Following the tumultuous tax issues that dominated 2007 into2008–changes that could have altered the captive industry–this yearby comparison has been relatively tame.

While there have been several developments on the taxation ofcaptive insurance this year, they generally did not expand thestatus quo. This is not surprising, as there were not many "hotbutton" issues scheduled on the IRS agenda. (See NU, "TaxChallenges Remain for Captive Entities," March 9, 2009.)

An issue potentially relevant to captives is the IRS BusinessPlan. Each year, the IRS publishes a Business Plan–technicallycalled its "Priority Guidance Plan"–which lists projects on whichthe IRS hopes to issue a public position (generally referred to as"guidance").

The July 1, 2008-June 30, 2009 IRS Business Plan listed twotopics relevant to captives:

o A "Revenue Ruling providing guidance on reinsurance agreementsentered with a single ceding company."

The IRS has not been more explicit as to what issues the RevenueRuling will address. The industry assumes it will not "break newground" and will be consistent with traditional captive insuranceconcepts.

o Cell taxation.

In 2008, the IRS ruled that whether a premium paid to a cell is"insurance" for federal income tax purposes will be determined on acell-by-cell basis, rather than by looking at the entire company(including the core and all the cells)–at least where the corecapital bears no risk.

This means that to meet the IRS tests of having enough insuredentities, or having enough unrelated business, only the activitiesof a given cell are taken into account.

For example, the cell cannot rely on the unrelated insurance inother cells to meet the IRS risk distribution tests. If there is"insurance" in a cell, in other words, the insured's premiums aredeductible. (See NU, "IRS To Research Cell-CaptiveTaxation," Feb. 11, 2008.)

This year, the IRS plans to finalize its proposal as to how totax the cell (the recipient of the premiums).

In Notice 2008-19, the IRS proposed to treat each cell as itsown company–at least where the core capital was not liable for thecell's debts.

If by looking exclusively at the activities within the cell,there is insurance, then the cell is treated as an insurancecompany that needs its own Employer Identification Number, filesits own tax return, and makes its own tax elections–all independentof the status or actions of the other cells.

While neither of these items were issued by June 30, 2009,unfinished items are generally included in the next year'splan.

The industry was asked to comment on the IRS proposal. Becausenone of the comments attacked the IRS's basic direction, however,the industry assumes the final regulations will follow the Notice'sapproach. The Notice stated that the regulations would not beeffective until at least 12 months after they are finalized.

The Captive Insurance Companies Association and the VermontCaptive Insurance Association had jointly requested liberaltransition rules that would permit taxpayers to conform to the newrules without adverse tax consequences.

At a conference in May, an IRS representative stated that theIRS had drafted guidance addressing both cell captives and "seriesLLCs." Series LLCs have nothing to do with captive insurance butpresent many of the same tax issues.

The IRS prefers to issue a single piece of guidance to addressboth, but may decide to issue the guidance on cells separately.(See 2009 Tax Notes Today 101-9.)

Meanwhile, captive owners should think about Small Tax-ExemptInsurance Companies–Section 501(c)(15) of the Internal RevenueCode, which provides a complete exemption from taxation for verysmall insurance companies.

Most captives do not qualify for this section, and it becameeven more difficult to qualify after a change in the law in2004.

However, it is often instructive to learn what the IRS saysabout these companies, because its approach is often applied tolarger captives.

Under the current statute, gross receipts of a tax-exemptproperty and casualty insurance captive (and its corporateaffiliates) cannot exceed $600,000, and more than 50 percent of thegross receipts must be premiums.

Prior to 2009, the IRS revoked many tax exemptions because thecaptives did not have valid insurance arrangements. In 2009, therewere also many revocations of exemptions, principally because thesenumerical tests were not met.

The IRS consistently has held that if a protective section831(b) election had also been made by an entity whose tax exemptionwas revoked, then the election would be treated as valid–but that aretroactive election cannot be made.

The IRS also has stated that if captives with revoked electionssubsequently meet the tests, then they "may be allowed to file theForm 990 for each year they qualify, as a self-declaredentity."

If the captive subsequently fails again to meet section501(c)(15), but had previously made a section 831(b) election, thenthe 831(b) election applies. (See private letter ruling 200903089,as well as PLR 200913069. Although a PLR may not be cited asprecedent, it does evidence IRS thinking.)

On the legislative front, President Barack Obama has railedagainst tax abuses using foreign entities, and Sen. Carl Levin,D-Mich., has often introduced legislation relating to foreigntransactions in general.

Rep. Richard Neal, D-Mass., introduced new legislation in Julythat would bar foreign-owned insurers from moving their excess U.S.earnings into "tax havens" through a reinsurance transaction withan affiliate. At this point nothing has passed, but this highlycontroversial topic bears watching. (See page 10 for more detailsabout the bill.)

Earlier this year, the U.S. Senate Finance Committee circulateda similar discussion draft, which drew vociferous comments fromboth proponents and opponents.

In the courts, there have been no 2009 cases that relate tocaptive insurance issues. One case did involve a tax-exemptinsurance company, but the issue addressed whether the captiveowned property that was sold and did not address the definition ofinsurance.

Charles J. (Chaz) Lavelle is an attorney inthe Louisville, Ky., office of Greenebaum Doll & McDonald PLLC.He served as outside tax counsel for both Humana and Ocean Drilling& Exploration Company in their U.S. Court of Appeals captiveinsurance victories.