CAPTIVE INSURANCE COMPANIES
IRS 831(b) CAPTIVES
NEW LEGISLATION: HIGHER PREMIUMS ALLOWED
This article discusses new rules relating to Captive Insurance Companies formed under IRC 831(b), which are typically owned by the principals of a Company, and which insures that Company or Companies. It is a statutory form of self-insurance and subject to the various rules and requirements briefly discussed below.
The current maximum annual deductible premium an insured company can pay to an 831(b) Captive Insurance Company is $1.2 million. (See the tax discussion below).
On December 18, 2015, Congress passed, and President Obama signed into law, the "Protecting Americans from Tax Hikes Act of 2015" known as "The PATH Act."; (the names of these Acts are always intriguing, to say the least). The PATH ACT increases the maximum allowed annual premium paid to an 831(b) Captive to $2.2 million, indexed to inflation, and starting 2017. This increase in the allowed premium limits is an obvious validation of the Captive formed under IRC831(b).
An 831(b) Captive must always meet the requirements of "risk shifting" and risk transfer" and the other criteria to be an "insurance company", and to allow the insured company to deduct the premiums as a business expense (casualty insurance). The PATH ACT, while it allows the increased premium, imposes new restrictions, some of which are ambiguous and still being analyzed; the IRS may or may not issue clarifications.
Generally, The ACT imposes two new alternative new tests for the 831(b) election:
(1) a diversification test, that no more than 20% of the insurance company's premiums can come from any one policyholder. (The broad definition of 'policyholder' applies the attribution rules of Sections 267(b) and 707(b) and a modified version of the controlled group rules of Section 1563(a).
(2) The second test, an alternative to the first, essentially requires that ownership of insured businesses and assets mirror (within a 2% de minimis margin) ownership of the insurance company. This is in fact the usual arrangement and it appears that the typical arrangement whereby the Captive is owned by the Principal or principals of the insured company in the same proportion remains a valid form of ownership.
The PATH ACT limits the use of a Captive Insurance Company for estate planning, which was commonly achieved by having children or a Trust for minor children as an owner of the Captive.
A Captive may serve a number of purposes, including a reduction of insurance costs by enhanced self-insurance, providing insurance at predicted costs to avoid otherwise unpredictable and fluctuating premium levels, controlling the claims process, and accessing reinsurance markets directly. A Captive can in addition provide insurance coverage not otherwise available.
TAX DEDUCTIBLITY OF
CASUALTY INSURANCE PREMIUMS
Captives may provide significant tax benefits because premiums paid for casualty insurance can be deducted as a business expense under IRC section 162, provided the premium is reasonable and there is a legitimate business purpose for the insurance. The Court of Appeals in one well known insurance case states,
"A "business purpose" does not mean a reason for a transaction that is free of tax considerations. Rather, a transaction has a business purpose (if it) figures in a bona fide profit seeking business".1
While a company can self-insure by creating a bookkeeping reserve for claims, no tax deduction is allowed regardless of whether the reserve is based on claims or premiums history.2 The IRC does not define insurance, and IRC section 162(a) simply states that that "ordinary and necessary "business expenses are deductible. IRC Regulations define business expenses to include premiums for insurance against fire, storms, theft, accident or "other similar losses in the case of a business".3
In general, any reasonable risk of a particular business can be insured against. However, the courts have sought to define what is an "ordinary and necessary business expense" and in fact this issue has been frequently litigated. The general rule is that a business expense need not be absolutely necessary, but only reasonably "appropriate and helpful". The term "ordinary" does not necessarily mean continuing or repeating.4
The definition of "insurance" has been left to the courts. An analysis of the extensive case law history is beyond the scope of this article, but the authoritative 1991 case of Harper Group v Commissioner,5 established a three- part test to determine the existence of "insurance":
(1) there must be a real insurance risk, i.e. a risk which the particular business has;
(2) there must be "risk shifting" and "risk distribution", discussed below; and
(3) the arrangement must provide for insurance in its "commonly accepted sense"; this last requirement essentially means that premiums are paid to an "insurance company", which can be a licensed Captive, that the premium is reasonable for the coverage provided, that the polices are legal, binding contracts, and finally that the insurance company is "adequately capitalized"; (capital as required under the laws of its jurisdiction, which in the case of a foreign Captive might be as little as USD $10,000 but typically USD $100,000.)
Once a company determines that a Captive is an attractive alternative, its analysis must then focus on a number of issues, including the deductibility of the premiums to be paid, and the Company might be wise to insist on qualified actuarial support for the premium. Next, the company will want to ensure that its Captive or Rent A Captive accomplishes "risk shifting" and "risk transfer", concepts which have a long tax court history.
Risk shifting may be best understood by an example of a situation which fails this test: a single purpose captive insuring its parent company does not shift the risk of loss from the company to the captive, because a claim paid by the captive directly affects the balance sheet of the parent company. However, a Captive might insure a parent company and number of subsidiaries, provided the parent company actually shifts the risk of loss among the subsidiaries, on an arms-length basis. A 2005 Revenue Ruling6, provided the example of a company conducting business through 12 Limited Liability Companies, all insured through a single purpose captive. The Ruling finds the risk shifting occurs if the 12 LLC's elect to be classified as Associations for Federal tax purposes, i.e., are not pass-through entities for tax purposes. While this Ruling does not provide a specific safe harbor (how many subsidiaries less than 12 would be sufficient?) it does confirm that the insured must transfer some of the economic risk of loss to other entities.
