Taxation

Insurance companies (of all sizes) operate under different tax rules than other companies.

The U.S. Tax Code (“Code”) recognizes that insurance companies receive premium dollars up front, but may not pay out claims (associated with those premiums) for many years. 
Therefore, the Code allows insurance companies more generous current deductions.

Taxation should not be the primary reason for the establishment of a captive or alternative risk transfer vehicle.  General business objectives must form the basis for establishing a captive.

Insurance taxation is an extremely complex area and professional advice should be sought to protect the interests of shareholders, insureds and the insurance company.

 

The Captive

This discussion is solely for U.S. captives, and foreign captives that have elected (under Section 953(d) of the Code) to be taxed as U.S. captives.  True “foreign” captives operate under different rules entirely.

Captives are taxed on an accrual basis, not a cash basis.  The captive files a Form 1120-PC tax return.

Captives are considered “C” corporations.  Even though some jurisdictions may allow a captive to be formed as a partnership or LLC, the captive will still be taxed as a “C” corporation for federal tax purposes.

 

The Insured

The “insured” is the business or organization paying insurance premiums to the captive.  Multiple insureds can pay premiums to the same captive.  These insureds can be related or unrelated companies.

In order for the insured to deduct the insurance premium as a necessary business expense the captive insurer must conform to the law.  Because the Code does not define “insurance,” much guidance can be found in precedent-setting court cases and IRS rulings.

In very simplistic terms, the IRS expects that the insurance company is established in a recognized jurisdiction, has professionals managing the company and is not established primarily for tax purposes and is adequately capitalized.

The court cases and IRS rulings hold that to be considered an insurance company, three tests must be met:

1. Involve “insurance” risk
2. Meet the standards for risk shifting and risk distribution
3. Follow the commonly accepted notions of insurance (and insurance companies)

 

The Shareholder / Dividends

A captive can be owned by most any person or entity, including estate planning vehicles.

A captive shareholder is treated much like the shareholder of a “C” corporation.  A captive is organized to have shareholders, and multiple classes of stock can be provided, including preferred and common stock.

The Jobs and Growth Tax Relief Reconciliation Act of 2003 contained provisions that may affect owners of offshore captive insurance companies including provisions that reduced the rate on qualified dividend income from 38.6% to 15%.

 

Insurance Risk

Neither the Code nor the regulations define the terms “insurance” or “insurance contract.”  But the courts have held that the transferred risk must be a risk of economic loss, must contemplate the fortuitous occurrence of a stated contingency, and must not be merely an investment risk.

Thus, for example, “insurance” (for federal tax purposes) would not include the risk of a price decline of a stock.  States may have different interpretations for what constitutes insurance.  

The IRS view is that insurance is not the mechanism to manage losses that are substantially certain to occur, i.e., that are not the result of fortuitous events.  However, some courts and many practitioners disagree with this approach, especially where the timing and amount of loss are uncertain, even though there is certainty about the loss eventually occurring.   This is an evolving area of insurance tax law.

 

Risk Distribution And Shifting

The requirement for both risk shifting and risk distribution to be present in an insurance transaction was first held by the courts in Helvering v Le Gierse, 312 U.S. 531 (1941). In this case, an 80 year old lady took out both a life insurance policy and an annuity one month before her death. The life insurance was a single premium policy and would not have been provided had the annuity not been taken out. The benefit upon death was less than the premiums paid in respect of the life insurance policy and the annuity combined. As such, the courts upheld that there was no transfer of risk from the insured to the insurer and that the contract did not meet the expectation of an insurance policy.

The accepted definition of risk shifting and risk distribution is as follows:

Risk shifting occurs if a person facing the possibility of an economic loss resulting from the occurrence of an insurance risk transfers some or all of the financial consequences of the potential loss to an insurer. The effect of such a transfer is that a loss by the insured will not affect the insured because the loss is offset by the insurance payment.  Example:  with homeowners’ insurance, you transfer the risk of your house burning down to a large insurance carrier.  

Risk distribution incorporates the law of large numbers to allow the insurer to reduce the possibility that a single costly claim will exceed the amount available to the insurer for the payment of such a claim. Risk distribution necessarily entails the pooling of premiums so that a potential insured is not in significant part paying for its own risk.  Example:  with homeowners’ insurance, the premiums are modest (e.g., $3,000), but the claims can be large (potentially over $1 million).  Many homeowners pool their premiums together, even though few have large claims in a particular year.

 

Risk Distribution And Shifting For Related Entities

Prior to 2001, the IRS looked upon the risk shifting involving entities in the same economic family unfavorably. Their contention was that insurance within the economic family was just an internal financial transaction and effectively did not involve the shifting of risk.

However, in Humana, Inc. v Commissioner, 881 F 2d 247 (6th Cir. 1989) the court ruled that the transferring of risk occurred between brother/sister companies as they were economically independent of each other.  Thus, one subsidiary could pay deductible insurance premiums to another subsidiary, of the same parent.  

However, the court stated that risk shifting did not take place in respect of transactions with the parent company and therefore premiums paid by the parent to its subsidiary captive were not deductible. Despite this ruling for a number of years the IRS continued to pursue their economic family theory, even against brother/sister captive arrangements.  This changed in 2001.

