IRS Seeks Feedback On Captive Taxation

Loans to captive parent, risk homogeneity, cells and finiteinsurance examined

The federal Internal Revenue Service is seeking comments fromtaxpayers on the tax aspects of four insurance topics of vitalinterest to the alternative risk-transfer markets–loans from acaptive insurance company to its affiliates, the significance ofthe "homogeneity" of insured risks, the use of cell captives andfinite insurance.

Since it generally issues official positions without such publicfeedback, the IRS is to be commended for seeking taxpayer inputbefore announcing an official position on these topics. Althoughthe request (Notice 2005-49) is generally viewed as directedprimarily to captive insurance arrangements, some of the topicshave broader application. Here are some details:

o Loan-backs

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

Insurance companies generally establish reserves for futurelosses and thus have substantial cash to invest. The IRS oftenstates that insurance does not exist if an insured is paying itsown losses.

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

Neither the IRS nor the courts have an official position, butthe IRS has informally indicated its concern about loan-backs–whilesome captives have not loaned any money to their affiliates, othershave loaned more than half the captive's assets. This is anopportunity for taxpayers to try to convince the IRS that theloan-back of premiums does not invalidate an otherwise validinsurance 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 businesswith unrelated insureds, premiums paid to a captive insurer by itsparent will be treated as tax-deductible. The IRS has ruled that 50percent unrelated business is clearly enough, but 10 percentunrelated business is clearly too little. (One case found insurancewhere there was 29 percent unrelated business in one of theyears.)

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

For instance, can a captive insuring the general liability ofits parent compute the percentage of insurance with unrelatedtaxpayers by using all insurance sold to unrelated parties? Or mustit only use the general liability insurance sold to thoseparties?

Similarly, many companies have begun insuring their employeebenefits, which is generally treated as unrelated business under anearly IRS ruling. If the IRS ultimately decides that unrelatedbusiness must be the same type as the related business(homogeneous), it would invalidate most of the current arrangementsthat rely on having unrelated business to supportdeductibility.

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

o Cell Captives

The IRS asked for comments on "the factors to be taken intoaccount in determining whether a cell captive arrangementconstitutes insurance and, if so, the mechanics of any applicablefederal elections."

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

If each cell is to be tested individually to determine if it hasan insurance arrangement with its affiliates, a number of otherissues arise. The IRS seeks comments as to whether election by aforeign 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 ofsections 501(c)(15) and 831(b) for small insurance companies becomputed on a cell-by-cell or companywide basis? Should the taxliability be computed on a cell-by-cell basis? Or should the lossesof one cell offset the income of another cell in computing theentire entity's tax liability?

o Finite Insurance

The IRS asked for comments on federal income tax issues raisedby transactions involving finite risk. This request for comments isnot exclusive to captive insurance companies but covers the widevariety of arrangements falling under the umbrella category of"finite insurance."

In addition to the IRS, the American Institute of CertifiedPublic Accountants is also reconsidering its definition ofinsurance.

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

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Head: Captive Owners Urged

To Send Feedback To IRS

To comment on the various tax questions concerning captiveinsurers being examined by the Internal Revenue Service outlined inthis article, follow the instructions below:

o Comments should reference Notice 2005-49 and be submitted inwriting on or before Oct. 3, 2005 by e-mail to [email protected]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 InsuranceAssociation and the Captive Insurance Companies Association areconsidering making comments.

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

Charles J. "Chaz" Lavelle