A closely held insurance company should only be implemented when it makes economic and business sense. There must be an inherent need to cover uninsured risk in a business before considering the implementation of such a company.
The IRS has issued multiple Revenue Rulings, Procedures, Notices and Bulletins addressing various issues associated with the use of closely held insurance companies. Recently issued IRS publications include:
Revenue Ruling 2001-31 – IRS Gives Up on “Economic Family Theory”
Revenue Procedure 2002-75 – Private Letter Rulings on Insurance Co. Issues
Revenue Ruling 2002-89 – 50 Third Party Insurance Risk
Revenue Ruling 2002-90 – 12 Brother / Sister Subsidiary Requirement
Revenue Ruling 2002-91 – Spreading of Risk in Captive Group
Notice 2003-34 – Use of Insurance Companies / Hedge Funds
Revenue Ruling 2005-40 – Tax deduction not applicable if entity is “sole client” of captive
Notice 2005-49 – IRS asks for comments on qualification of certain arrangements as insurance
CICAcomments_IRSnotice2005-49 – The Captive Insurance Company Association’s comments on IRS notice 2005-49
Revenue Ruling 2001-31, issued June 4, 2001: With this ruling, the Internal Revenue Service has acknowledged that it will no longer invoke and follow the “economic family theory” with respect to captive insurance transactions. The judicially accepted definition of insurance involves the following elements of risk:
Risk Shifting-the transferring of the financial consequences of the potential loss to the insurer, and Risk Distribution-allowing the insurer to reduce the possibility that a single costly claim will exceed the amount taken in as premiums and set aside for the payment of such a claim.
The sharing and distribution of the insurance risk by all the parties insured is essential to the concept of true insurance. The “economic family theory” argues that where insurance risk has not been shifted or distributed outside the “economic family” there cannot be valid or bona-fide insurance contracts. Valid and bona-fide insurance contracts are essential in obtaining deductions for premiums paid to a related party insurer.
As an alternative to the “economic family theory,” the courts have historically employed a balance sheet test to determine if bona-fide insurance exists. Thus, where the risk of loss has been removed from the insured’s balance sheet, shift of risk has occurred. Although the IRS has indicated that it will no longer invoke the “economic family theory” as an argument that risk has not shifted between related parties, the Service has indicated that it will continue to scrutinize each entity involved in an insurance transaction on many levels to determine if bona-fide insurance contracts exist. These areas may include:
Amount of capitalization of the insurance company
Revenue Ruling 2002-89, issued December 11, 2002: This ruling discusses two scenarios involving the payment of premiums by a parent to its two wholly-owned captive subsidiaries.
In the first scenario, the premiums paid by the parent to its wholly owned subsidiary accounted for 90 of the subsidiary’s income for the year. In the second scenario, the premiums paid accounted for 50 of the second subsidiary’s income for the year. In determining whether these scenarios represented valid insurance arrangements, the IRS noted that:
Both insurance captives were adequately capitalized,
Both insurance captives were properly regulated,
The companies transacted their insurance business in a manner consistent with the standards applicable to an insurance arrangement between unrelated parties.
The IRS again focused on the concepts of adequate risk shift and risk distribution and concluded that the arrangement in scenario 1 did not provide sufficient risk shift or distribution while the facts in scenario 2 did. Thus, where 50 of the subsidiaries risk is with unrelated third parties, the IRS has concluded that sufficient shift and distribution of risk has passed to the subsidiary to constitute a valid and bona-fide insurance arrangement for the parent.
Although Revenue Ruling 2002-89 appears to definitively state that 50 of an insurance company’s business must be with unrelated parties in order for the related party insurance arrangement to constitute bona-fide insurance, judicial precedent exists in the 9th Circuit’s Harper Group decision that this third party element may be as little as 29 to constitute a valid and bona-fide arrangement between related parties.
