When Are Premiums Paid to a Captive Insurance Company Deductible for Federal Income Tax Purposes?
Generally, premiums paid for insurance are deductible for federal income tax purposes in the year paid if the policy is an annual policy and are amortized over the policy period for a multiyear policy. In addressing the question of when premiums paid to a captive insurance company are deductible for federal income tax purposes, the key determination is whether the coverage provided by the captive will be respected as insurance for federal income tax purposes. A number of factors need to be taken into account when making that determination. The basic requirements for insurance treatment are insurance risk, risk transfer, risk distribution, and a policy that embraces common notions of insurance.
This element addresses the fact that there must be a transfer of risk from the insured to the captive insurance company.
The Internal Revenue Service (IRS) has taken the position, and courts have agreed, that if a party owns a captive ("Parent") and Parent insures its risk with its subsidiary, there is no risk transfer because economically Parent is in the same position as it was without the insurance (i.e., if the captive receives a premium or pays a loss, the Parent's balance sheet is unaffected).
Alternatively, case law and the IRS have recognized that if a captive with Parent risk has sufficient "unrelated risk" the Parent risk will be shifted along with the unrelated risk. Another IRS safe harbor ruling quantifies sufficient unrelated risk at 50 percent, but a Ninth Circuit case, Harper, involved just under 30 percent unrelated risk. Thus, questions arise as to what constitutes unrelated risk as there is no specific definition. However, common risks that are generally considered unrelated risks include risks of customers of the captive's corporate group, extended warranty risk, risk relating to employee benefits provided to employees of the corporate group of which the captive insurer is a part, and risks that are derived from a risk pool.
Also, although there is no legal authority on point, the general rule of thumb is that, in determining the percentage of unrelated risk, one should look to the net retained risk in the captive. Thus, for example, if one were to write a large premium relating to unrelated risk and reinsure it 100 percent to a third party, there would be no unrelated risk to take into account.
If a captive insures brother/sister (i.e., in general, companies owned by the same Parent that owned the captive) risk, generally, that risk is shifted provided the policy transfers risk. Thus, for example, if a policy effectively provides for limits equal to premium, there will be no transfer of risk. In addition, the captive must have resources (e.g., assets or reinsurance sufficient to pay losses covered under a policy between an insured and the captive), or transfer of risk may be found lacking.
Risk distribution addresses the concept of receiving premium attributable to various unrelated risks.
Until recently, based on existing case law and IRS rulings, the focus in determining whether adequate risk distribution was present was the number of so-called brother/sister insureds and the amount of risk (generally determined by premium allocation) attributable to each. Thus, the IRS in Rev. Rul. 2002–90 published a "safe harbor" indicating that if there were 12 such insureds each accounting for between 5 percent and 15 percent of the risk, there was adequate risk distribution. Various rulings have refined this test. In one ruling, the IRS noted that if there were to be a single insured that accounts for 90 percent of the risk, there is inadequate risk distribution. The IRS also has ruled that if certain types of entities are insured the risk may be treated as risk of their owner (e.g., single member LLCs). Unrelated risk insured directly or through a reinsurance pool could add to the number of insureds and the spread of the risk providing a strong risk distribution position under the IRS rulings.
At the end of 2014 and beginning of 2015, two cases were decided by the Tax Court, Rent-A-Center and Securitas, which in a context of fewer brother/sister entities determined there was a significant number of independent exposure units and, accordingly, sufficient risk distribution could be found to exist. The Tax Court unfortunately did not provide a basis for determining when there would be a sufficient number of independent exposure units, but found them to exist in the facts of these particular cases. This, obviously, leads to some questions of how reliance may be placed on these cases when there are significantly different facts.
Insurance Risk and Common Notions of Insurance
The IRS has also raised issues regarding whether certain types of coverage should be treated as insurance for federal income tax purposes. Thus, for example, imbedded warranty, retroactive coverage (i.e., coverage for an event that has already happened), and currency value protection have been questioned. Recently, the IRS litigated, and lost, the question of whether residual value insurance was insurance for tax purposes.
In addition, the IRS has questioned other elements of captive formation that to some degree overlap with the risk transfer and risk distribution categories, for example, whether loanbacks to insureds or guarantees provided by the parent or another member of the consolidated group affect insurance status, whether unrelated business must be "homogeneous" or similar to the related business written by the captive, and whether the method of calculating premium (e.g., actuarially or by some other method), and its allocation among subsidiaries or members of a corporate group was appropriate.
Although this article does not provide a complete discussion of all of the issues described, it provides a meaningful start to an analysis. For much greater detail, please see "Tax Implications of Risk Financing," by P. Bruce Wright, Esq., and Saren Goldner, Esq., in the section titled "Insurance Characterization for U.S. Federal Income Tax Purposes" of the IRMI reference service Risk Financing. If you subscribe in IRMI Online, you will find the discussion here. If you subscribe in ReferenceConnect, you will find the discussion here.