Will Rev. Rul. 2014-15 Expand the Use of Captive Insurance Companies? 

    TAX CLINIC 
    by Anthony S. Bakale, CPA, MT, and Raymond Polantz, CPA, MT, Cleveland 
    Published August 01, 2014

    Editor: Anthony S. Bakale, CPA, M.Tax

    Employee Benefits & Pensions

    On May 9, the IRS issued Rev. Rul. 2014-15, which analyzes an economic arrangement to determine whether it constitutes insurance. The proper characterization of an arrangement may determine whether the issuer qualifies as an insurance company for federal income tax purposes and when amounts paid under such an arrangement are deductible. This ruling is significant because rising health care costs are causing many companies to strongly consider self-insured medical plans using captive insurance companies.

    Facts

    A domestic corporation provided health care benefits to a large group of retired employees and their dependents through a voluntary employees' beneficiary association (VEBA). The corporation made contributions to the VEBA to insure the costs of the health benefits, and these contributions were deducted in accordance with Secs. 419 and 419A. Neither the corporation nor the VEBA was legally obligated to provide these benefits and could cancel coverage at any time.

    The VEBA entered into an insurance contract with an unrelated insurance company to cover the cost of providing these benefits. The contract provided that the insurance company would reimburse the VEBA quarterly for payments it made related to claims made by the covered retirees. The unrelated insurance company was taxable as a life insurance company under Sec. 801 and was regulated by the relevant state insurance commissioner. In an effort to keep contract premiums affordable, the insurance company entered into a reinsurance contract with a wholly owned subsidiary of the domestic corporation (a captive insurance company). The subsidiary was regulated under state law as an insurance company, and the reinsurance contract was regulated as insurance. The subsidiary was paid premiums by the insurance company and, in turn, reinsured 100% of the insurance company's liability under the contract with the VEBA.

    Premium payments were considered made on an arm's-length basis in accordance with applicable insurance industry standards. The subsidiary maintained adequate capital to fulfill its obligations under the contract. Neither the former employer nor the VEBA was required to reimburse the subsidiary for its obligations under the reinsurance contract. The subsidiary was not required to loan any premium payments back to the VEBA or to the former employer. In all respects, the parties conducted themselves consistently with an insurance arrangement between unrelated parties.

    Law

    Neither the Code nor the regulations define the terms "insurance" or "insurance contract." Therefore, taxpayers must rely on court precedent, legislative history, and IRS rulings to determine whether an arrangement constitutes insurance for federal income tax purposes. In Helvering v. Le Gierse, 312 U.S. 531 (1941), the Supreme Court provided that for an arrangement to constitute insurance, both risk shifting and risk distribution must be present.

    In Clougherty Packing Co., 811 F.2d 1297 (9th Cir. 1987), the Ninth Circuit further defined this concept, providing that risk shifting occurs if a person, facing the possibility of economic loss, transfers some or all of the financial consequences of the potential loss to an insurer, such that a loss by the insured does not affect the insured because the loss is offset by a payment from the insurer. Risk distribution incorporates the statistical phenomenon known as the "law of large numbers." Risk distribution allows the insurer to reduce the possibility that a single costly claim will exceed the amount of premiums collected and set aside for claim payments. By assuming numerous, relatively small, independent risks that occur randomly over time, the insurer balances its payment obligations with its receipt of premium income.

    The IRS has issued many rulings over the years addressing whether economic arrangements constitute insurance. Two rulings issued in 2002 (Rev. Ruls. 2002-89 and 2002-90) have long been considered the standard for whether particular arrangements or business activities constitute insurance. These two rulings provide guidance on the risk shifting and spreading required to achieve insurance.

    Rev. Rul. 2002-89 held that an arrangement between a parent and its subsidiary would constitute insurance if more than 50% of the premiums received by the subsidiary came from unrelated parties. In Rev. Rul. 2002-90, the IRS held that an arrangement in which a captive insurance company insured the risks of 12 of the parent's operating units created adequate spreading of risk and therefore constituted insurance.

    Risk distribution necessarily entails pooling premiums so that a potential insured is not in significant part paying for its own risks. Rev. Rul. 2005-40 provides that an arrangement under which an issuer contracts to indemnify the risks of a single policyholder does not qualify as insurance for federal income tax purposes because those risks are not, in turn, distributed among other policyholders.

    Overall Impact

    In Rev. Rul. 2014-15, the IRS emphasized the need to consider all the facts and circumstances in determining whether an arrangement constitutes insurance, including whether the risks are shifted and distributed. In this ruling, the risks being indemnified were the covered retirees' and their dependents' risks of incurring medical expenses due to accident and health insurance contingencies. Neither the VEBA nor the former employer had a legal commitment to provide such insurance, and either could cancel the coverage at any time. The IRS concluded that the risks being shifted were the risks of the insured retirees and not those of the former employer or related VEBA. The risks were distributed among the large group of covered individuals, so the analyses of Rev. Rul. 2002-89 and Rev. Rul. 2005-40 were not applicable. Accordingly, the risks associated with the contract between the unrelated insurance company and the former employer's captive insurance company were insurance risks, and this contract constituted insurance for federal income tax purposes.

    The importance of attaining the classification of an insurance company relates to the timing of the deduction for a self-insured taxpayer. When a taxpayer decides to self-insure, timing differences can occur between when an expense is recorded for book purposes versus when that expense is deductible for tax purposes. This is prevalent in self-insured health plans because covered employees who have already met their annual deductible will often "bunch" health care costs at the end of the year-before the start of the next year when their deductibles will reset. This creates a category of expenses generally known as "incurred but not reported" (IBNR) claims. Under GAAP, IBNR claims must be reserved for in the year the expenses are incurred, even though the corresponding tax deduction is deferred to the year paid (usually the following year). (For a more comprehensive discussion of this issue, see General Dynamics Corp., 481 U.S. 239 (1987), where the taxpayer was denied a deduction for health care costs incurred by employees during the current tax year but not reported and paid until the subsequent year.)

    By entering into an arrangement similar to the one described in Rev. Rul. 2014-15, an employer providing medical benefits to its employees should be able to deduct most (if not all) of the premium payments made to its captive insurance company. Although the company will recognize income as the premiums are received, it can deduct its required reserves, which include the IBNR liability in most cases, thereby avoiding the deduction timing issue described above. (The definition and calculation of "life insurance company taxable income" is beyond the scope of this item.)

    Taxpayers who wish to self-insure for employee health care costs by using a captive insurance company should pay particularly close attention to this ruling. The determination of whether an arrangement is considered an insurance contract will be based on all of the facts and circumstances. The taxpayer's fact pattern needs to adhere to the major provision of this ruling: The risks that are shifted should be those of the covered employees and not risks of the employer or a related VEBA. In addition, the taxpayer's captive insurance company must be regulated under state law, its insurance contract must be a regulated contract, and premiums must be at arm's-length rates. The guidance provided by this ruling may expand taxpayers' use of captive insurance companies by clarifying the critical concepts of risk shifting and risk distribution.

    EditorNotes

    Anthony Bakale is with Cohen & Co. Ltd., Cleveland.

    For additional information about these items, contact Mr. Bakale at 216-774-1147 or tbakale@cohencpa.com.

    Unless otherwise noted, contributors are members of or associated with Cohen & Co. Ltd.




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