Tax Challenges Remain For Captive Entities

Also in 2009, expect more activity in the areas of whether a risk is an insurance risk or a business risk (for example, the IRS thinks an imbedded warranty is a business risk, but an extended warranty is an insurance risk), homogeneity (discussed below) and additional scrutiny of Section 501(c)(15) (very small tax-exempt) captives.

The areas of activity in 2008 included proposed consolidated return regulations, a determination of who is the insured, cell taxation, a cascading excise tax, tax-exempt status revocations, pooling and homogeneity.

o Proposed Consolidated Return Regulations Withdrawn.

In late September 2007, the Treasury Department proposed regulations that would have effectively put captives in a consolidated return on a cash basis for deductibility of losses, eliminating the tax benefits for most public companies. This was important to nonpublic companies because of the belief that if the IRS would take on the largest companies, it wouldn't hesitate to take on the smaller ones as well.

However, as a result of an outcry by the captive industry, state and federal legislators, technical analysis, policy arguments and lobbying, the proposed regulations were withdrawn in February 2008. (See NU, "IRS Captive Proposal Blindsides Industry," Oct. 22, 2007; "Top Captive Groups Unite to Fight IRS Tax Proposal," Nov. 19, 2007; "Captives Fight to Derail IRS Tax Proposal," Jan. 21, 2008; and "IRS Drops Proposed Change in Captive Tax," Feb. 25, 2008.)

o Identity of Insured in LLCs and Limited Partnerships.

The IRS requires that a captive insure many insureds for there to be "insurance" for tax purposes. Accordingly, it is important to determine who is an insured.

Unrelated to captive insurance, a single-member LLC is usually disregarded for income tax purposes, unless the LLC elects to be taxed as a corporation. This means that the LLC's operations are reported as if conducted by the owner.

Relying on this, the IRS previously ruled that a disregarded LLC is not the insured–the owner is. For example, suppose a real estate developer has a dozen projects, with each project in its own LLC; assume further that each LLC insures with a captive. The IRS view is that the owner, not the dozen LLCs, is the only insured.

In "Technical Advice Memorandum 200816029," the IRS ruled that a multimember LLC, and not its owners, is the insured. Also, in a limited partnership, each general partner is the insured, rather than the limited partnership or the limited partner(s). (See NU, "IRS Finally Answers The Big Question: Who Counts As An Insured For Tax Purposes?" July 7/14, 2008.)

o Cell Taxation.

In 2008, the IRS addressed cell company taxation by focusing on a situation where the core capital is not liable for the obligations of the cells. Under Rev. Rul. 2008-8, insurance is tested on a cell-by-cell basis.

For example, there must be enough risk distribution–such as entities and/or third-party business–within a cell. The cell also cannot rely on the unrelated owners and insureds in the other cells to supply risk distribution.

If the transaction is insurance, the premiums paid are deductible. In Notice 2008-19, the IRS proposed (to be finalized later) that each cell will be treated as its own insurance company and can make its own elections, such as whether to be taxed as a U.S. taxpayer under section 953(d)). (See NU, "IRS To Reassess Cell-Captive Taxation," Feb. 11, 2008.)

o Cascading Excise Taxes.

There is an excise tax placed on premiums paid to most foreign insurance companies on U.S. risks. In Rev. Rul. 2008-15, the IRS said that excise tax is due on each successive reinsurance of such U.S. risks to successive foreign reinsurer(s).

In Announcement 2008-18, the IRS offered an amnesty for prior periods for those companies that began complying by Oct. 1, 2008.

The IRS issued the "Insurance Excise Tax Audit Technique Guide" in September 2008, which is guidance to IRS auditors. The guide also contains a chapter on captive insurance. (In an unrelated excise tax item, the IRS internally determined that a contractual pool was a separate foreign insurance company–thus the pooled premiums on U.S. risks were subject to excise tax.)

o Section 501(c)(15) Captive Tax Exemption Revocations.

This section of the IRS Code provides for a complete exemption from income tax for very small insurance companies. Several audits have revoked 501(c)(15) exemptions.

In addition to the issues primarily relevant to Section 501(c)(15) (mathematical tests and excessive investments), many of the revocations raised issues that can be used against other captives. These include no employees or time devoted to the insurance business, soliciting business, or products; capital and efforts not used to conduct insurance; no claims; minimal reserves; no risk distribution; not run properly; or lack of risk homogeneity.

o Pooling.

Late in 2008 and early in 2009, the IRS upheld two pooling arrangements–one "ground up" and the other where the lower-limit insurance was pooled and the higher-limit insurance was reinsured directly with the captive.

o Homogeneity.

In 2005, the IRS queried the industry about the importance of all risks being homogenous–for example, must all related and unrelated risks be general liability risks, or may related risks be general liability risks, and unrelated risks be workers' compensation exposures?

The industry responded that heterogeneity was often better than, and no worse than, homogeneity. In "ILM 200849013," the IRS National Office refused to take a formal position on homogeneity and deferred to IRS auditors to determine if homogeneity had an impact on whether insurance was present in an arrangement.

So while 2008 began on a tremendous note with the withdrawal of proposed regulations determining tax benefits, 2009 may also clarify the taxation of captives, but not in such high-profile areas.