Captive Insurance Busted by the IRS
April 30, 2015
While I still advocate for captive insurance in the right circumstance, one of the key elements of a captive insurance company is that it has to actually be a real insurance company. Real insurance companies have multiple policyholders and claims. Insurance companies take on risk (and then sometimes offload said risk by way of reinsurance). And barring really bizarre events, they make money from insurance premiums. When these things are not present, the odds of you winning an audit are not very good. Such is the case with an audit, a subsequent private letter ruling, which then served as the basis for a technical advice memo that the Service issued. Since this case did NOT go to the tax court, the impacted company was not published. If you have questions about how a captive insurance program can help your business or if you'd like to know about some of the risks, please drop us a line. The complete memo follows:
Taxpayer didn't qualify as insurance company where primary business wasn't insurance
In a redacted Technical Advice Memorandum (TAM), IRS has concluded that a corporation didn't qualify as an insurance company under Code Sec. 501(c)(15) for the years at issue because the majority of its business wasn't related to insurance and it failed to achieve adequate risk distribution during those years.
Background. Small nonlife insurance companies may qualify for tax exemption if they meet the requirements of Code Sec. 501(c)(15). Nonlife insurance companies (including interinsurers and reciprocal underwriters) may qualify for tax exemption if the company's gross receipts don't exceed $600,000, and 50% or more of those gross receipts consist of premiums. For nonlife mutual insurance companies, the requirements to qualify for tax exemption are less stringent—gross receipts cannot exceed $150,000 and 35% or more of those gross receipts must consist of premiums.
Neither the Code nor the regs define the terms “insurance” or “insurance contract.” The U.S. Supreme Court has said, however, that both risk shifting and risk distribution must be present for an arrangement to be treated as insurance. (Helvering v. LeGierse, (S Ct 1941) 25 AFTR 1181) IRS says that risk shifting occurs if a person facing the possibility of an economic loss transfers some or all of the financial consequences of the potential loss to the insurer, so that an actual loss won't affect the insured because the loss is offset by the insurance payment. Risk distribution allows the insurer to reduce the possibility that a single costly claim will exceed the amount taken in as premiums and set aside for the payment of such a claim. By assuming numerous relatively small, independent risks that occur randomly over time, the insurer smooths out losses to match more closely its receipt of premiums. (Clougherty Packing Co v. Com., (CA 9, 1987) 59 AFTR 2d 87-668, affg (1985) 84 TC 948) Risk distribution necessarily entails a pooling of premiums, so that a potential insured is not in significant part paying for its own risks. (Humana Inc v. Com., (CA 6, 1989) 64 AFTR 2d 89-5142)
Payments under “captive insurance” arrangements—i.e., ones where a corporate taxpayer places its insurance business with a corporate entity owned by or related to the taxpayer—aren't deductible where there's no true risk-shifting. Cases analyzing such arrangements have described the concept of insurance for federal income tax purposes as having the following three elements: (1) an insurance risk; (2) shifting and distributing of that risk; and (3) insurance in its commonly accepted sense. (Amerco Subsidiaries Inc v. Comm., (CA9 1992) 70 AFTR 2d 92-6048, affg (1991) 96 TC 18)
Rev Rul 2002-89, 2002-2 CB 984, and Rev Rul 2002-90, 2002-2 CB 984, provide that an arrangement between a domestic corporation and its wholly owned subsidiary won't constitute insurance if the parent accounts for 90% of the risk, but will be insurance if other insureds constitute more than 50% of the risk.
The courts have said that there may be sufficient risk distribution even if more than 50% of an insurer's business comes from a related party. In Harper Group & Includible Subsidiaries, (1991) 96 TC 45, affd (1992, CA9) 70 AFTR 2d 92-6053, the Tax Court held that where approximately 70% of the insurer's business came from related parties and approximately 30% from unrelated parties, there was a sufficient pool of insureds to provide risk distribution.
In Rev Rul 2005-40, 2005-2 CB 4, IRS concluded that an arrangement under which an issuer contracts to indemnify the risks of a single policyholder did not qualify as insurance for federal income tax purposes because those risks were not, in turn, distributed among other insureds or policyholders.
Facts. Taxpayer applied for and was granted tax-exempt status under Code Sec. 501(c)(15). Taxpayer, by common ownership and/or control, has interests in a group of businesses that include Companies F, G, H, L, and K (collectively, the “Companies”). Companies except L, are located at the same address/location as Taxpayer; however, Taxpayer's director, D, is one of L's directors and a minority owner.
Under Taxpayer's business plan, 50% or more of Taxpayer's business will consist of providing insurance services to the Companies. The remaining balance of Taxpayer's business will consist of reinsurance business of unrelated, licensed insurance companies. Taxpayer would cover risks not covered by traditional insurance companies.
