The Internal Revenue Service has come out with guidelines to help insurers apply insurance company proration rules to corporate-owned life insurance.

The guidelines, given in IRS Revenue Procedure 2007-61, affect insurers that pay taxes under Subchapter L of the Internal Revenue Code.

Current tax rules let insurers deduct increases in insurance reserves and “tax-favored income,” such as intercorporate dividends, from taxable income, IRS officials write in the revenue procedure.

“The insurance company proration rules require that tax-favored income be prorated between the insurance company and its policyholders,” officials write.

Before 1997, insurers had to apply the proration rules only to tax-exempt interest and intercorporate dividends, but the Taxpayer Relief Act of 1997 required insurers to apply the proration rules to increases in the cash values of some life insurance policies and annuity contracts.

The 1997 changed affected treatment of life insurers’ reserve deductions and life insurance company dividend deductions, officials write.

In recent years, officials write, questions have risen about how the 1997 change affects COLI contracts that cover owners, officers, directors and employees of an insurer.

IRS officials have responded by developing a safe harbor for insurer COLI contracts covering no more than 35% of the officers, directors, employees and “20% owners” of an insurer.

The safe harbor provision states that, for purposes of applying the proration rules, “an insurance company is not required to take into account any portion of the increase for the taxable year in the policy cash values…of I-COLI contracts to which this revenue procedure applies pending the publication of additional guidance.”

But the IRS can challenge the I-COLI arrangements under other tax law provisions, such as the business purpose doctrine, officials write in the revenue procedure.

The IRS is asking for comments about the operation of I-COLI arrangements and about any non-tax rules that limit an insurer’s ability to invest in I-COLI contracts.

A copy of the revenue procedure is available