 

Economic Family Ruling

Since 2001, there has been a move by the IRS to recognize brother/sister transactions as being deductible. In Revenue Ruling 2001-31 the IRS announced its decision to abandon its long standing position that premiums paid to captive insurance companies are not deductible under the “economic family” theory.

By abandoning its long held argument, the IRS implicitly accepted the “balance sheet” approach to captive taxation. Under this approach, risk shifting will exist if the risk of loss is transferred off the insured’s balance sheet to the captive.

However, Revenue Ruling 2001-31 did not address the issue of risk distribution.  (This was addressed by the IRS in 2002, with the “Safe Harbor Trilogy”).  The courts have failed to express a coherent and consistent approach to risk distribution. While some courts indicated that risk distribution required the spreading of risk among multiple independent insureds (the independent entity approach), others suggested that risk distribution depends on the number of independent risk exposures (the independent risk approach) assumed by the captive.  The IRS provided guidance in 2002 on these issues.

Despite Revenue Ruling 2001-31, on September 27, 2007, the IRS issued proposed regulations that would provide new guidance regarding the treatment of transactions between members of a consolidated group, including captive insurance company arrangements.  If the proposed regulations become effective, it could significantly impact the tax treatment of premium payments to U.S.-based captives and non-U.S. captives which have elected to be taxed as a U.S. corporation.  These proposed regulations only impact captives that are part of a consolidated group (and file as such for tax purposes).

 

Safe Harbor Trilogy

In 2002, the IRS issued three revenue rulings on captive transactions.  These three rulings (discussed in subsequent sections) provide IRS “safe harbors” for captive transactions.  For businesses desiring a captive arrangement that is fully tax compliant with IRS guidelines and recommendations, these safe harbor rulings provide a roadmap.

Revenue Ruling 2002-89
Revenue Ruling 2002-90
Revenue Ruling 2002-91

While individual circuit courts have approved captive arrangements that are more aggressive than the revenue rulings above, by structuring the captive according to a “safe harbor,” clients can know in advance that the captive is approved by the IRS.

 

Third Party Risk to Provide Risk Distributions and Risk Shifting

In Revenue Ruling 2002-89 the IRS discussed two scenarios where a parent made premium payments to its two wholly owned captive subsidiaries.

Scenario 1
The premiums paid by the parent to its wholly owned captive accounted for 90% of the captive’s income for the year (i.e., only 10% of the premiums were from unrelated parties).

Scenario 2
The premiums paid by the parent accounted for less than 50% of the captive’s income for the year (i.e., more than 50% of the premiums were from unrelated parties).

In its determination whether either or both of these scenarios represented valid insurance transactions the IRS further noted that:

• Both captives were adequately capitalized
• Both captives were properly regulated
• The companies transacted business in a manner consistent with the standards applicable to an insurance arrangement between unrelated parties

In their determination as to whether either or both of the scenarios represented valid insurance transactions, the IRS concentrated on factors of risk shifting and risk distribution. The IRS concluded that scenario 1 did not provide sufficient risk shifting or risk distributions; however, scenario 2 did. Where more than 50% of the captive’s risk is with unrelated third parties, the IRS concluded that sufficient risk shifting and risk distribution had occurred.

This “more than 50%” rule is now considered an IRS safe harbor.

Previous case law relating to unrelated risk placed into a captive held that as little as 29% third party business constitutes a valid and bona fide arrangement (Harper Group, 9th Circuit).  However, in recent years the IRS has sought to distinguish case law that was below the 50% standard.

 

IRS Ruling on Brother / Sister Transactions

In Revenue Ruling 2002-90, the IRS concluded that an arrangement whereby a single parent captive insurance company provided professional liability coverage to 12 brother/sister subsidiaries constituted insurance for federal income tax purposes.

Some key facts in the ruling:

• None of the operating subsidiaries had liability coverage less than 5%, nor more than 15%, of the total risk insured by the captive.
• The captive was adequately capitalized and regulated in the states in which the operating subsidiaries conducted their business.
• There were no parental guarantees of any kind were made in favor of the captive.
• The captive did not loan funds to its parent or to the 12 operating subsidiaries.
• The parties conducted themselves in a manner consistent with the standards applicable to an insurance arrangement between unrelated parties.

This ruling gives a test for whether brother/sister transactions involving a captive insurance company provided sufficient risk distribution and risk shifting so as to enable arrangement to be considered insurance.

Revenue Ruling 2002-90 is significant in that it validates brother/sister arrangements as insurance and it also suggests that both the independent risk and independent entity approach are important in the risk distribution equation. Although the ruling refers to facts that form the basis of the independent risk approach, it also stated that risk distribution necessarily entails the pooling of premiums, so that a potential insured is not in significant part paying for its own risk.

Note 1:  Revenue Ruling 2005-40 indicates that the related entities must be separately taxable entities (i.e., corporations or taxable LLCs), and not simply LLCs that are “disregarded” for federal tax purposes.  Thus, single-member LLCs would not qualify as a separate entity for purposes of Revenue Ruling 2002-90.

