately on a subgroup basis — to avoid zeroing life
gains with non-life losses — and which calculations can
be done on a consolidated basis. See State Farm Mut.
Auto. Ins. Co. v. Comm’r of Internal Revenue, 105
F. App’x 67 (7th Cir. 2004) (discussing the “book in-
come” adjustment that was later replaced by the ACE
adjustment detailed above).
In deciding the alternative minimum tax issue, the
Tax Court addressed at length the choice between two
alternative calculation methods other than the one ad-
vocated by State Farm. The question was whether the
ACE adjustment should be calculated on a subgroup
basis (as State Farm did in its initial returns, but not in
the lawsuit), or on a consolidated basis, starting with
a consolidated pAMTI and with allocation to sub-
groups after the fact. The Tax Court concluded that the
relevant regulations supported the latter method, and
we agree. We adopt the reasoning of the Tax Court
on this question and point interested readers to the
charts that the court included in an appendix to demon-
strate the difference in approaches. See State Farm, 130
T.C. 294, reproduced in edited form as Appendix A
below. The method originally used by State Farm (chart
A.1 below) and the method required by the Tax Court
(chart A.3 below) ultimately came to the same end result,
though. The different method that State Farm proposed
during this litigation (chart A.2 below) did not come to
No. 11-3478 27
the same end result — in fact it created a loss $4.3 billion
larger — because of a failure to apply the loss limitation
rule properly.
B. State Farm’s Proposed Calculation Method
2001 was a very bad year for State Farm’s non-life
insurance subgroup, which lost $5.8 billion. State Farm’s
life insurance subgroup, however, had ordinary taxable
income of more than $500 million. If State Farm sold
vegetables or anything else other than life insurance, it
would have had a consolidated net loss and its consoli-
dated pAMTI would have been negative. See 26 C.F.R
§ 1.56(g)-1(n)(3)(i). But State Farm properly applied the
loss limitation calculations of section 1503(c) and ended
up with a positive pAMTI of more than $500 million.
When calculating its consolidated ACE according to
an adjacent subparagraph of the regulations, see 26
C.F.R § 1.56(g)-1(n)(3)(ii), State Farm proposed using a
pAMTI number that did not apply the loss limitation
rule. This negative $5.3 billion pAMTI number absorbed
State Farm’s substantial section 56(g) adjustments. Even
after the 75% ACE adjustment discount, the new calcula-
tion left State Farm with a negative $3.6 billion ACE
adjustment and a negative $9.4 billion alternative mini-
mum taxable income. Unsurprisingly, in a year when
State Farm lost 5.3 billion real dollars overall, it was not
in fact subject to any alternative minimum tax in 2001.
But the net operating loss carry-back rules allowed
State Farm to use this newly claimed $9.4 billion AMTI
loss in prior years — to generate claims for refunds in
28 No. 11-3478
years when it had turned large profits and had
actually paid the alternative minimum tax.6
State Farm argues that there is nothing fishy about
using one number for pAMTI for the purpose of
comparing with ACE, and another number for pAMTI
for the purpose of calculating ACE — or applying
section 1503(c) loss limitation rules to generate consoli-
dated pAMTI in one place but not in another. But of
course, nothing in section 1503(c), or in regulation sub-
paragraphs 1.56(g)-1(n)(3)(i) and (ii), gives any hint
that “pre-adjustment alternative minimum taxable in-
come” could mean two different things depending on
whether you are calculating it or using it to calculate
something else.
One of the more reliable canons of statutory construc-
tion — the normal practice — is that a term or phrase is
ordinarily given the same meaning throughout a statute.
E.g., Nijhawan v. Holder, 557 U.S. 29, 39 (2009) (applying
canon to adjoining subparagraphs in immigration
law); Comm’r of Internal Revenue v. Lundy, 516 U.S. 235,
250 (1996) (applying canon to term in adjoining sections
of Internal Revenue Code); Gustafson v. Alloyd Co., 513
U.S. 561, 570 (1995); Brown v. Gardner, 513 U.S. 115, 118
6
Companies ordinarily can carry losses back no more than
three years, but for 2001 and 2002, post-September 11th stimulus
and recovery legislation extended this period to five years,
enabling State Farm to reach back to the tax years at issue here.
See Job Creation and Worker Assistance Act of 2002, Pub. L.
No. 107-147, 116 Stat. 21.
No. 11-3478 29
(1994); Comm’r of Internal Revenue v. Keystone Consolidated
Industries, Inc., 508 U.S. 152, 159 (1993).
