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Captive premium deductibility Recent IRS revenue rulings may shed new light for captive users By Michael J. Moody, MBA, ARM
Historically, captives and the Internal Revenue Service (IRS) have had a running battle as to which insurance premiums are tax-deductible to a captive’s parent. For the most part, group captives have quite specific requirements that must be met to afford an insurer/owner tax deductibility. It typically has been the single parent captives that have represented a huge gray area with regard to the tax deductibility issue. This task has been made more difficult due to the fact that there is no statutory or regulatory definition of “insurance.” However, over the years, the IRS has issued a number of Revenue Rulings to help clarify the issue of what is “insurance.” On July 5, 2005, it issued yet another new ruling (Rev. Rul. 2005-40) that has shed some light on the overall deductibility issue. The information provided in 2005-40 is in the form of four specific situations that the IRS uses to illustrate its current position regarding how tax deductibility would be viewed in each case. Background Recent concerns surrounding the issue of tax deductibility would lead one to believe that this is a new problem. In fact, it has been going on for years; and the IRS’s main position was articulated in a 1941 Supreme Court case (Helvering v. LeGierse), which served as the foundation with regard to gaining tax deductibility for income tax purposes. The Helvering v. LeGierse case was the first that dealt with two important principles, risk shifting and risk distribution, which must be present to qualify as “insurance.” These two concepts have served as the centerpiece of the IRS position regarding deductibility. Risk shifting occurs, according to the IRS, when an organization facing the possibility of an economic loss transfers some or all of the financial consequences of the potential loss to an insurer. Risk distribution occurs when an organization reduces the impact of a single, costly claim by pooling insureds and their premiums and incorporating the statistical phenomenon known as the law of large numbers. Over the years there have been numerous cases and rulings that reaffirmed various aspects of these two key concepts. However, for a while the IRS did broaden its focus to another concept that was called “economic family theory.” In this theory that was set out in Rev. Rul. 77-316, the IRS indicated that tax deductibility could not be gained by divisions or subsidiaries of the same company. It felt that since they were all part of the same economic family, no requisite risk shifting or risk transfer was present. But, over the years, in one court case after another the IRS was consistently losing tax challenges by captive owners. As a result, the IRS abandoned the “economic family theory” and issued Rev. Rul. 2001-31 stating that it would no longer raise the theory in addressing whether captive transactions constituted insurance for federal income tax purposes. Rev. Rul. 2005-40 Previously, most of the IRS’s attention has been directed at the risk shifting aspects of the “insurance” transaction, but in Rev. Rul. 2005-40, the IRS has shown through the use of four specific case studies that an equally important aspect of any transaction that is trying to qualify for tax deductibility is risk distribution. The first situation deals with an insured that has a substantial auto fleet that is insured with a captive insurance company. The vehicles represent a significant volume of homogeneous risks. The insured passes on the risk of loss to the auto fleet to the captive insurance company. However, the unrelated captive insurance company does not “insure” any other entity. The fact pattern of the second situation is the same as the first, but the captive insurance company also provides coverage to a second unrelated insured, which accounts for 10% of the insurer’s book of business. Premium from the initial insured represents 90% of the premiums to the insurance company. The third case involves a courier business that is made up of 12 LLCs, which are disregarded entities for federal income tax purposes. The LLCs own a fleet of vehicles that is “insured” against the risk of loss by an unrelated captive insurance company. The LLCs’ fleet of vehicles represents a significant volume of independent and homogeneous risks. None of the 12 LLCs accounts for less than 5% or more than 15% of the total risk assumed by the captive insurer. The insurer, however, does not “insure” any other entities other than the LLCs. Again the facts of situation four are identical to the third one, except that the 12 LLCs elect to be treated as corporations for federal income tax purposes. Based on the four situations that the IRS has outlined, they conclude that all four satisfy the risk shifting requirements for “insurance.” However, they found that in the first three cases, risk distribution was lacking and, as a result, the transactions would not be considered “insurance.” They did note that situation four had ample risk distribution and would therefore be considered “insurance” from a federal income tax perspective. This would than allow the LLCs to gain tax deductibility for the insurance premiums paid to the captive insurance company. Notice 2005-49 The IRS also raises the question of what qualifies as insurance in Notice 2005-49, which was also released on July 5, 2005. In this notice, the IRS requests public comment on the qualifications of four specific arrangements as insurance for federal income tax purposes. The four specific areas of inquiry should be of great interest to captive owners, or anyone involved with captives for that matter, because they are all quite popular topics: • Homogeneity—concern about the relevance of homogeneity in determining whether risks are adequately distributed • Cell Captives—factors used to determine whether “cell” captives constitute insurance and the effect of any tax elections • Loan Backs—the effect of loan backs between related parties • Finite Risk—issues raised from the use of finite products The IRS notes that it is aware that further guidance is needed in the area of captive insurance companies and has requested the taxpayers’ assistance in identifying those areas where additional help should be placed. Comments were to be provided to the IRS by October 3, 2005. Even at this early date, much has been written regarding the effects of Rev. Rul. 2005-40. Most experts agree that there is little new information presented in 2005-40; rather the ruling was issued to clarify the IRS position and reinforce the importance of risk distribution. In that regard, while 2005-40 does provide additional guidance for those captives that may have similar fact patterns, there is a modest amount of new data provided by the ruling. It is interesting to note, however, that the IRS chooses to highlight the risk distribution aspects of the relationship. Of much more consequence is Notice 2005-49. On the face of it, it is just another request for comment that is being presented by the IRS. But, it is possible that this Notice may in fact leave the door open to a major reassessment of the entire issue of deductibility of property and liability insurance premiums. The recent popularity of cell captive formations has required some input from the IRS, and the loan back provisions of some captives could also benefit from further clarification. The recent concern about the use of finite risk products with regard to captives should be well received. Insight into all four of these areas could work to the advantage of captive owners if the IRS does in fact provide additional guidance to clarify its position regarding these hot topics. * |
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