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IRS Captive Insurance Tax Rulings - IRS Safe Harbor Rulings for Captive Insurance

An Overview of IRS Captive Insurance Revenue Rulings

On December  30, 2002 the US Internal Revenue Service (IRS) issued three revenue rulings and a new revenue procedure in Internal Revenue Bulletin 2002-52. Specifically, the three revenue rulings were (Rev. Rule. 2002-89, Rev. Rule 2002-90 and Rev. Rule 2002-91) and the new revenue procedure was (Rev. Proc. 2002-75).   These rulings came more than a year after Rev. Rul. 2001-31 declared obsolete both Rev. Rul. 77-316, 1977-2 CB 52, which, in general, sought to deny deductions for premiums between affiliated entities (both parent entities and operating affiliates) and captives, and Rev. Rul. 88-72 which, in general, sought to disregard the presence of unrelated business in determining whether premium paid for related risk was deductible.  

On July 5, 2005,  the US Internal Revenue Service issued Revenue Rule 2005-40 in Internal Revenue Bulletin No. 2005-27.

On July 23, 2007, the US Internal Revenue Service issued  Revenue Rule 2007-47  in  Internal Revenue Bulletin No. 2007-30 .

Set forth below is a brief discussion of these revenue rulings and procedures.

Rev. Rul. 2002-89( Parent Premium Deductibility, The 50% Unrelated Risk Rule, and "7 Other Factors" )

Rev. Rul. 2002-89 considers two situations. In the first, P, a domestic entity, enters into an insurance contract with its subsidiary, S, to insure the professional liability risks of P (either directly or as a reinsurer). S is regulated as an insurer in each state in which it does business. The premiums paid by P to S under the insurance/reinsurance contracts are established according to customary industry rating formulas, and P and S conduct themselves consistently with the standards applicable to an arm’s-length insurance arrangement. S writes similar contracts for unrelated parties, and the premiums paid by unrelated parties also are based on customary industry rating formulas. P does not provide any guarantee of S’ performance and all funds and business records of P and S are separately maintained. S does not loan any funds to P. The premiums S earns from the contracts with P constitute 90% of S’ earned premium on  a net and gross basis, and the coverage provided to P accounts for 90% of the total risks borne by S.

In the second situation, the facts are the same except that P’s premiums constitute less than 50% of the net and gross earned premiums. The liability coverage S provides to P accounts for less than 50% of the total risks borne by S. Although the premiums are found not to be deductible in the first (90%) fact pattern, the IRS held that they were deductible in the second. Rev. Rul. 2002-89 seems to provide a safe harbor The 50% rule that can be inferred from the ruling is based on a number of field service advices that the IRS has published during the last few years and the IRS’ reference in Rev. Rul. 2001-31 to reviewing ‘other factors’ in determining whether premium paid to a captive insurer is deductible as premium in the year in which it is paid. Set forth below is a brief analysis of seven (7)  so-called `other factors’.

1. Guarantees
In a number of cases, the courts have denied a deduction for premiums paid if a parental guaranty, hold harmless agreement or similar arrangement was in place with respect to the obligations of the insurance subsidiary. See, e.g., Malone & Hyde Inc v Commissioner, 62 F.3rd 835 (6th Cir. 1995), rev’g 66 TCM 1551, and Kidde Industries Inc v United States, 40 Fed Cl. 42 (1997). Accordingly, Rev. Rul. 2002-89 posits that such arrangements are not in place.

2. Loan backs
Rev. Rul. 2002-89 posits no loan backs to P. In several field service advices (see, e.g., FSA 200202002), the IRS has taken the position that loans from the insurance subsidiary to the parent or other affiliates may affect deductibility (although the IRS has indicated that a loan of a significant portion of premiums by a captive to a finance affiliate that is not insured by the captive may not adversely affect the premium deductibility analysis in FSA 199945009).

