For Captive Insurance, 2020 Was a Busy Year on the Tax Front as Well

Wooden building blocks spelling out the words TAX in blue and red letters

February 08, 2021 |

Wooden building blocks spelling out the words TAX in blue and red letters

With a hardening commercial insurance market, the past year wasn't just a busy one for new captive insurance company formations. On the tax front, 2020 might have been more mixed, but there was significant activity.

Speaking as part of a recent Strategic Risk Solutions (SRS) webinar titled "Navigating the Captive Taxation Landscape," Patrick Theriault, managing director at SRS, noted that from a captive insurance tax perspective, 2020 "was a tale of two sides."

While the COVID-19 pandemic prompted delays in some captive tax case proceedings and Internal Revenue Service (IRS) audit activity, there were other captive insurance tax developments.

It began in January 2020 with the IRS announcing results of settlement offer letters it had issued during the fourth quarter of 2019. According to the IRS, 80 percent of those captive owners who'd received the letters accepted the settlement terms.

More important, perhaps, was the announcement that month that the IRS had formed 12 new audit teams focused on captives, Mr. Theriault said, "specifically on small captives."

Also in January, CIC Services appealed its case with the IRS to the US Supreme Court. In May, the high court agreed to take up the case, hearing arguments in December.

February 2020 brought the filing of an appellate brief in the Reserve Mechanical case. Then, there was "quite a bit of stir in March," Mr. Theriault said.

"In March, the IRS issued Letter 6336 that created quite the stir and confusion," he said. The IRS sent letters to hundreds if not thousands of entities that operated micro-captives, asking whether the captive was still operating and, if not, when it closed down.

In July, the IRS released its 2020 Dirty Dozen list, with micro-captives not included on the list for the first time in years. The IRS soon made it clear that it had not changed its position on micro-captives, however, noting the existence of the 12 new audit teams, Mr. Theriault said.

Also in July, the IRS sent a second round of Letter 6336 to micro-captive owners. That same month, the US Government Accountability Office issued a report addressing offshore micro-captives and variable life insurance products.

In August, Washington State, after 2 years of settlements with large captive parents in the state's efforts to tax captive premiums, announced that it was conducting a study of 5,000 Washington-based entities.

In October, the IRS issued an announcement ahead of October 15 tax filings urging small captive owners to consult with their tax advisors, Mr. Theriault noted. Shortly after the filing deadline, the IRS announced it would present a second round of settlement offers to small captive owners, indicating that the terms of that offer would not be as good as the one presented in 2019.

In December, Johnson & Johnson won its Supreme Court state self-procurement tax case against the state of New Jersey.

While the pandemic might have slowed IRS audit activity for a time, "The IRS certainly was relentless as they promised in their last announcement in October," said Laurie Bizzell, senior manager at Bennett Thrasher LLP. Audit activity picked up again in October, around the same time as the IRS released what it called its "limited" second micro-captive settlement offer.

Given the focus on captive insurance taxation, Ms. Bizzell set out several reasons why it's important that captive insurance companies have valid insurance arrangements for US tax purposes.

  • Insurance premiums are deductible under the Internal Revenue Code (IRC).
  • An insurance company is allowed to create a reserve and reduce its current income for unearned premiums.
  • An insurance company is able to establish a current deductible reserve for loss and loss adjustment expenses.

Ms. Bizzell explained that the Internal Revenue Code defines an "insurance company" as any company for which more than half the business during the taxable year is the issuing of insurance or annuity contracts or the reinsuring of risks underwritten by insurance companies. However, neither the IRC nor US Treasury regulations defines "insurance."

Instead, "insurance" has been defined by legal precedent, which sets out the "three-prong test," Ms. Bizzell said.

  • The presence of insurance risk: "There must be an insurable risk of loss, not just a speculative or an investment risk," Ms. Bizzell said.
  • Risk shifting and risk distribution: The court and the IRS have put forth inconsistent views about whether risk distribution is based on the number of insured entities or insured events, Ms. Bizzell said. "Myself and many of my colleagues would argue that both of those scenarios could provide for risk distribution based on the facts," she said.
  • Commonly accepted notions of insurance: the captive is organized, licensed, and regulated as an insurance company; premiums are arm's length; insurance policies are executed in a timely fashion and are legally binding; the captive has separate books and records, generally maintained by a captive manager; procedures exist for submitting, reviewing, and paying claims; investment policies are in place.

"I think the pandemic has highlighted the need, if anything, for captive insurance companies and that level of insurance, whether it's loss of key contracts, loss of key employees, business interruption, all of which are valid insurance risks which we've highlighted this past year," Ms. Bizzell said.

Another panelist, Michael Domanski, partner in the Insurance Tax Practice at Honigman LLP, noted that 2020's captive tax activity wasn't just at the federal level.

"For those involved in captive arrangements, one thing that's always important to keep an eye on, we often focus on federal tax, but the state tax is equally important," Mr. Domanski said.

"These taxes that we're talking about are more at the insured level," he said. The issue is, if a company pays insurance premiums to a captive insurance company domiciled in another state, can the company's home state seek to tax the transaction?

"For many years, it's been somewhat unenforced and for whatever reason states, except for a handful of states, have not been focusing on it," Mr. Domanski said. Now, many states are recognizing the popularity of captive insurance and that they have procurement taxes on their books, so some states are thinking it might be time to see how the taxes might be applied.

"We've been seeing more activity where states are intending to impose this direct procurement tax on a captive arrangement," he said. While there's a handful of states that don't have such taxes on the books, most states do have them.

All of these taxes are similar in that they are imposed on an insured that is purchasing insurance from an insurer that is not authorized to provide insurance coverage in the home state of the insured, Mr. Domanski said. These taxes differ from a surplus lines tax that involves a surplus lines insurer and a surplus lines broker that typically will collect and remit the surplus lines tax.

Explaining the significance of the Johnson & Johnson case, Mr. Domanski said the court ruled that the company only had to pay direct procurement taxes to its home state for premiums paid for risks in the home state, not for the entirety of its multistate risks.

Meanwhile, "Washington State, interestingly enough, is one of the states that doesn't have one of these so-called direct procurement taxes," Mr. Domanski said. Instead, Washington's approach has been to take the position that captives are not authorized to provide coverage in the state without registering as a surplus lines insurer or reinsuring a fronting commercial insurer that is licensed in the state.

Ms. Bizzell agreed that states are becoming increasingly focused on applying procurement taxes to captive insurance company premiums. "I certainly know for my larger clients the states are getting more aggressive," she said.

In general, captive insurance company parents should review their captives' tax issues with tax lawyers, their captive managers, or other professionals, she suggested. "Do a captive health check," Ms. Bizzell said. "Really, it's just about getting back to the basics."

February 08, 2021