Taxpayer offered policies covering “administrative actions” which indemnified insureds for a broad variety of actions, including disciplinary proceedings or governmental actions taken against the insured pertaining to the business, trade or profession of the insured. Disciplinary proceedings included any professional review action against the insured by a voluntary or mandatory trade association or professional organization with which the insured had privileges, membership or any similar association, which action had the potential to affect adversely said privileges, membership, or association. In addition, it offered policies covering “employment practices liability”; such policies included severance pay insurance coverage, i.e., coverage of an event that causes a liability pertaining to the business, trade or profession of the insured resulting from the termination of an employee and the granting of a severance package in accordance with the business, trade or profession of the insured. Taxpayer also offered policies on special risk/medical and commercial excess liability.
Taxpayer concluded that no reserves were necessary for unpaid losses whenever a contract period closed with no open-ended claims. Consistent with its business plan, Taxpayer expected numbers of claims to be low and dealt with claims on an ad hoc basis. Because Taxpayer deemed itself financially able to meets its claim obligations, Taxpayer neither reinsured its direct-written policies nor limited its losses through guarantees, indemnification, or hold harmless agreements.
Taxpayer's insurance activity for tax years Year 3 and 4 was almost identical in terms of number of insureds, types of coverage, and percentage of risk allocation among insureds. For Year 3, Taxpayer's premium revenue was 1.36% of Taxpayer's aggregate revenue, and net gain from sale of non-inventory assets was 95.3% of Taxpayer's aggregate revenue. For Year 4, Taxpayer's premium revenue was 1.41% of Taxpayer's aggregate revenue, and net gain from sale of non-inventory assets was 93.24% of Taxpayer's aggregate revenue. For Year 5, Taxpayer's premium revenue was 24% of Taxpayer's aggregate revenue, net gain from non-securities sales was 18.67%, and revenue from other investments was 58.26%.
IRS audited Taxpayer's Year 3, 4, and 5 tax years and concluded that it should revoke Taxpayer's tax-exempt status retroactively to include the tax years Year 3, 4, and 5.
TAM's conclusion. In the TAM, IRS determined that Taxpayer wasn't an insurance company exempt from tax under Code Sec. 501(c)(15) for Year 3, 4 and 5. IRS said that the principal concern with Taxpayer's activities was whether Taxpayer's primary and predominant business during each of the tax years was insurance as required. Of Taxpayer's total business for the tax Year 3, 4 and 5, only 1.36%, 1.41% and 24%, respectively, were related to its purported insurance activities. Thus, it was clear that the majority of Taxpayer's business for the tax years at issue was related to business other than insurance and, so, Taxpayer didn't qualify as an insurance company for these years.
As for risk distribution, IRS noted that the various risks “insured” during Year 3 and 4 were not homogeneous and thus had to be separated from one another and analyzed separately as to whether there was risk distribution as to each risk. It appeared that Taxpayer did not sufficiently distribute its risk among each type of coverage, i.e. Taxpayer maintained one administrative actions policy, one employment practices liability policy, and a pro-rata share of special risks/medical coverage. Accordingly, Taxpayer failed to adequately distribute its risk. There appeared to be too much concentration of risk among its insureds and “reinsurance” arrangement.
Taxpayer failed to achieve adequate risk distribution in Year 5 because it had an insufficient number of insureds in which risk was too concentrated. There was also insufficient distribution in Year 5 with respect to the coverage for administrative actions and employment practices liability.
IRS rejected Taxpayer's reliance on Harper Group to support of its argument that it qualified as an insurance company for the years at issue. IRS noted that, unlike in Taxpayer's case, in Harper Group, there were 13 entities making up nearly two-thirds of the risk concentration in all of the years at issue. Harper Group could also be distinguished on the basis that the risks involved in Harper Group were diverse and widespread—an extensive variety of cargo shipments throughout the world via a variety of means and vessels; the various risks insured were homogeneous and numerous such that risk distribution was accomplished with respect to each separate risk.
In the TAM, IRS also noted that an arrangement that provides for the reimbursement of believed-to-be inevitable future cost doesn't involve the requisite insurance risk for purposes of determining whether the assuming entity may account for the arrangement as an “insurance contract.” Business risks (such as investment-type or market risk that are part of the business environment) aren't insurable. In Taxpayer's case, it paid claims in payment for “EPA clean-up” associated with two real estate properties—a claim that was questionable and appeared to be a business cost for real estate development ventures. If such was so, the “risk” wasn't fortuitous and wasn't an expense for which the requisite insurance risk existed.