Does the form of malpractice insurance control the deductibility of the premium?

• Author: Schneider, Arthur C.

Much liability insurance coverage is purchased on an "occurrence basis." This form of insurance protects against loss events that arise during the policy period and is not contingent on the date on which the claim for reimbursement is filed. Another type of liability insurance coverage, commonly offered as protection against malpractice or other acts of misfeasance, takes the form of "claims-made" insurance. Claims-made coverage indemnifies the policyholder for claims reported during the policy period. Under neither form of insurance is the policyholder purchasing insurance protection against loss events arising beyond the end of the current period. With occurrence-based insurance, the policyholder is paying a premium for protection against losses that arise during the current policy period, no matter when reported. With claims-made insurance, the protection is for losses reported in the current policy period.

The IRS has previously concluded that a premium, paid for insurance indemnification for claims reported in future periods but relating to prior-period loss events, is capitalizable, as the benefits pertain to future periods; see Field Service Advice 9925007 and Letter Ruling (TAM) 9402004. That analysis may be incorrect, and could have been explored by the Tax Court in Steger, 113 TC No. 18 (1999). Unfortunately, in reaching its decision, the Tax Court was able to sidestep the question of whether a payment for insurance that provides future claims protection and indemnification against prior acts is a payment for a long-term benefit that must be capitalized.

Prior to his retirement as a practicing attorney, the taxpayer in Steger maintained malpractice insurance. In the year of retirement, he converted his policy to nonpracticing malpractice insurance coverage for a specified premium amount. For an indefinite period, the nonpracticing insurance covered acts, errors or omissions related to the attorney's professional services rendered prior to his retirement from private practice. This coverage, known as "prior acts" liability insurance, was necessary because (although not explicitly stated in the case), the taxpayer previously maintained claims-made insurance. Without the purchase of this "prior acts" (or "tail") coverage, the taxpayer would not have been insured for acts of malpractice that occurred before his retirement, but which were not reported until after his retirement.

The Service challenged the taxpayer's deduction of the...