Internal Revenue Code (IRC) and Regulations
The rules and principles debated and decided upon in the leading court cases involving captives have largely now been codified with a slant toward the government’s view in the US Internal Revenue Code and Regulations and Revenue Rulings.
They are summarized below.
IRC Section 501 (c) (15)
This allows very small insurance companies (under $600,000 in gross receipts with the majority from premium income) to be tax-exempt. The IRS took widespread enforcement action against abuses of 501(c)(15) captives over a decade ago and even made them listed tax shelter transactions for a period of time. Rule changes have made it impractical for nearly all applications and few 501(c)(15) captives are utilized today as IRC 831(b) qualifying small captives discussed below are of greater interest and application today..
Internal Revenue Code Section 831(a) and 831(b)
These code sections govern general insurance company taxation and the election available under 831 (b) for small captive insurance companies is very important. It is statutorily authorized tax incentive allowing small captive insurance companies with $1.2 million or less in annual written premium to be taxed on investment income only. Click here to read actual statute. This special election was enacted in 1986 during President Reagan’s 2nd term.
This greatly simplifies how these small captive insurance companies compute taxable income. 831(b) captives are growing in popularity as the flexibility of design, structure and use is better understood. Many captives formed today are 831(b) captives owned by successful family businesses. The 831(b) captive effect is to shelter up to $1.2 million per year in what might otherwise be taxable income to the operating business with these pre-tax dollars set aside and accumulating to protect against losses and facilitate business succession planning when structured properly. See Tax Articles for more information on how to correctly design and implement a valid 831(b) captive.
IRS Concedes in 2001 on Important Captive Industry Tax Issues
Prior to Revenue Ruling 2001-31, the IRS took the position that brother-sister company transactions were not arms-length “risk shifting,” and special tax provisions would not be recognized within an “economic family.” The IRS since this ruling has abandoned its long standing position that premiums paid to captive insurance companies were not deductible under this “economic family” theory. The IRS continues to measure if a transaction lacks economic substance or is abusive using other methods of evaluation.
IRS Adds Three (3) Foundation Safe Harbor Rulings on Risk Shifting and Distribution (Revenue Rulings 2002-89, 2002-90 and 2002-91)
In 2002, three revenue rulings were issued by the IRS on captive insurance taxation. Revenue Ruling 2002-89 (50% unrelated risk qualifies as sufficient risk distribution to be considered an insurance company), 2002-90 (finding 12 subsidiary companies where no one subsidiary makes up more than 15% of total premium qualifies even though all are related party affiliated companies), and 2002-91 (finding 7 unrelated insureds part of a group captive sufficed for risk shifting and risk distribution).
Many court cases are more liberal than these three “safe harbor” revenue rulings. However if you can design captive insurance company structures to meet these safe harbors, the captive will likely be approved for favorable tax treatment by the IRS if it is reviewed. While the IRS has made it clear they do not like captive ownership structures incorporating advanced asset protection and estate planning considerations, and may consider layering such tax incentives abusive, many captives are planned coordinated with estate and business succession impacts, with many captives designed to be owned by successor generations (usually through complex irrevocable trusts) to facilitate ancillary business and financial objectives. We understand courts like the US sixth Circuit in Crawford Fitting Co. vs. US have found risk shifting under these circumstances. This area is a hot topic with IRS tax counsel and changes could occur. This website may be dated on this and other topics.
- Click here to read IRS release on Revenue Ruling 2002-89, 2002-90 and 2002-91 and related materials.
2008 Revenue Ruling Impacting Cell Captives
The IRS issued Revenue Ruling 2008-8 (January 2008) to give some clarity to structures known as “cell captives,” “rent-a-captives” and “protected cell captives.” A related ruling, 2008-19, accompanied 2008-8. These rulings are favorable on the increasing use of cell captive structures, very popular today, and more guidance should come on this from the IRS in the future to help effective use of cell captives by more companies.
Some Additional IRS Rulings to Consider
Revenue Ruling 2005-40 (risk distribution and disregarded entities for meeting the Rev. Rul. 2002-90 Rule of 12 safe harbor),Rev Rul. 2007-47 (what is a risk) and 2009-26 (reinsurance impact). The IRS’s view in some of these revenue rulings will likely not be upheld if challenged in court, such as ignoring the legal and economic substance of extending coverage to include multiple single owner LLCs that are distinct legal entities with distinct businesses, assets and liabilities, and similarly aggregating for Rule of 12 audit review purposes separate limited partnerships that have the same general partner.
New proposed regulation in September 2011 would greatly impact cell and series captives. Many Private Letter Rulings have also been issued impacting captive design and operating structures.
2011 Codification of the Economic Substance Doctrine
Part of the ACA (Obama health care law) added section 7701(o) to the Internal Revenue Code. This new section codifies an economic substance test previously developed by the various US courts. This new test requires meeting 2 prongs. While the statute states clearly it is not intending to modify and the IRS should follow existing case law concepts, this new statute may make it harder for captive designs and structures to meet the test. Extra care should be taken to with new captives and old to have documentation that clearly aims to meet these standards. The new law also enacts a new penalty for understatements of tax if the economic substance requirements are not met. See a recent article on this topic for more information by clicking here.
