Using Captives to Manage Risk

A captive insurance arrangement is an alternative risk management mechanism that has become popular in todays business environment for managing certain risks as part of a companys (or group of companies) overall risk management program. Captives typically have been used to fund property and casualty insurance coverage, such as general liability, products liability and workers compensation. Depending on the business reason for using captives, their tax implications vary.

Domestic Tax Benefits

Premium deductions: Insurance premiums (which qualify as insurance for Federal tax purposes) paid by policyholders to a captive are deductible as ordinary and necessary business expenses under Sec. 162(a). In contrast, reserves set aside for self-insuring certain risks are not deductible; see Spring Canyon Coal Co., 13 BTA 189 (1928), affd, 43 F2d 78 (10th Cir. 1930), and Pan-American Hide Co., 1 BTA 1249 (1925).

Insurance company tax rules: Captives (which qualify as insurance companies for Federal tax purposes) are taxed as insurance companies. Thus, they can take advantage of certain Code provisions specifically targeted to insurance companies. Examples include the captives being able to:

• Recognize premium income as it is earned, rather than when paid, under Sec. 832(b)(4);

• Deduct accrued losses in a manner unavailable to other taxpayers (due to the Sec. 461(h) all events test), by deducting currently an estimate of losses incurred and future expenditures needed to settle such losses, under Sec. 832(b)(5) (rather than deducting when paid);

• Elect to be taxed only on investment income under Sec. 831(b), if net written premiums (or if greater, direct written premiums) for the tax year do not exceed $1.2 million (as revised by the Pension Funding Equity Act of 2004 (PFEA)); and

• Qualify for tax-exempt status under Sec. 501(c)(15) if gross receipts for the tax year do not exceed $600,000, more than 50% of which are derived from premiums (rather than investment income); see PFEA Section 206.

State taxes: Captives generally are not subject to state income taxes, but instead pay state premium taxes. This may result in permanent tax savings on income-producing assets held within the captive.

Requirements

To take advantage of these tax benefits, a captive must satisfy two primary requirements: (1) a valid insurance arrangement must exist between the captive and its policyholders (2) and the captive must be an insurance company for Federal tax purposes.

Over the years, courts have examined a number of factors that, when present, should help support the second requirement, including:

• A valid business purpose (nontax) exists for forming the captive;

• Insurance risk is present, not merely investment risk;

• The contractual arrangement involves risk shifting;

• The captive insures sufficient independent risks to support the risk distribution requirement;

• The absence of any parental guarantees or hold-harmless agreements;

• The captive meets statutory capital surplus requirements in its jurisdiction of incorporation;

• The captive is subject to regulation and licensure;

• The captive is adequately capitalized;

• The captive deals with its policyholders on an arms-length and standard commercial basis; and

• The policies are insurance contracts as commonly understood in the industry.

Besides having a valid insurance arrangement, the captive must be an insurance company for Federal tax purposes. The term insurance company, as defined by PFEA Section 206(c), means any company more than 50% of the business of which during the tax year is the issuing of insurance or annuity contracts or the reinsuring of risks underwritten by insurance companies.

Issues and Recent Guidance

According to the IRS, two principal issues found in captive insurance cases are the deductibility of (1) premiums paid by a parent to a captive subsidiary and (2) payments paid by one subsidiary to a captive within the group;  see Internal Revenue Manual 4.43.1.5.7. To help reduce the uncertainties associated with using a captive, the Service has issued general safe harbor rulings and provided the possibility of advance rulings for those taxpayers that cannot meet those safe harbors (Rev. Proc. 2002-75).

In Rev. Rul. 2002-89, the IRS held that an insurance arrangement between a parent and its wholly owned subsidiary captive will be treated as insurance if more than 50% of the risks the captive insures are those of persons unrelated to the parent and captive, and if more than 50% of the total premiums (on both a gross and net basis) are attributable to such unrelated persons. However, when only 10% of the risks insured by the captive are those of persons unrelated to the parent and captive, the arrangement will not constitute insurance (Rev. Rul. 2002-89).

In Rev. Rul. 2002-90, the Service held that a brother-sister captive would be treated as insurance, despite the absence of risks of unrelated parties being insured by the captive. It found that each of the 12 subsidiaries risks, which represented a significant amount of independent risks, was sufficiently distributed, as the liability to any one of the subsidiaries accounted for no more than 15%, and no less than 5%, of the total risks. Accordingly, premiums the subsidiaries paid to the captive would be deductible.

Finally, in Letter Ruling (TAM) 200323026, the IRS held that certain captives were not insurance companies, as a result of the (1) captives inadequate capitalization, (2) informality between the contracting parties, (3) presence of parental guarantees and (4) lack of risk distribution and concentration of risk.

Observations

Increasingly, noninsurance businesses are using captives to manage certain risks as part of their overall risk management programs. In knowing the nontax advantages and disadvantages associated with captives, tax practitioners will be able to articulate the basic domestic tax benefits and to discuss the significant issues that IRS agents might pursue in an examination.

The intent of this item was to introduce tax advisers to the domestic tax benefits of using a captive. However, it did not address many important tax and nontax issues. In particular, practitioners would need to analyze choice of captive domicile, a feasibility analysis, captive development and implementation, and disclosure requirements and international taxation, before rendering advice to a particular company on its prospects for successfully implementing a captive.

From Clinton N. McGrath, Jr., CPA, J.D., LL.M., Washington, DC