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New IRS Rulings Clarify Captive Taxation
Tom Jones
Partner
McDermott, Will & Emery
Chicago
tjones@mwe.com
The
issuance of Rev. Rul. 2001-31 on June 4, 2001 paved the way for
corporations to structure their captive insurance arrangements in a
tax-friendly manner. However, as is often the case, Rev. Rul. 2001-31
left a number of questions unanswered. Fortunately, on December 10,
2002, the Internal Revenue Service issued a series of rulings that
provide additional guidance on the taxation of captive insurance
arrangements.
Background -- Rev. Rul. 2001-31
In Rev.
Rul. 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 so-called “economic family” theory. This
concession apparently reflected IRS recognition of the courts’
consistent refusal to adopt this doctrine.
By
abandoning its economic family argument, the IRS implicitly accepted the
“balance sheet” approach to captive taxation. Under this approach, risk
shifting, one of the hallmarks of “insurance” status, will exist if the
risk of loss is transferred off the policyholder’s balance sheet to the
captive. Both the 6th Circuit Court of Appeals and Federal Claims Court
have applied the balance sheet approach to conclude that risk shifting
exists where the policyholder entity and the captive insurer are
subsidiaries of the same parent (“brother-sister captive insurance
arrangements”). Thus, by abandoning the balance sheet approach, Rev.
Rul. 2001-31 implied acceptance of brother-sister captive insurance
arrangements.
Rev. Rul. 2001-31, however, failed
to clearly articulate the IRS’s position regarding risk distribution,
the second hallmark of “insurance” status. To date, the courts have
failed to express a coherent and consistent test for risk distribution.
While some courts have indicated that risk distribution requires the
spreading of risk among multiple independent policyholders (the
“independent entity approach”), others have hinted that risk
distribution depends on the number of independent risk exposures assumed
by the captive (the “independent risk approach”).
Also left
unanswered was whether the IRS would continue to challenge captive
insurance arrangements involving a substantial amount of unrelated risk
exposures. The Tax Court, in a series of 1991 decisions, held that
amounts paid made by a parent corporation and/or its operating
subsidiaries to a captive are deductible “insurance premiums” if the
captive assumes a substantial portion of unrelated risk. Although the
IRS had previously rejected the contention that unrelated risk may, in
some circumstances, create risk shifting and risk distribution, until
now the IRS failed to articulate the effect of Rev. Rul. 2001-31 on its
prior position.
Rev. Rul. 2002-90
In Rev.
Rul. 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. The captive was adequately capitalized and
regulated in the states in which the operating subsidiaries conducted
their businesses. In addition, no parental guarantees of any kind were
made in favor of the captive and the captive did not loan funds to its
parent or to the 12 operating subsidiaries. The ruling also noted that,
in all respects, the parties conducted themselves in a manner consistent
with the standards applicable to an insurance arrangement between
unrelated parties.
The IRS,
applying the brother-sister approach, concluded that risk shifting and
risk distribution were present such that the arrangement constituted
“insurance” for federal income tax purposes. Accordingly, amounts paid
by the subsidiary-policyholders were characterized as deductible
“insurance premiums.”
While Rev.
Rul. 2002-90 is significant insofar as it validates the “insurance”
status of brother-sister arrangements, its primary significance derives
from its approach to risk distribution. Rather than adopting the
independent risk approach or the independent entity approach, Rev. Rul.
2002-90 indicates that both approaches factor into the risk distribution
equation. Although the ruling refers to facts that form the basis for
the independent risk approach (i.e., the fact that the subsidiaries had
a significant number of independent, homogeneous risks), it also states
that “[r]isk distribution necessarily entails a pooling of premiums, so
that a potential insured is not in significant part paying for its own
risks.” Further, the ruling emphasizes that none of the operating
subsidiaries had liability coverage for less than 5%, nor more than 15%,
of the total risk insured by the captive. This factor, while relevant in
applying the independent entity approach, would not affect the risk
distribution determination under the independent risk approach.
The
application of the independent entity approach could be regarded as
inconsistent with dicta in a number of captive insurance cases,
including the Tax Court’s statements in Gulf Oil (“a single insured can
have sufficient unrelated risks to achieve adequate risk distribution”).
Nonetheless, it appears, at least for the time being, to form a key part
of the IRS’s risk distribution analysis. As a result, taxpayers should
anticipate resistance on the part of the IRS in the case of captive
insurance arrangements involving a limited number of brother-sister
policyholders, especially if the risk exposures are concentrated in a
single sibling of the captive. Finally, for unknown reasons, the IRS
chose an unrealistic fact pattern to illustrate its point, stating that
this “direct writing” captive was licensed as an insurer in all 12
states in which it provided coverage. This configuration simply never
occurs in practice, where either a licensed “fronting” carrier is
interposed between the captive and its policyholders or a “risk
retention group” multi-owner structure is used to overcome state laws
prohibiting the unlicensed conduct of an insurance business.
Rev. Rul. 2002-89
In Rev.
Rul. 2002-89, the IRS applied the unrelated risk approach to conclude
that a parent’s premium payments to its captive insurance subsidiary
were deductible if over 50 percent of the captive’s premium income and
risk exposures derive from unrelated parties. The ruling discussed two
captive insurance companies that assumed the risk exposures of their
parent corporations and various unrelated parties. Both of the captives
were adequately capitalized and regulated, and both conducted their
business consistent with the standards applicable to an insurance
arrangement between unrelated parties.