Revenue Ruling 2002-90, issued December 11, 2002: The IRS concluded that the premiums paid by 12 operating subsidiaries to a captive insurance subsidiary owned by a common parent are deductible. The facts in Revenue Ruling 2002-90 are similar to the brother-sister subsidiary arrangement as outlined in the 5th Circuit’s ruling in Humana. The IRS concluded that the transaction contained adequate risk shift and risk distribution and that the amounts paid for insurance by domestic operating subsidiaries to an insurance subsidiary of a common parent are deductible as “insurance premiums.” The IRS also based their position on several facts as follows:
The premiums of the operating subsidiaries were determined at arms-length.
The premiums were pooled such that a loss by one operating subsidiary is borne, in substantial part, by the premiums paid by others.
It is important to note that the IRS analyzed each of the subsidiaries to ascertain:
If they conducted themselves in all respects as would unrelated parties to a traditional relationship;
If the insurance company was able to pay claims;
The adequacy of the insurance company’s financial performance; and
If separate financial reporting was maintained on behalf of the insurance company.
Revenue Ruling 2002-91, issued December 11, 2002: The IRS concluded that a group captive arrangement, which was formed by fewer than 31 unrelated insured’s, with each insured having no more than 15% of the total risk, was a bona-fide insurance arrangement. The ruling also outlines other factors that the IRS will consider in determining whether a transaction constitutes a bona-fide insurance arrangement. These factors include:
Whether the risks are shifted and distributed to the insurance company, since the entities are commercially and economically related;
Whether the policies contain provisions such that the covered risks may exceed the amount of premiums charged and paid;
Whether the validity of claims were established before payments are made;
The IRS again focuses on risk shifting and risk distribution in determining whether the transactions are considered deductible “insurance premiums".
Revenue Procedure 2002-75, issued December 11, 2002: This revenue procedure discusses certain insurance transactions whereby the IRS will now contemplate issuing private letter rulings regarding whether a valid and bona-fide insurance arrangement exists between related parties. The IRS has indicated that taxpayer’s seeking a ruling should contact the appropriate department at the IRS to determine whether the facts in each case will be considered by the IRS for a ruling before preparing the ruling request.
Issued June 9, 2003: Notice 2003-34 involves the use of offshore insurance companies organized for the purpose of sheltering passive investment income over the life of the company. The shareholder of the offshore insurance company then disposes of the stock in a transaction that qualifies for capital gain treatment. The insurance written by these companies frequently contains unrealistic policy limitations and the investment income generally far exceeds the amount of premiums received from insurance contracts. The IRS in this notice has indicated that it intends to attack these types of transactions in one of three ways.
Option 1 – Definition of Insurance: In this method of challenging these transactions, the Service will argue that the insurance written by the insurance company does not meet the judicial established definition of insurance. This is the traditional attack based on the premise that bona -fide insurance contracts must shift and distribute risk from the insured to the insurer and that the insurer must distribute the risk amongst potential claimants.
Option 2 – Status as Insurance Company: This method of challenge relies upon the premise that a taxpayer taxed as an insurance company must use its capital and efforts primarily in earning income from the issuance of insurance contracts. The income tax regulations provide that a company will qualify as an insurance company only if more than half of its business is the issuing of insurance or annuity contracts or the reinsuring of risks underwritten by insurance companies. Thus, the IRS in asserting this challenge will look to all of the relevant facts and circumstances for making the determination of whether an entity qualifies as an insurance company. Items taken into consideration in this assessment may include the size and activities of the insurance company’s staff, whether it engages in other trades or businesses, and its sources of income.
Option 3 – Possible Tax Treatment of Stakeholder’s Interest in Foreign Corporation: In this method of challenge the Service will look for ways to categorize the income earned by the foreign corporation as passive investment income subject to U.S. income tax. This method depends upon the Service’s ability to show that the foreign corporation is not involved in the active conduct of an insurance business.
Issued June 2005, Revenue Ruling 2005-40 disallows the premium deduction for a company that is the sole client of an insurance company. According to the IRS, such coverage does not spread risk among more than one policyholder and hence is not a bona fide insurance transaction. In this case policyholders are simply insuring themselves. In other words, the transaction might be considered a deposit, a loan, a contribution to capital, or a non-insurance indemnity arrangement – none of which are tax-deductible – but it wouldn’t be considered insurance.