This canon is not an absolute rule, of course. It can be
overcome with persuasive evidence from the statutory
text, context, or other sources that different meanings
were intended. See, e.g., General Dynamics Land Systems,
Inc. v. Cline, 540 U.S. 581, 595-97 (2004); United States v.
Cleveland Indians Baseball Co., 532 U.S. 200, 213 (2001)
(general presumption is not rigid; giving phrase
“wages paid” different meanings for Internal Revenue
Code and Social Security taxes); Atlantic Cleaners & Dyers
v. United States, 286 U.S. 427, 433 (1932). But the canon
that identical terms or phrases in the same statute have
the same meaning surely carries a great deal of force
when dealing with such a highly technical and defined
term in consecutive subparagraphs of the same Treasury
regulation. See Comm’r of Internal Revenue v. Lundy,
516 U.S. at 250 (“interrelationship and close proximity
of these provisions of the statute ‘presents a classic case
for application of the “normal rule of statutory construc-
tion that identical words used in different parts of the
same act are intended to have the same meaning” ’ ”),
quoting Sullivan v. Stroop, 496 U.S. 478, 484 (1990); Hotel
Equities Corp. v. Comm’r of Internal Revenue, 546 F.2d
725, 728 (7th Cir. 1976) (agreeing with taxpayer and
applying canon to give same meaning to same term in
different sections of Internal Revenue Code). State Farm
has offered us no persuasive reason for giving the
phrase “pre-adjustment alternative minimum taxable
income” a meaning in 26 C.F.R § 1.56(g)-1(n)(3)(i) dif-
ferent from its meaning in 26 C.F.R § 1.56(g)-1(n)(3)(ii).
30 No. 11-3478
State Farm defends its method by arguing that it better
comports with the purpose of alternative minimum
taxation because it should make taxable income more
closely match “book income” or “economic income.” Under
both State Farm’s original method and the Tax Court’s
method that we affirm, State Farm had a positive ACE
adjustment in a year when it experienced an overall
loss. This, says State Farm, is an unreasonable and incon-
gruous result. There are several flaws in this argument.
First, as discussed above, the purpose of the alterna-
tive minimum tax is not to match taxable and book
income simply for the sake of matching, but to
recapture and subject to the alternative minimum tax
book income that might otherwise escape taxation
through many deductions, exemptions, and credits.
Second, the fact that a company lost money overall in
a taxable year does not imply that every number on
every line of the company’s tax return must be nega-
tive. For example, State Farm took a deduction
(increasing its tax loss) on its ordinary tax return for
hundreds of millions of dollars in tax-exempt interest
income. Section 56(g) required State Farm to add that
deduction back when computing adjusted current
earnings for alternative minimum tax purposes. State
Farm did have positive section 56(g) adjustments in
2001 and 2002, and there is nothing unusual about
that result. The ACE adjustment is merely an inter-
mediate calculation figure — one that the IRS under-
stood could be positive even in a loss year because of
the loss limitation rules. See 48 Fed. Reg. 11436, 11439
(Mar. 18, 1983) (“section 1503(c)(1) may result in a
No. 11-3478 31
life-nonlife group paying a tax when it has no net in-
come”). Finally, there is the overriding unreason-
ableness and incongruity of the result State Farm
seeks. State Farm’s proposed calculations create a
$9.4 billion tax loss in a year when the company
actually lost (“only”) $5.3 billion. The only sense in
which the $9.4 billion figure lines up with State Farm’s
“book income” is that both are large negative numbers.
State Farm suggests that the regulations are ambigu-
ous with regard to calculating alternative minimum tax
liability on consolidated life/non-life groups, so that
its proposed method should be blessed as a reasonable
taxpayer resolution of ambiguity. Although the regula-
tions are not precisely targeted to the exact question
raised here, we do not think they are ambiguous. State
Farm was able to understand and apply the loss limita-
tion rule on its 2001 consolidated return twice (both
times it applied pAMTI) in its original calculations,
and correctly applied it once in its new proposed cal-
culation. The Tax Court’s method applies the loss lim-
itation rule to pAMTI, and then keeps that consolidated
number through a consolidated ACE calculation. State
Farm’s innovative suggestion that the pAMTI variable
can hold two values — one value on line 3 of Form 4626
and another value when entered on line 1 of the
Adjusted Current Earnings Worksheet in the instruc-
tions to that form, which says “Enter the amount from
line 3 of Form 4626” — seems to be less a response
to ambiguity than an attempt to create ambiguity. Even
if we accepted for the purpose of argument that the
regulations are ambiguous, the parties present us a
32 No. 11-3478
choice between (1) a method that can produce a
positive intermediate adjustment (available for carrying
forward) in a loss year, and (2) a method that can
produce a virtual tax loss billions of dollars larger
than reality and requires different meanings for the
identical key phrase in consecutive subparagraphs of
the same Treasury regulation. The Tax Court correctly
rejected State Farm’s proposed method for calculating
its alternative minimum tax.