The first
arrangement involved a domestic corporation that entered into an
arrangement with its wholly-owned captive insurance subsidiary whereby
the captive insured the professional liability risks of the parent
corporation. The captive also entered into similar arrangements with
various unrelated entities. The premium payments made by the parent
corporation comprised 90 percent of the total premiums earned by the
captive. Further, the liability coverage provided to the parent
corporation accounted for 90 percent of the total risk borne by the
captive.
The second
arrangement was the same as the first, except that the premiums derived
from the parent corporation accounted for less than 50 percent of the
total premiums earned by the captive. Likewise, the parent corporation’s
risk comprised less than 50 percent of the total risk assumed by the
captive.
Because of
the high concentration of parent premium and parent risk involved in the
first arrangement, the IRS concluded that the arrangement lacked risk
shifting and risk distribution and, consequently, premium payments made
by the parent corporation were not deductible as insurance premiums. In
contrast, the IRS concluded that the second arrangement did, in fact,
involve risk shifting and risk distribution. This conclusion was based
on the relatively high concentration (over 50%) of unrelated premiums
and unrelated risk transferred to the captive.
While Rev.
Rul. 2002-89 sets a clear 50 percent threshold for determining the
sufficiency of unrelated risk, it appears that, in certain
circumstances, a lesser amount will suffice. That, at least, was the
conclusion reached by the Tax Court and 9th Circuit Court of Appeals in
The Harper Group, where the taxpayer prevailed despite the fact that
during one of the years in issue only 29 percent of the retained
premiums were attributable to unrelated parties. Thus, although Rev.
Rul. 2002-89 implicitly provides a “safe harbor” for application of the
unrelated risk approach, it should not foreclose the possibility of
“insurance” status where lesser amounts of unrelated risk are involved.
Rev. Rul. 2002-91
An
additional issue not addressed by last year’s Rev. Rul. 2001-31 was the
treatment of group or association captives. The IRS’s position regarding
such arrangements was first articulated in Rev. Rul. 78-338. There, the
IRS considered a situation in which a foreign insurance company was
organized by 31 unrelated corporations, none of which owned a
controlling interest in the insurance company. The insurance company
provided insurance only to its shareholders and their affiliates and
subsidiaries, with premium rates established according to customary
industry rating formulas. Pursuant to the bylaws of the insurance
company, no shareholder’s risk coverage could exceed 5% of the total
risks insured by the company. The IRS held that, because the shareholder
insureds were not economically related, the economic risk of loss could
be shifted and distributed among the shareholders comprising the insured
group. Because the requisite risk shifting and risk distribution
necessary to constitute insurance were present, the amounts paid by the
taxpayer for insurance were held to be deductible premiums, provided
they were reasonable in amount for the insurance coverage obtained and
were based on sound actuarial principles.
In Rev.
Rul. 2002-91, the IRS “updated” its position on group captives. It
concluded that a captive formed by fewer than 31 unrelated companies
qualified as an insurance company where no member owned more than 15
percent of the captive insurance company and no member had more than 15
percent of the vote on any corporate governance issues. Significantly,
the IRS noted that the insurance company was formed by companies
operating in a highly concentrated industry for which affordable
insurance coverage was not available.
The ruling
also noted that the arrangement was designed to effectuate risk transfer
to the captive. Specifically, the policy limits were structured such
that there was a real possibility that a member’s covered losses would
exceed the amount of premiums it paid to the captive. In addition, the
policies provided that the members would not receive a return premium in
the event of a positive loss experience. Based on those facts, the IRS
concluded that the captive was an insurance company and that premiums
paid by the members were deductible.
Rev. Rul.
2002-91 is significant insofar as it represents a “softening” of the
standards previously articulated in Rev. Rul. 78-338. The ruling
indicates that, as long as no policyholder/shareholder’s risk exceeds 15
percent of the total risk insured by the group captive, the arrangement
can be structured to achieve favorable tax treatment, including
deductibility of premium payments and “insurance company” status for the
captive.
The IRS’s New Ruling Policy
In addition
to the above-referenced revenue rulings, the IRS, on December 10, 2002,
announced in Rev. Proc. 2002-75
that it would consider ruling requests regarding the proper
tax treatment of captive insurance companies. This represents a
departure from the its prior position regarding issuance of private
letter rulings on captive insurance arrangements. Prior to the issuance
of Rev. Proc. 2002-75, the IRS would not ordinarily issue rulings
regarding the deductibility of premiums paid to captives or the status
of captives as “insurance companies.” The revenue procedure states,
however, that given the highly factual nature of the determinations
involved, the IRS should be contacted prior to submission of a ruling
request to confirm that the IRS indeed will issue the requested ruling.
Summary
Although
the December 10, 2002 rulings provide additional guidance on the
taxation of captive insurance arrangements, the IRS avoided “going out
on a limb” to address many of the gray areas relating to the
organization and operation of captives. Notwithstanding that fact
patterns chosen in the rulings lead to virtually obvious conclusions,
they should provide taxpayers with greater planning confidence regarding
those polar captive arrangements that fall within the parameters
reflected in the rulings.
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