US Owned Foreign Insurance Companies
Most US owned captives domiciled offshore today are small micro-captives using the special elections under IRS code sections 953 and 831(b) to have the offshore captive taxed as a US company, and exempt all of the captives income from premiums from US income tax. See 831(b) captives for more information. International tax and the US tax laws applicable to controlled foreign companies is complex. The US Internal Revenue Code has a section called subpart F that impacts the tax treatment of controlled foreign companies and foreign sourced income. It also has provisions that modify related party income, passive foreign investment company earnings (which a captive can be considered depending on its investment earnings ratio to premium income), excise taxes on premiums paid to foreign insurers, and other considerations.
We believe or risk pooling facility is the most cost effective quality designed risk pool program in the industry. If you are another captive manager looking to improve your client captives 3rd party risk pooling reinsurance program, please contact us as we may, selectively, allow captives managed by others to participate if they qualify.
Many captive insurance company promoters and consultants are using “pooling” arrangements to meet the US safe harbor tests, particularly the more than 50% unrelated risk safe harbor. The business risk of using such pool structures include increased potential for unexpected loss experiences that could impede the projected economic benefit of the captive insurance program strategy. The risk distribution impact of pooling arrangements may be tested in future disputes if they are designed to inhibit claims and are designed purely for tax purposes. Not all pooling arrangements are identical and it may very well turn out some are effective to achieve risk distribution while others will fail.
Asset Protection, Estate Planning and Wealth Transfer Tax Benefits
Be aware that integrating wealth transfer planning protection and efficiency in captive ownership can increase likelihood of problems with IRS staff on audit review, despite many advisers finding clear support for designing to achieve related objectives. It would seem using congressionally approved tax incentives is anything but abusive, but IRS seems to be suggesting otherwise. To date the courts seem to side with taxpayers on similar issues, supporting use of legislated tax incentives even if they seem to derive subantial benefit and weigh heavily into the economic considerations of using captives to protect businesses from risks otherwise informally self insured, but this is an increasingly controversial area and could dilute the attention needed on traditional risk management. Nevertheless, there are valuable incidental benefits beyond typical income tax benefits (risk finance efficiencies) of well designed captive insurance structures when integrated with advanced wealth protection and transfer ownership structures.
Summary of Key Law Cases Impacting Captive Insurance Companies
Caveat: Please note that subsequent IRS rulings and case law impact the findings of some of these older cases. These are however generally considered the line of cases setting forth the framework for forming and operating insurance companies.
Helvering v. LeGierse, 312 U.S. 531 (1941). Established that both risk shifting and risk distribution are requirements for a contract to be treated as insurance.
Carnation Co. v. Com’r., 71 T.C. 400 (1978), aff’d, 640 F.2d 1010 (9th Cir. 1981), cert. denied, 454 U.S. 965 (1981). Denied a deduction for premiums paid by a parent corporation to an unrelated U.S. insurer to the extent the premiums were ceded (pursuant to a reinsurance arrangement) by the insurer to the parent’s wholly owned Bermuda captive. The court’s decision hinged on its determination that the captive wrote no unrelated risk, was inadequately capitalized and entered into an agreement under which the parent could be compelled to contribute additional capital to the captive.
Stearns-Roger Corp. v. Com’r, 577 F. Supp. 833 (D. Cob. 1984), aff’d, 774 F.2d 414 (10th Cir. 1985). The U.S. District Court held that premium payments by a parent to its wholly-owned captive subsidiary were not deductible based on the “economic family” doctrine. The 10th Circuit Court of Appeals supported the denial, but rejected the economic family argument.
Clougherty Packing Co. v. Com’r., 84 T.C. 948 (1985), aff’d, 811 F.2d 1297 (9th Cir. 1987). This complex Tax Court decision, disallowing captive premium deductions, touched on many controversial issues and resulted in wide differences of opinions among the 19 judges.
Crawford Fitting Co. v. U.S., 606 F. Supp. 136 (N.D. Ohio 1985). The court held that insurance premiums paid to a Captive by a group of separate corporations that were owned and controlled by a group of related individuals were deductible because the shareholder/policyholders of the captive were not so economically related that their separate financial transactions had to be aggregated and treated as the transactions of a single taxpayer.
Humana, Inc. v. Com’r, 881 F.2d 247 (6th Cir. 1989). The 6th Circuit Court of Appeals held that the brother-sister captive arrangement constituted insurance for federal income tax purposes and, as such, premium payments attributable to the risk exposures of the captive’s brother-sister entities (but not the parent) were deductible. The Court’s decision was based on the so-called “balance sheet” approach, under which risk shifting depends on the effect of the arrangement on the policyholder’s net assets.
Kidde Industries, Inc. v. U.S., 40 Fed. Cl. 42 (Cl. Ct. 1997). Applying the balance sheet approach articulated in Humana, the Court held that premium payments made by brother-sister entities to the captive were currently deductible. In contrast, payments made by divisions of the parent corporation did not constitute insurance premiums deductible under IRC §162.
