Captive Insurers Urged To Accept IRS Invitation For Input On Key Tax Issues

o Arrangements involving product warranties.

o "Other" areas.

Two years ago, in Notice 2005-49, the IRS solicited industry comments on the effect of taxation in four specific situations–loan-backs, homogeneity, cell captives and finite insurance–as covered in National Underwriter's Sept. 5, 2005 edition.

The IRS is to be commended for asking taxpayers where guidance is needed. By allowing the industry to address "other" areas, in fact, the IRS has extended a broad invitation for guidance. And while the IRS request is not limited to captive insurance companies, it certainly applies to them.

The IRS request can be found at the end of Rev. Rul. 2007-47. This involved a corporation (X) that conducted a business inherently harmful to both people and property.

When X ceased business at a location, it was legally obligated to clean up the location. While the amount and timing of the cleanup was uncertain, there was no doubt that the cleanup costs would be incurred. The estimated present value of the cleanup was $150,000, so the company purchased a "policy" from an unrelated insurance company for that amount.

The policy obligated the insurer to clean up the property at any time in the future that the company was legally required to do so, unless the costs reached the policy's limit of $300,000.

The ruling declares that insurance requires risk shifting and risk distribution, but focuses on whether the risk involved was an insurance risk, rather than an investment or business risk.

The ruling states that an insurance risk must be a "fortuitous occurrence of a stated contingency," and that there must be a risk of economic loss.

The ruling concludes that there is no insurance in this case, because the cleanup costs are not an insurance risk. In other words, the risks are not "fortuitous," because there is no doubt that they will be incurred.

The IRS viewed the arrangement as merely a pre-funding of unavoidable future obligations. The ruling further concludes that the overall risk is whether the future value of the $150,000 premium will exceed the cleanup costs (limited by the $300,000 policy limits).

The ruling listed the following risks that were involved in the situation:

o The scope of the cleanup.

o Inflation in labor and materials costs.

o The time frame over which the cleanup would occur.

o The insurance company's earnings rate.

The ruling, however, determined that these risks did not constitute an insurance risk.

Rev. Rul. 2007-47 views the risk involved there as similar to the timing and investment risks in Rev. Rul. 89-96, which also found that insurance did not exist.

In Rev. Rul. 89-96 (said to be modeled after the MGM Hotel fire situation), the insured suffered a catastrophic loss that far exceeded its $30 million limits. After the fire, the insured bought retroactive insurance for the layer between $30 million and $130 million.

Because the expected losses far exceeded $130 million, Rev. Rul. 89-96 concludes that the risk was an investment risk, not an insurance risk, so that the policy did not qualify as insurance for federal tax purposes.

How about the context in which comments are invited?

In 2001, the IRS stated that proper captive insurance arrangements would be respected for federal tax purposes. This reversed 24 years of the IRS officially asserting that captive insurance could never be respected (other than group captives).

The IRS issued three Revenue Rulings in 2002, and one each in 2005 and 2007 addressing several scenarios. Since 2001, the IRS also has issued many informal rulings and advices.

From these documents, audit issues and informal discussions, it appears that hot topics include what constitutes an insurance risk, risk distribution and the effect of loanbacks.

Rev. Rul. 2007-47 explicitly states that it does not apply to the situations listed earlier in this article (for example, reinsurance, retroactive insurance, loss-portfolio transfers, environmental, cost overruns and warranties), but states that the IRS may apply the authorities cited in the ruling to such situations.

As stated above, Rev. Rul. 2007-47 invites taxpayers to advise the IRS if comments are needed in those or "other" areas.

Despite the fact that no specific guidance has been issued in response to the industry comments to Notice 2005-49 (covering loan-backs, cells, homogeneity and finite insurance), the industry should seriously consider whether and how to respond to this request. (See the accompanying information box.) It may be very helpful to the industry to do so.