Captive Insurance Update

Captive insurance arrangements insure risks within a group of related companies. A captive insurance company functions as an alternative to purchasing an insurance policy from an outside insurer. Having a related insurance company assume the function of an outside insurer can be an efficient way of managing risk within a group. Group members pay premiums to the related insurance company as consideration for assuming their risks.

The IRS has been skeptical of captive insurance arrangements, believing they were designed solely to take advantage of more favorable timing rules or to shift taxable income to companies that paid little or no tax in the U.S. Because of the Service's attitude toward captive insurance, some companies have hesitated to use captive insurance companies. This June, there were two favorable developments that may decrease the associated risk.

First, in Rev. Rul. 2001-31, the IRS formally announced that it would no longer use the "economic family" theory to attack captive insurance arrangements. The Service first articulated this theory almost 25 years ago in Rev. Rul. 77-316. Under this theory, captive insurance arrangements did not qualify as true insurance, because a group of related companies should be treated as a single economic unit. Viewing a group of companies as a single economic unit meant that there was no shifting of risk or distribution of risk—two of the primary requirements for insurance. The IRS asserted this theory in litigating captive insurance cases, but met only with limited success at best.

In Rev. Rul. 2001-31, the Service acknowledged that no court had ever fully accepted the economic-family theory. It stated that it would no longer invoke this theory in attacking captive insurance arrangements. However, it may continue to challenge specific captive insurance arrangements based on their facts and circumstances in a particular case. For example, a captive insurance company that was thinly capitalized or somehow propped up by its parent company could still be vulnerable to attack.

The second development, United Parcel Service of America (UPS), 254 F3d 1014 (11th Cir. 2001), rev'g TC Memo 1999-268, involved an insurance arrangement established by UPS. UPS had restructured its business to shift income from its profitable package insurance business to a former subsidiary. Before the restructuring, UPS had self-insured its "excess value" coverage. It sold excess-value coverage to customers who needed package insurance above the $100 of coverage that UPS automatically provided on every package. For every $100 of excess-value coverage, UPS collected 25 cents from a customer. The insurance was highly profitable, because it cost UPS only a few cents to provide every $100 of coverage.

As a first step in restructuring, UPS formed a Bermuda subsidiary and spun it off by making a taxable stock dividend to its shareholders. Subsequently, UPS entered into an insurance agreement with an outside insurer. It paid the outside insurer the excess-value charges UPS collected from its customers, in exchange for assuming the risks of the excess-value coverage. Because the excess-value coverage was so highly profitable, it was unlikely that the insurer would ever have any real risks or that UPS would have paid such high premiums for insurance coverage. The outside insurer then entered into a reinsurance agreement with the former UPS subsidiary. Under the reinsurance agreement, the former subsidiary received practically all of the excess-value charges that the outside insurer received (less an amount retained by the insurer as its fee). UPS continued to administer all of the claims and paperwork associated with the excess-value coverage.

The Tax Court determined that the insurance restructuring had no purpose other than tax avoidance and that it lacked economic substance. The court rejected the nontax business purposes UPS had asserted and found that the transaction was not conducted at arm's length. As a result, it disallowed the deductions UPS had claimed for the payment of insurance premiums and also imposed substantial penalties.

The Eleventh Circuit overturned the Tax Court's ruling, finding that the transaction had economic substance and a bona fide business purpose. The court believed that the creation of genuine, legally enforceable obligations with a third party meant that the transaction had economic substance. The outside insurer had assumed a real obligation under the insurance contract, even if its risk was slim. Further, the court emphasized that the former Bermuda subsidiary was an independent taxable entity not under UPS's control. Finally, the transaction had a sufficient business purpose, because it involved an existing business. However, the court's conclusion did not mean that UPS was entitled to the entire amount it had claimed as a deduction. The court remanded the case back to the Tax Court for a determination as to whether the premiums should be reallocated under Sec. 482 or 845 (which provides allocation rules for reinsurance transactions).

Given recent developments, taxpayers may have more flexibility in structuring captive insurance arrangements. After Rev. Rul. 2001-31 and UPS, the Service has fewer avenues for attack. Nonetheless, it may be able to reallocate income under Secs. 482 and 845, and it could still argue that a captive insurance company should be disregarded as a sham in certain circumstances. Also, it is unclear whether another court would have been as willing to approve of a captive insurance arrangement as the Eleventh Circuit in UPS.

From Helen S. Yanchisin, J.D., Washington, DC