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Memorandum

The partners at captive.com send our thanks to Tom Jones from the law firm of McDermott, Will & Emery, and the Captive Insurance Companies Association for sharing this memo with us.

McDermott, Will & Emery - Chicago, Illinois

Memorandum

TO:       Captive.com

FROM:  Tom Jones

DATE:   June 7, 2001

RE:       Major IRS Captive Tax Concession

On Monday, June 4, 2001, the Internal Revenue Service issued Revenue Ruling 2001-31, in which it officially abandoned its 24-year old "economic family theory" basis for denying "insurance" status (and therefore premium/loss reserve deductions) for single parent captives. Acknowledging a string of rejections in court, this IRS ruling likely will have the following implications for planning future captive structures or for defending currently ongoing captive tax audits:

• A single parent ("pure") captive covering only risks of its parent will continue to be subject to IRS challenge due to the lack of risk shifting and risk distribution.
  
  
• A captive also will remain in tax jeopardy if its parent directly or indirectly guarantees its or its policy issuing carrier’s obligations, or if the captive is undercapitalized and/or it operates in an "under-regulated" jurisdiction.
  
  
• But it appears that pure captives writing a significant level of brother-sister risk (i.e., other affiliates of the parent) no longer will be pursued by the IRS. That is, the IRS may accept brother-sister risk because it will substitute the "balance sheet test" for the now defunct "economic family theory."
  
  
• Because this ruling fails to address how much unrelated risk is necessary to create true "insurance," existing case law will continue to control (e.g., the at least 30 percent unrelated risk, measured by net premiums, rule-of-thumb derived from Harper Group). The 1988 "Sears-Allstate" ruling, among others, was declared obsolete, which means that it no longer is "considered determinative with respect to future transactions." Thus, the IRS has abandoned its former extreme position that, no matter how much unrelated risk a pure captive covers, there never can be premium deductibility by its single parent.
  
  
• The existing parameters of what constitutes unrelated risk exposures have not been changed. For example, the surprise 1992 ruling declaring employee long-term group life coverage to constitute unrelated risk remains intact.
  
  
• This ruling does not seem to change the existing tax situation of group captives (including rent-a-captives and "cell" captives). The 1978 ruling indicating that a captive with 31 unrelated owners, no one of which accounts for more than 5 percent of premiums, constitutes true "insurance" remains unchanged. However, to the extent that classification of activities of a rent-a-captive’s or segregated account captive’s "cell" as "insurance" is in question, presumably the liberalized brother-sister rules above should facilitate a favorable outcome.
  
  
• Impact of this ruling on offshore captives owned by tax exempt organizations is complex as they typically strive to avoid "insurance" status and consequent federal excise tax (tax deductibility is not an issue for them). It remains to be seen if this ruling could be used to their detriment, although indications are that they usually will be able to preserve desired non-"insurance" status via other means.

Of course, it is early to predict how actual application of this landmark ruling will evolve. Past experience in non-captive areas indicates that it generally will discourage zealous IRS agents from pursuing captives unless the "payoff" (i.e., taxpayer misbehavior) is obvious. On the other hand, one could read this ruling as merely a "housekeeping" pronouncement finally recognizing the judicial reality that the "economic family theory" is inconsistent with the long-standing tax maxim that every legal entity has a separate and independent existence. The likely long-term impact of this ruling is that, more than ever, intelligently structured captives will achieve tax success. But it will not permit tax-dodge captives to operate with impunity.

Comments or questions on this ruling or any aspect of the above analysis can be directed to Tom Jones at tjones@mwe.com.

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