Note 2:  Some court cases have held that as few as seven (7) related companies are all that is necessary to have risk distribution, whereas this safe harbor ruling indicates a minimum of 12 related companies. 

 

Group Captives

In Revenue Ruling 2002–91, the IRS addressed group captives and concluded that such a captive that was formed by a “significant number” of unrelated insureds, with each having no more than 15% of the total risk, was held to be a valid insurance arrangement. The ruling also went on to set out other factors that the IRS expects to see in a bona fide transaction:

• Whether the insured parties truly face hazards
• Whether premiums charged are based on commercial rates
• Whether risks are shifted and distributed to the captive
• Whether the policies contain provisions such that the covered risks may exceed the amount of premiums charged and paid
• Whether the validity of claims were established prior to payment
• Whether the assets and operations of the captive are kept separate from the business operation and assets of its shareholders

This ruling paves the way for franchisees, industry groups, and other associations to form a captive with the benefit of an IRS safe harbor ruling.

 

Cell Captives

The IRS issued Revenue Ruling 2008-8 (January 2008) to give some clarity to structures known as “cell captives,” “rent-a-captives” and “protected cell captives.”  A cell captive is basically a captive with several “cells” within it.  The income, expense, assets, liabilities and capital of each cell are accounted for separately from any other cell and of the captive generally.  Usually the laws of the jurisdiction provide legal separation between cells.

Each cell is generally owned by unrelated owners, such that within the captive there is a wide distribution of risks. 

Under the ruling, if company X owns Cell X and pays premiums to Cell X, this arrangement would not be considered insurance because there is no risk distribution within Cell X – all of the risks are from a related party, company X. 

However, where company Y owns the stock of 12 domestic subsidiaries, and company Y owns Cell Y, then premiums paid from Y to Cell Y do constitute insurance premiums (if meeting the other insurance tests), because there is risk distribution within the 12 domestic subsidiaries.

This ruling closely tracks Revenue Ruling 2002-90, in terms of its facts and holdings.

Notice 2008-19, which accompanied this ruling, indicates that it may be possible for a cell within a captive to be treated as an insurance company separate from any other entity.  More discussion and guidance is expected on this in the future.

 

Private Letter Rulings

The IRS issued Revenue Procedure 2002–75 as a method to obtain a private letter ruling regarding a captive transaction.

While this appears to be a beneficial option on its face, as a practical matter, a private letter can take well over a year to receive, and the IRS is not issuing private letter rulings that depart from the safe harbor rulings from 2002 (Rev. Rul. 2002-89, 2002-90, 2002-91).  As such, few practitioners apply for private letter rulings on a regular basis.

 

Section 4371 Excise Tax

Under Code Section 4371, an excise tax applies to premiums paid to foreign insurers and reinsurers covering U.S. risks. The excise tax was designed to protect domestic insurance companies from perceived unfair competition from foreign insurance companies that are not subject to U.S. income tax. Under this rule, an excise tax is imposed at the rate of 1% on reinsurance and life insurance premiums and at a rate of 4% on property and casualty insurance premiums.

However, if a corporation makes an election under Section 953(d) of the Internal Revenue Code of 1986, the companies are not subject to the Code Section 4371 excise tax.   This allows foreign captives to make the Section 953(d) election, and be taxed for all purposes as U.S. insurance companies. 

This election is very common with foreign insurers, including foreign captives.  For example, even though a captive is established in Bermuda, with a 953(d) election, the captive would be taxed as if it were a U.S. insurance company, and would file a U.S. tax return for insurance companies. 

 

US Owned Foreign Insurance Companies

If the insurance company does not elect to be a US tax payer there are still tax implications. The company would be considered a controlled foreign corporation (“CFC”) and under the IRS subpart F rules, U.S. shareholders with a 10-percent or greater interest in a CFC are subject to U.S. federal income tax currently on certain income earned by the CFC, whether or not such income is distributed to the shareholders. The income subject to subpart F includes, among other things, insurance income including that relating to risks located in a country other than the CFC's country of organization.

 

Important Legal Information

Captive insurance and alternative risk transfer planning involves sophisticated insurance and risk management issues, regulatory and corporate legal issues, federal, state and usually international tax issues, and a wide range of accounting and financial issues. This planning is specific to each set of circumstances.  It is not appropriate to apply general information described herein to any particular situation. The formation of a captive is a part of a client's implementation of alternative risk transfer planning, and is dwarfed by its ongoing operations. As a result, this planning should not be undertaken without a competent team of professionals who have extensive experience in captive insurance and alternative risk transfer planning.

The information herein is general in nature, and may not be relied on for any specific use. The content herein (including graphics) does not purport to show all details and complexity in establishing a compliant captive or alternative risk transfer program. Tribeca is not engaged in rendering legal services or advice.

Disclosure under IRS Circular 230: The information and services offered are not intended to and do not comply with the U.S. Treasury Department’s technical requirements for a formal legal opinion, and cannot be used by a taxpayer to avoid any penalty that might be imposed on a taxpayer. Nothing herein may be used in promoting, marketing or recommending an investment plan or arrangement.

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