The Harper Group v. Com’r, 96 T.C. 45 (1991), aff’d, 979 F.2d 1341 (9th Cir. 1992). The Tax Court held, and the 9th Circuit Court of Appeals affirmed, that risk shifting and risk distribution were present where the captive received 29 to 32 percent of its premiums from unrelated parties. As such, the captive arrangement was found to constitute insurance for federal income tax purposes and payments made to the captive were deductible under IRC §162.
Inverworid v. Com’r, T.C. Memo 1996-301, supplemented by, T.C. Memo 1997-226. Transacting offshore company’s business through a U.S. office found to constitute engaging in a U.S. business for federal income tax purposes.
United Parcel Service vs. Com’r, T.C. Memo 1999-268 (1999), rev’d, 254 F.3d 1014 (11th Cir. 2001). The 11th Circuit found that the Tax Court had improperly determined that a restructured program in which a shipping corporation transferred its “excess value charge” income and obligations to a Bermuda insurance company was a tax sham. The Tax Court opinion describes the economic-substance doctrine as follows, “This economic-substance doctrine, also called the sham-transaction doctrine, provides that a transaction ceases to merit tax respect when it has no ‘economic effects other than the creation of tax benefits.’ [Citations omitted]. Even if the transaction has economic effects, it must be disregarded if it has no business purpose and its motive is tax avoidance.”
Other Tax Considerations
In planning a captive program, be sure to give careful consideration in your feasibility study and business plan, and organizational and corporate governance documents, to the business purpose, the economic substance (IRC section 7701(o)), and the arm’s length pricing of transactions (IRC section 482) to help avoid IRS adjustments and possible penalties. No matter how sincere and diligent your planning, when it comes to complex structures with substantial tax benefits like captive insurance companies, tax audit and adjustment exposure is simply something one has to accept and live with as another business risk notwithstanding the best of intentions to design and use a captive properly and foremost for risk management planning purposes.
Importance of the Looming Self-Procurement, Independently Procured, Non-Admitted Retaliatory Premium Tax Issue Often Overlooked
Insurance regulatory bodies, particularly in the US, have historically financed insurance regulation by charging premium taxes on premiums paid insurance companies they licensed to sell insurance to residents and businesses in the state. For constitutional reasons, residents and businesses are able to buy insurance from out of state insurance companies under many circumstances. This includes captives. As discussed below, when a company in State A forms a captive in State (or Country) B, and buys insurance from the captive, whether or not State A can levy and collect premium taxes depends on the states laws and on the facts and circumstances of each situation. Generally if the captive does business wholly outside of State A, and negotiates the insurance contracts outside of State A, then State A would lack sufficient constitutional nexus to tax the captive in any way including premium taxes. State A may however have statutory authority to levy and collect from the business in State A that buys insurance from a related out of state captive.
To read the full opinion of a 2001 Circuit Court decision over a controversy involving application of Texas’s 4.85% independently procured insurance premium tax to Dow Chemical where the court upholds the US Supreme Court’s Todd Shipyards ruling from the 1980s, visit www.captiveexperts.com.
See a copy of a recent 2001 case, Dow Chemical, where Texas levied Dow Chemical $427,149 dollars for premium taxes on policies Dow purchased from insurance companies not admitted in Texas. In Dow Chemical, the Circuit Court confirmed the Todd Shipyard’s constitutional doctrine established long ago by the US Supreme Court limited a state’s capacity to tax an out of state company that does not conduct business within that state, negotiated its insurance arrangements outside of the state, and otherwise does not have the requisite constitutional nexus to become subject to the state’s taxing powers. Most captives and their owners are not likely to have the resources needed to challenge a state’s levy of self procurement premium tax on premiums paid an out of state captive.
The NAIC (US National Association of Insurance Commissioners) supports states extending their tax even to out of state insurers with no business presence in the state (See the NAIC’s Amicus Curiae brief submitted in support of the State of Texas in the 2001 Dow Chemical by clicking here). The NAIC’s “Nonadmitted Insurance Model Act,” adopted by over 40 states since 1999, enables states to tax premiums (and levy insureds doing business in their state) paid out of state insurers on the portion of the premium fairly allocated to risks within the state.
The Dodd-Frank Act NRRA provisions attempt to streamline this compliance headache area by allowing only a “home state” of an insured to tax certain non-admitted insurance. Some states enterred compacts to share premiums with other states, many states are going it alone like Wisconsin and New York and intend to keep all such taxes. The NRRA provisions of the Dodd-Frank Act will need to be clarified, including whether or not they apply to captives which most industry experts believe they do not.
Captive or Not To Captive
This brief introductory overview is meant to alert you to the many ways a captive can be taxed. Its impact on consolidated tax returns is complex as are related elections. Sometimes it may prove sufficient, even more attractive ,to simply retain risk and earn possible underwriting income in a non-insurance operating company verses transferring that risk to a captive and earning the profits there. Tax and regulatory considerations must be evaluated correctly and considered along with all the other pros and cons of starting up or participating in an existing captive program.
******* Please contact us if you would like to discuss these matters further or need a referral to qualified tax experts to help you navigate these complex but beneficial waters.