IRS Seeks Feedback On Captive Taxation

Loans to captive parent, risk homogeneity, cells and finite insurance examined

The federal Internal Revenue Service is seeking comments from taxpayers on the tax aspects of four insurance topics of vital interest to the alternative risk-transfer markets–loans from a captive insurance company to its affiliates, the significance of the "homogeneity" of insured risks, the use of cell captives and finite insurance.

Since it generally issues official positions without such public feedback, the IRS is to be commended for seeking taxpayer input before announcing an official position on these topics. Although the request (Notice 2005-49) is generally viewed as directed primarily to captive insurance arrangements, some of the topics have broader application. Here are some details:

o Loan-backs

Of the four topics, this is the one generating the most interest. The IRS asked for comments on circumstances under which a bona fide captive insurance arrangement would be affected (invalidated) by a "loan back" to related insureds of amounts paid as premiums.

Insurance companies generally establish reserves for future losses and thus have substantial cash to invest. The IRS often states that insurance does not exist if an insured is paying its own losses.

The IRS has never taken a formal position on the degree to which insurance companies can loan money to their insureds but has privately stated that in egregious situations (97.5 percent of all assets were loaned back to the insureds, coupled with numerous irregularities), there would be no insurance for tax purposes.

Neither the IRS nor the courts have an official position, but the IRS has informally indicated its concern about loan-backs–while some captives have not loaned any money to their affiliates, others have loaned more than half the captive's assets. This is an opportunity for taxpayers to try to convince the IRS that the loan-back of premiums does not invalidate an otherwise valid insurance arrangement.

o Homogeneity

The IRS has asked for comments on the relevance of "homogeneity" in determining if there is insurance. While this is very technical, it has great practical consequences.

The IRS and courts have held that if there is enough business with unrelated insureds, premiums paid to a captive insurer by its parent will be treated as tax-deductible. The IRS has ruled that 50 percent unrelated business is clearly enough, but 10 percent unrelated business is clearly too little. (One case found insurance where there was 29 percent unrelated business in one of the years.)

The IRS apparently is seeking comment on whether insurance with unrelated insureds must be the same type–such as liability–as coverage with related insureds, in order to be taken into account when calculating the proportion of unrelated business.

For instance, can a captive insuring the general liability of its parent compute the percentage of insurance with unrelated taxpayers by using all insurance sold to unrelated parties? Or must it only use the general liability insurance sold to those parties?

Similarly, many companies have begun insuring their employee benefits, which is generally treated as unrelated business under an early IRS ruling. If the IRS ultimately decides that unrelated business must be the same type as the related business (homogeneous), it would invalidate most of the current arrangements that rely on having unrelated business to support deductibility.

"Homogeneity" may also be relevant if the captive insures very limited risks for a variety of different coverages.

o Cell Captives

The IRS asked for comments on "the factors to be taken into account in determining whether a cell captive arrangement constitutes insurance and, if so, the mechanics of any applicable federal elections."

The IRS has not taken an official position on cell captives. It is first asking what should be considered in determining if the cell is issuing insurance. Should it look at the activities of each independent cell and treat it as its own separate insurance company (which would generally be less favorable)? Or should it ignore the separate cells and look at the combined operations of the entire insurance company?

If each cell is to be tested individually to determine if it has an insurance arrangement with its affiliates, a number of other issues arise. The IRS seeks comments as to whether election by a foreign insurance company to be taxed as a domestic can, or should, be made on a cell-by-cell basis or on a companywide basis.

Similarly, should eligibility for the beneficial provisions of sections 501(c)(15) and 831(b) for small insurance companies be computed on a cell-by-cell or companywide basis? Should the tax liability be computed on a cell-by-cell basis? Or should the losses of one cell offset the income of another cell in computing the entire entity's tax liability?

o Finite Insurance

The IRS asked for comments on federal income tax issues raised by transactions involving finite risk. This request for comments is not exclusive to captive insurance companies but covers the wide variety of arrangements falling under the umbrella category of "finite insurance."

In addition to the IRS, the American Institute of Certified Public Accountants is also reconsidering its definition of insurance.

Charles J. "Chaz" Lavelle is an attorney in the Louisville, Ky., office of Greenebaum Doll & McDonald PLLC. He was outside tax counsel for both Humana and Ocean Drilling & Exploration Company in their U.S. Court of Appeals captive insurance victories.

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To Send Feedback To IRS

To comment on the various tax questions concerning captive insurers being examined by the Internal Revenue Service outlined in this article, follow the instructions below:

o Comments should reference Notice 2005-49 and be submitted in writing on or before Oct. 3, 2005 by e-mail to Notice.Comments@irscounsel.treas.gov or by regular mail to CC:PA:LPD:PR (Notice 2005-49), Room 5203, Internal Revenue Service, P.O. Box 7604, Ben Franklin Station, Washington, D.C. 2004.

o All comments are open to public inspection and copying.

o Be aware that groups such as the Vermont Captive Insurance Association and the Captive Insurance Companies Association are considering making comments.

"Since it generally issues official positions without such public feedback, the IRS is to be commended for seeking taxpayer input before announcing an official position on these topics."

Charles J. "Chaz" Lavelle

Special Reports /

IRS Seeks Feedback On Captive Taxation

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