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New IRS Rulings Clarify Captive Taxation

Tom Jones
Partner
McDermott, Will & Emery
Chicago
tjones@mwe.com

Reprinted with permission from Captive Insurance Companies Association (CICA). Visit the CICA website for additional information on issues impacting the captive industry. Captive.com is proud to include a link to CICA on our Association Center page.

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.