A 2002 Revenue Ruling7 provides that there is no "insurance" where 90% of a Captive's premiums are from its single parent. But, the Ruling also states that there is "insurance" and risk shifting if 50% of the premiums come from unrelated insureds. The court in the Harper Case, cited above, found risk shifting, and risk distribution if the Captive receives at least 30% of its premium income from unrelated sources and therefore has at least 30% of unrelated risk. While the 30% guideline is regarded by many Administrators and practitioners as the absolute minimum threshold, it is not a clear safe haven. Several cases have found there to be "insurance" with when more than 30% comes from unrelated companies, but no cases approve a lesser percentage.
Another 2002 Rev. Rule8 found risk shifting and risk distribution in a Captive owned by a "relatively small group of unrelated businesses in a highly concentrated industry.", but it did not define the number. However, it the example in the Rule cited that no individual company's risk exceeded 15%. The guidance provided by the Revenue Rulings seems unclear at best, but it would appear that n IRS safe haven of 50% of unrelated premium and risk is established in Rev Rule 2002-89.
Risk distribution is a requirement distinct from risk shifting:
"Risk distribution incorporates the statistical phenomenon known as the law of large numbers. Distributing risk allows the insurer (Captive) to reduce the possibility that a single costly claim will exceed the amount taken in as premiums and set aside as for the payment of such a claim by assuming numerous relatively small, independent risks that occur randomly over time, the insurer smooths out losses to match more closely its receipt of premiums".9
The 831(b) Captive can achieve "risk distribution" and "risk shifting", commonly but not always, by contracting with a bona fide insurance pool, maintained either on-shore or offshore, usually by licensed insurance managers. These insurance or reinsurance Pools insure any number of unrelated parties. The Captive can contract to join this pool, and assume risk obligations to the Pool limited to 50%, or at least in excess of 30%, of the premium it receives from its parent. As a Member of the Pool, the Captive will also participate or share in the premiums paid by unrelated parties.
The end result is that the Captive shifts a percentage of risk to the pool, so in the event of a claim, at least up to a contractual maximum, the Captive recovers from the Pool to pay its parent's claims, and the parent has therefore "shifted" some of risk off its balance sheet. The Captive has also distributed risk because it has other Members of the Pool to share its losses. It is important that the Pool be carefully managed and that participants have excellent claims histories and proven risk management practices. Pooling arrangements can be complex and must be carefully arranged and documented. It should be noted that a Captive or Rent A Captive might use a "segregated" or "cell" account", as allowed by many jurisdictions, to maintain an insured's funds separately from other participants in the company. The IRS has asked for "further guidance" to determine if a "cell" captive arrangement constitutes insurance. In any case, a bona fide Pooling of risk should meet the current requirements of risk shifting and risk distribution, regardless of the use of cells or segregated accounts.
JURISDICTIONS AND EXCISE TAXES
There are several Sates which authorize the formation of Captives, including Vermont, S. Carolina, Colorado, Delaware, Utah, Montana, Arizona, and the District of Columbia. Offshore jurisdictions include Anguilla, the Bahamas, the British Virgin Islands, the Cayman Islands Gibraltar, and Ireland, just to name the most popular. Neither the IRC nor case law distinguishes between domestic and offshore insurance companies. The advantages and disadvantages of specific jurisdictions are beyond the scope of this article. Highly regulated offshore jurisdictions may offer the benefits of lower capital and administrative and lower annual maintenance costs, but several States are certainly competitive.
With regard to offshore jurisdictions, a U.S. company may not do business with any entity listed with the Trading with The Enemy Act (TWEA) or any entity or person listed on the Office of Foreign Assed Control.
A 4% excise tax is imposed on premiums paid to a foreign insurer on casualty insurance. ((IRC 4371). However, a Captive or Rent a Captive will usually elect to be taxed in the U.S. as a domestic corporation by filing Form 953(d). However, the U.S. reporting company must nevertheless pay a 1% percent excise tax on reinsurance placed to non-reporting insurance companies or Pools.
Many States also seek to impose an excise or premium tax, a discussion of which is beyond the scope of this article. However, with regard to an offshore Captive which insures only its parent, and not third parties in a State if it does not maintain a fixed place of business it should generally not be deemed to be "doing business" in that State. For Federal tax purposes, an offshore Captive not otherwise "doing business" in the U.S. is not taxable in the U.S.
However, as noted, to avoid the federal excise tax most offshore insurance companies elect to be taxed on U.S. source income.
This Writer rarely sees a purpose for forming the Captive offshore.
The new limits are effective for tax years beginning in 2017 and beyond, and the new rules will apply to new and existing 831(b) insurance companies. There are no grandfather provisions. If an existing 831(b) insurance company does not meet one of the new tests, the insurance company and/or the insured companies must be restructured to continue to qualify under 831(b).
Captive insurance companies, in their many forms and applications, have become mainstream insurance and tax planning vehicles. A Captive must meet the statutory and regulatory requirements, including risk shifting and risk distribution. For qualified companies, the increased annual premium (effective 2017) makes the 831(b) Capti
e a more valuable plan.
1 United Parcel Service of America, 254 Fed 3rd 1014 (11th Cir. 2001)
see e.g. Rev Rules 60-275, 57-485
4 See E.G. 55 T.C.M. 34 (1998)
5 Harper Group v. Comr., 96 T.C. 45 (1991)
6 Rev.Rule 2005-40 (7/5/2005)
7 Rev Rule 2002-89
8 Rev Rule 2002-91
9> 811 f21297 (9th Cir 1987)