For years the Internal Revenue Service has essentially beensaying that if it “walks like a duck and talks like a duck, for allintents and purposes, it is a duck”–or in the case of captives, aninsurance company. But captive insurers beware: the definition of a“duck” can get murky, as with multimember LLCs (limited liabilitycorporations) and limited partnerships.

As has been the case for some time, the IRS is examining grayareas and has revoked tax exemptions for two section 501(c)(15)captive insurance companies– this time in Chief Counsel Advice(CCA) 200952060 and CCA 200952061.

The benefit of this type of captive is that it is completely exempt from all federal income tax–thiscomplete tax exemption is granted to very small insurance companiesthat meet the qualifications.

These revocations demonstrate that the IRS continues toscrutinize captive insurers. The IRS justified its decision thatthe captive was not engaged in selling insurance by focusingon:

o The number of insureds.

o Concentration of risks with a few insureds.

o Lack of independent risks.

The CCAs involved A, an individual owning all the stock ofcaptive insurer D, which insured six-to-10 related entities, two ofwhich were limited liability corporations, with the rest limitedpartnerships with the same general partner, C.

Apparently, D also insured A and his relatives for relativelyminor amounts. D sold two policies–one covered one entity in onelocation. The other covered the remaining entities, each of whichwas in the same geographic area. Included in the coverage was floodand windstorm from “named” storms (for example, Hurricane Katrina)and earthquake coverage.

The IRS first determined how many insureds there were. Eventhough there were six-to-10 entities, the IRS counted only threeinsureds for tax purposes.

The IRS determined that each multimember LLC was a separateinsured because an LLC owner has no more at risk than its equity inthe LLC, just as a shareholder has no more at risk than its equityin the corporation.

The IRS determined, however, that the general partner of alimited partnership is the insured. Since each of the limitedpartnerships had the same general partner, the general partner (C)was the insured, rather than each of the numerous limitedpartnerships. Accordingly, rather than six-to-10 insureds, the IRSviewed there to be only three insureds for tax purposes.

The reason the IRS determined that a general partner is theinsured, rather than the limited partnership itself, is that in thecase of a severe loss the general partner would be liable for theentire loss without limitation. The general partner's loss was notlimited to its equity in the limited partnership.

Accordingly, the IRS viewed the general partner as the oneattempting to shift its risk through insurance. This is the sameposition the IRS took in TAM 200816029.

Neither TAM 200816029, CCA 200952060 nor CCA 200952061 can becited as precedent, but they represent the only times the IRS hasdecided who is the insured in a multimember LLC and a limitedpartnership situation. Some in the industry believe that thelimited partnership (rather than the general partner) is theinsured, at least under some circumstances.

An example is a limited partnership that buys property insuranceon a building subject to a nonrecourse note. In that instance, manyview the general partner as having no more at risk than its equityin the limited partnership, just as a shareholder's loss is limitedto equity in its stock.

Once the IRS determined that there were three primary insureds(the two LLCs and the general partner), it focused on theconcentration of risk with those insureds.

To have insurance for tax purposes, there must be enoughdistribution (sharing) of risk. This means several things,including that there be enough exposure units (opportunities forloss) so that the law of averages can statistically predict thelikely amount of losses.

The IRS believes there must be multiple insureds (not justsufficient exposure units) and that no insured can so dominate thepremium payments that it is effectively paying its own losses withits own premiums. The IRS “safe harbor” is that there should be atleast 12 insureds–none representing more than 15 percent, nor lessthan 5 percent, of the risks.

The precise numbers with CCAs were redacted, but it was clearthat each of the primary insureds had concentrations greater than15 percent (and the implication was the three insureds bought thebulk of the insurance). One example would be 40 percent for thegeneral partner, 35 percent for one LLC, 20 percent for the otherLLC, and 5 percent for the individual insureds.

The IRS determined that the risks were too concentrated in toofew entities to find that there was insurance. Because the CCAs areheavily redacted, it is impossible to know the exact facts, butbased on the above assumptions, the industry would likely disagreewith the IRS conclusion.

One principle of insurance is that risks should be independentof each other. This means that the same conditions that caused oneinsured to have a loss will not simultaneously cause anotherinsured to have a loss. For instance, the hurricane risks of twoadjacent houses are not independent.

For 50 years, the IRS has held that flood insurance issued onlyto those in the same flood plain is not insurance. That is becausea flood would result in a loss to everyone, so that in essence,one's premiums were being used to pay one's own loss.

In the CCAs, the IRS concluded that because all but one of theproperties were in the same geographic area, the same “named storm”or the same earthquake would affect all the insureds–thus the riskswere not independent of each other. Accordingly, the policies werenot insurance for tax purposes.

These CCA are reminders that the IRS continues to scrutinizecaptive insurance arrangements. While properly structuredarrangements should pass muster for tax purposes, those that arenot properly structured and implemented will not.

Charles J. “Chaz” Lavelle is an attorney in theLouisville, Ky., office of Greenebaum Doll & McDonald PLLC. Hewas outside tax counsel for both Humana and Ocean Drilling &Exploration Company in their U.S. Court of Appeals captiveinsurance victories.