Captive Insurance Taxation Generally
It will likely surprise many readers who are unfamiliar with captive insurance companies to learn that many captives do not seek to be treated as insurance companies for tax purposes. Many captives simply perform a pure insurance function within a given tax year, because they are insuring risks that are immediately resolved and paid within that year, and there is little necessity for the captive to carry over reserves into future years.
Yet, just as many, if not more, captive insurance companies are a fundamentally a product of tax -- not insurance -- law. The reason is that the U.S. Tax Code does not allow a business to internally take a current-year deduction for setting aside funds against current risks that might not fully mature into payable claims until future years. That same business, however, might be able to accomplish that needed result through the artifice of a captive. Which is to say that Congress could easily eliminate all captives that have qualified as insurance companies for tax purposes by simply allowing businesses to internally reserve against these claims. That Congress has not done so speaks volumes for the importance of captive insurance for businesses, in terms of their managing risks and acquiring insurance more efficiently by direct access to the reinsurance markets, thus eliminating the "middleman" commercial carriers.
From the inception of captive insurance companies taxed as insurance companies, the IRS waged a long battle against the very concept of captives, arguing what was then known as the "Economic Family Theory", which was to the effect that the captive arrangement simply allowed a business organization to shift money from one pocket to another pocket, generating a tax deduction to the business organization in the process, while ultimately not changing the economic position of shareholders. After the IRS lost its landmark case involving the United Parcel Service's captive, however, the IRS in 2001 (in Rev.Ruling 2001-31 which is reprinted in full below) finally abandoned its Economic Family Theory and conceded that certain tightly-defined captive arrangements could be proper, i.e., the captive could be an insurance company for tax purposes, and appropriate premium payments made to the captive could be deducted by the insured businesses. This ruling opened the floodgates for captives, and they quickly (within a decade) took over the corporate world, and began tricking down in their use to smaller, privately-held businesses.
This section looks at tax law generally as it applies to captives.
Revenue Ruling 2001-31, 2001-26 I.R.B. 1348 (6/25/2001)
Amplified by Rev. Rul. 2002-89
Amplified by Rev. Rul. 2002-90
Section 162 - Trade or Business Expenses
26 CFR 1.162-1: Business Expenses
(Also sections 118, 165, 301, 801, 831; 1.118-1, 1.165-1, 1.301-1)
This ruling explains that the Service will no longer raise the "economic family theory" set forth in Rev. Rul. 77-316 (1977-2 C.B. 53), in addressing whether captive insurance transactions constitute valid insurance. Rather, the Service will address captive insurance transactions on a case-by-case basis.
Rev. Rul. 2001-31
Recent abuses of IRC § 501(c)(15) companies have compelled the IRS to issue multiple Revenue Rulings, Procedures, Notices and Bulletins addressing various issues associated with the use of closely-held insurance companies. In addition, the IRS is closely scrutinizing companies organized pursuant to IRC § 501(c)(15). Recently issued IRS publications include:
In Rev. Rul. 77-316, 1977-2 C.B. 53, three situations were presented in which a taxpayer attempted to seek insurance coverage for itself and its operating subsidiaries through the taxpayer's wholly-owned captive insurance subsidiary. The ruling explained that the taxpayer, its non-insurance subsidiaries, and its captive insurance subsidiary represented one "economic family" for purposes of analyzing whether transactions involved sufficient risk shifting and risk distribution to constitute insurance for federal income tax purposes. See Helvering v. Le Gierse, 312 U.S. 531 (1941). The ruling concluded that the transactions were not insurance to the extent that risk was retained within that economic family. Therefore, the premiums paid by the taxpayer and its non-insurance subsidiaries to the captive insurer were not deductible..
No court, in addressing a captive insurance transaction, has fully accepted the economic family theory set forth in Rev. Rul. 77-316. See, e.g., Humana, Inc. v. Commissioner, 881 F.2d 247 (6th Cir. 1989); Clougherty Packing Co. v. Commissioner, 811 F.2d 1297 (9th Cir. 1987) (employing a balance sheet test, rather than the economic family theory, to conclude that transaction between parent and subsidiary was not insurance); Kidde Industries, Inc. v. United States, 40 Fed. Cl. 42 (1997). Accordingly, the Internal Revenue Service will no longer invoke the economic family theory with respect to captive insurance transactions.
The Service may, however, continue to challenge certain captive insurance transactions based on the facts and circumstances of each case. See, e.g., Malone & Hyde v. Commissioner, 62 F.3d 835 (6th Cir. 1995) (concluding that brother-sister transactions were not insurance because the taxpayer guaranteed the captive's performance and the captive was thinly capitalized and loosely regulated); Clougherty Packing Co. v. Commissioner (concluding that a transaction between parent and subsidiary was not insurance).
EFFECT ON OTHER DOCUMENTS
Rev. Rul. 77-316, 1977-2 C.B. 53; Rev. Rul. 78-277, 1978-2 C.B. 268; Rev. Rul. 88-72, 1988-2 C.B. 31; and Rev. Rul. 89-61, 1989-1 C.B. 75, are obsoleted.
Rev. Rul. 78-338, 1978-2 C.B. 107; Rev. Rul. 80-120, 1980-1 C.B. 41; Rev. Rul. 92-93, 1992-2 C.B. 45; and Rev. Proc. 2000-3, 2000-1 I.R.B. 103, are modified.
The principal author of this revenue ruling is Robert A. Martin of the Office of Associate Chief Counsel (Financial Institutions & Products). For further information regarding this revenue ruling, contact Mr. Martin at (202) 622-3970 (not a toll-free call).
Foreign Insurance Excise Tax - Audit Technique Guide, April 2008
NOTE: This document is not an official pronouncement of the law or the position of the Service and can not be used, cited, or relied upon as such. This guide is current through the publication date. Since changes may have occurred after the publication date that would affect the accuracy of this document, no guarantees are made concerning the technical accuracy after the publication date.
Chapter 6 - Captive Insurance Companies
In recent years, the use of captives, both domestic and foreign, has increased dramatically. This is due in part to the global economy. It is also due to corporations structuring transactions to utilize more favorable tax rates and capitalization requirements. Use of captives opens numerous issues which have ramifications not only for excise taxes, but for income taxes as well.
A captive insurance company is generally defined as a wholly owned insurance subsidiary. The purpose of a captive insurance company is to insure the risks of the parent and affiliated entities. Captives can either be formed as a domestic captive within the United States, or as a foreign captive in another country. When 100% of the insurance risk accepted by the captive is the risk of the parent entity the captive is called a ‘pure’ captive. Pure captives may not be treated as true insurance companies for purposes of income and excise taxes.
A captive can insure the risks of other entities within the affiliated group (i.e. brother/sister risks) and the risks of unrelated outside third parties. Once brother/sister risks and especially unrelated third party risks are accepted by the insurance subsidiary, there becomes a point where the insurance subsidiary can no longer be called a pure captive. At that point, depending upon the facts and circumstances of the case, namely the percentage of premiums received by the captive from affiliated entities and third party entities, the captive may not be treated as a true insurance company.
Reasons for Captives
The question is often asked why a corporation would go through the start-up costs and the capitalization expense to establish a captive insurance company. The answer depends upon the strategy of the parent corporation, which may include any of the following:
Captive Issues in General
The main issue for captives is whether the captive insurance entity is a valid insurance entity. This determination must be coordinated closely with the income and/or international agents assigned to the case. The determination has an effect on the income tax expense deduction for the insurance premiums expense paid from the parent and/or related entities to the captive.
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