The Internal Revenue Service recently issued a long-awaited answer to the debated question–"Who counts as an insured?"–in two captive insurance arrangements.
The IRS declared that in a limited partnership, the general partner is the insured, while in a multimember limited liability company, the LLC is the insured. If there is more than one general partner, each is an insured.
Notwithstanding that the document (TAM–Technical Advice Memorandum–200816029) may not be cited as precedent, this clarity will assist both the IRS and taxpayers in determining if a policy is "insurance" for federal income tax purposes.
The IRS previously had issued a Revenue Ruling (an official position) that there must be multiple insureds to have a valid insurance arrangement.
While many in the industry believe insurance can exist even with just one insured, few will create an arrangement directly contrary to a Revenue Ruling. Accordingly, determining the number and identity of the insureds is critical.
The IRS and the courts previously had determined that for an arrangement to be deemed "insurance" for federal income tax purposes, there must be risk-shifting and risk distribution.
Risk distribution requires a pooling of premiums and sufficient exposure units so that the law of large numbers–or averages–works.
Earlier rulings state that not only must there be enough exposure units, but there must be multiple insureds.
The prior IRS rulings and the court cases have almost exclusively dealt with the insurance of "C" corporations–corporations that pay tax themselves, and do not "pass through" their income to their owners. For IRS purposes, a "C" corporation is the insured and the owner is not an insured.
However, business is increasingly being conducted not through C corporations, but more often through limited liability companies. Moreover, historically, real estate investments have often been conducted in limited partnerships. Accordingly, it is critical to know who counts as an insured when these entities buy insurance from a captive.
In Revenue Ruling 2005-40, the IRS ruled that if the taxpayer had elected to tax the LLC as a corporation, then the LLC is the insured. However, the IRS also ruled that if the LLC is disregarded for income tax purposes, it will also be disregarded as an insured and the owner will be the insured.
Many in the industry believe this is wrong because, like a corporation, an LLC has limited liability and the owners are not liable for its debts. Accordingly, like a shareholder, the owner of an LLC is never at risk for the losses of the LLC.
Revenue Ruling 2005-40 provided the IRS' view on single-member LLCs, but until recently the IRS view on multimember LLCs or on limited partnerships was not known.
Getting the IRS view on these entities in TAM 200816029 is important because these types of entities purchase substantial insurance from captive insurance companies.
In particular, closely held multi-owner businesses often use multimember LLCs.
A TAM arises during an audit when the IRS auditor or the taxpayer asks the IRS National Office to rule on a specific fact situation.
What's more, TAM 200816029 answers the question of who counts as an insured in a multimember LLC and limited partnership.
A multimember LLC can elect to be treated either as a corporation or a partnership, but unlike a single-member LLC, it cannot elect to be disregarded.
The TAM determined that the LLC is the insured (and the owners are not insureds) because the LLC is the one that bears the loss. This assumes–as is generally the case in LLCs–that no member is liable for the LLC's liabilities in the same way a general partner would be.
The TAM does not address why the IRS apparently still clings to its view that the owner of a single-member LLC (and not the LLC itself) is the insured, but the LLC itself (and not the owners) is the insured in a multimember LLC.
A limited partnership is composed of limited partners who have no liability for the liabilities of the partnership, and one or more general partners who have unlimited liability for the liabilities of the partnership.
The TAM concludes that because of the unlimited liability, the general partner(s) is the one(s) at risk. Accordingly, the risk transferred under the insurance policy is that of the general partner(s), and the general partner(s) is (are) the insured(s).
In reaching this conclusion, the TAM considered, but rejected, whether the limited partners (who, for example, might enjoy 99 percent of the profits and bear 99 percent of the losses) should be treated as insured(s).
The TAM deals with a specific set of facts, but it appears that the IRS National Office set forth an analysis it believes applies to all situations.
Some have wondered if there would be a different answer if a real estate limited partnership had a huge non-recourse debt and the property was insured–in that case the general partner would not be at risk on the debt. The TAM did not address this situation.
Others have wondered if the answer would be different if the limited partnership had substantial net worth, so that it was unlikely the general partner would have to pay any debts.
The TAM rejected any consideration of the limited partnership's net worth. The TAM states there is no way to predict if such a partnership would still be liquid and solvent at the time of a loss, which is the relevant time; nor is there any way to predict the size or frequency of losses.
Although some might have anticipated a different answer (and might take contrary views), this TAM provides guidance for the IRS and the taxpayer to evaluate insurance.
The TAM does not address S corporations. Presumably, the S corporation, and not its owner or owners, would be treated as the insured.
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