Conclusion
The 2008 judgment of the Tax Court on the alternative
minimum tax issue is A FFIRMED. The 2010 judgment
of the Tax Court with regard to the loss reserve issue
is A FFIRMED in part and R EVERSED in part, and the
case is R EMANDED for recalculation of the amount of
State Farm’s tax liability with an allowed deduction for
the portion of the Campbell judgment that did not
consist of punitive damages and interest thereon.
No. 11-3478 33
Appendix A:
Tax Court’s Illustrative Charts for 2001 Tax Year
A.1: Petitioner’s Original Calculations for 2001
Non-life Sub- Life Subgroup Consoli-
group dated
Calculation of Pre-adjustment AMTI
1. Regular taxable in- ($5,777,523,614) $526,283,059 $526,283,059
come (loss) before NOL
deduction
2. Adjustments and ($20,722,240) ($629,289) ($629,289)
preferences
3. Pre-adjustment ($5,798,295,854) $525,653,770 $525,653,770
AMTI (to compare with
ACE)
Calculation of ACE
4. Pre-adjustment ($5,798,295,854) $525,653,770 $525,653,770
AMTI (to calculate
ACE)
5. Section 56(g)(4) ad- $1,032,435,020 $218,868 $218,868
justments
6. ACE (lines 4 + 5) ($4,765,860,834) $525,872,638 $525,872,638
Calculation of AMTI
7. Excess of ACE over $1,032,435,020 $218,868 $218,868
Pre-adjustment AMTI
(line 6 - line 3)
8. 75% of excess $774,326,265 $164,151 $164,151
9. ACE Adjustment $774,326,265 $164,151 $164,151
10. AMTI before alter- ($5,023,969,589) $525,817,921 $525,817,921
native tax NOL deduc-
tion (lines 3 + 9)
34 No. 11-3478
A.2: Petitioner’s Revised Methodology for 2001
Non-life Sub- Life Sub- Consolidated
group group
Calculation of Pre-adjustment AMTI
1. Regular taxable in- ($5,777,523,614) $526,283,059 $526,283,059
come (loss) before NOL
deduction
2. Adjustments and ($20,722,240) ($629,289) ($629,289)
preferences
3. Pre-adjustment ($5,798,295,854) $525,653,770 $525,653,770
AMTI (to compare with
ACE)
Calculation of ACE
4. Pre-adjustment ($5,272,642,084) ($5,272,642,084)
AMTI (to calculate
ACE)
5. Section 56(g)(4) ad- $1,032,653,888 $1,032,653,888
justments
6. ACE (lines 4 + 5) ($4,239,988,196) ($4,239,988,196)
Calculation of AMTI
7. Excess of ACE over — — ($4,765,641,966)
Pre-adjustment AMTI
(line 6 - line 3)
8. 75% of excess — — ($3,574,231,475)
9. ACE Adjustment ($3,573,473,926) ($757,548) ($757,548)
10. AMTI before alter- ($9,371,769,780) $524,896,222 $524,896,222
native tax NOL deduc-
tion (lines 3 + 9)
No. 11-3478 35
A.3: Respondent’s Position: Petitioner’s Methodology Using Consistent Pre-
adjustment AMTI for 2001
Non-life Sub- Life Sub- Consolidated
group group
Calculation of Pre-adjustment AMTI
1. Regular taxable in- ($5,777,523,614) $526,283,059 $526,283,059
come (loss) before NOL
deduction
2. Adjustments and pref- ($20,722,240) ($629,289) ($629,289)
erences
3. Pre-adjustment AMTI ($5,798,295,854) $525,653,770 $525,653,770
(to compare with ACE)
Calculation of ACE
4. Pre-adjustment AMTI — — $525,653,770
(to calculate ACE)
5. Section 56(g)(4) adjust- — — $1,032,653,888
ments
6. ACE (lines 4 + 5) — — $1,558,307,658
Calculation of AMTI
7. Excess of ACE over — — $1,032,653,888
Pre-adjustment AMTI
(line 6 - line 3)
8. 75% of excess — — $774,490,416
9. ACE Adjustment $774,326,265 $164,151 $774,490,416
10. AMTI before alterna- ($5,023,969,589) $525,817,921 $525,817,921
tive tax NOL deduction
(lines 3 + 9)
8-31-12