3. Unrelated premium tested on both a net and gross earned basis There have been four cases which have specifically held that the introduction of unrelated business in sufficient amounts results in a deduction for related business that might otherwise not be deductible, see The Harper Group v Commissioner, 96 T.C. 45, aff’d 979 F.2d 1341 (9th Cir. 1992); Ocean Drilling & Exploration Co v United States, 988 F.2d 1135 (Fed. Cir. 1993); AMERCO, Inc v Commissioner, 97 F.2d 162 (9th Cir. 1992); Sears Roebuck and Co. v. Commissioner, 96 T.C. 61, aff’d in part, rev’d in part 972 F.2d 858 (7th Cir. 1992). The cases, however, all dealt with a comparison of related and unrelated premium on a gross basis, i.e., no reinsurance of either the net or gross premium was discussed. Clearly, the IRS is taking the position that ratios of unrelated business to total business must be tested on both a net and gross basis. Thus, for example, if an insurance subsidiary were to write US$100x of related premium and US$100x of unrelated premium and retrocede or reinsure the US$100x of unrelated premium to an unrelated party, the IRS would conclude that since no net unrelated premiums were retained there could be no deduction for related business based on the gross amount of unrelated business assumed. In addition, the IRS seems to be making clear that they will be applying the test on an earned basis, accordingly, e.g., writing substantial amounts of unrelated premium on the last day of the year would not normally result in a deduction for related premium as little of the unrelated premium would be earned at year-end. When these factors are combined with the requirement of homogeneity of risk discussed immediately below, it seems clear that the IRS has attempted to tighten the mechanics for measuring unrelated risk.

4. Homogeneity of risk The IRS has in at least one field service advice (FSA 1998-578) indicated that unrelated business must be of the same kind (here all is professional liability). Hence, Rev. Rul. 2002-89 posits that all of the risks are of one kind.

5. Liability analysis
This seems to be a new ‘other factor’ (it is not discussed in recent field service advices), i.e., that the liability risks borne by S comport with the premium analysis. Thus, the IRS might argue if an amount of premium for related  risk is equal to unrelated premium, but the related risk assumed is an excess cover giving rise to a greater exposure of limits, it could question the deduction for the premium paid.

6. Quantum of unrelated risk
Rev. Rul. 2002-89 also looks to amount of unrelated risk. In general, a number of cases have indicated that premium ceded from a parent to an insurance subsidiary was not deductible but premium paid by an operating subsidiary to an insurance subsidiary was deductible, see, e.g., in general, Humana, Inc v Commissioner, 881 F.2d 247, 257 (6th Cir. 1989), Kidde, supra, Hospital Corporation of America v Commissioner, 74 TCM 1020 (1997). However, the Harper case, supra, held that if approximately 30% of premium was unrelated, a deduction would be afforded to the related party for premium that could not qualify under the Humana line of cases, e.g., that paid by its parent. Comparing Situation 1 at 10% in which no deduction is allowed and 50% in Situation 2 in  which a deduction is allowed, the IRS is establishing another safe harbor and, perhaps indicating a grey area as far as it is concerned (notwithstanding Harper) below the 50% level of unrelated premium.

7. Arm’s-length premium according to customary industry formulas and normal insurance practices
Clearly the IRS is indicating that premiums cannot be arbitrary, and it may be inferred that the IRS expects an actuarial determination to be used to set premiums. In FSA 200202002, the IRS National Office indicates that loose attention to the structures of an insured/insurer relationship would not be a helpful factor in determining premium deductibility. In this ruling, the IRS indicates that both related and unrelated premium are based on customary industry formulas, and that P and S conduct themselves in a manner similar to standards applicable to an insurance arrangement between unrelated parties (e.g., separation of funds and business records of P and S, and no loan-back from S to P).

Rev. Rul. 2002-90 - (12 Brother Sister Insureds each accounting for 5% to 15% of the total risk insured )

Rul. 2002-90 establishes further safe harbors. It involves a domestic holding company with 12 operating subsidiaries, which have a `significant volume of independent homogeneous risks.’ P, the parent, also owns S, a domestic insurer formed for a valid non-tax business purpose and licensed in each of the states in which its 12 operating subsidiaries have operations. S is adequately capitalized. Each operating subsidiary is charged an arm's length premium according to customary industry formulas. None of the operating subsidiaries have liability coverage for less than 5% nor more than 15% of the total risk insured by S. There are no guarantees of S’ obligations by P or any related person, and no loans by S to P or to any of the 12 subsidiaries. No other insurance is written. The risks written are professional liability. The ruling concludes the arrangements between S and its affiliates is insurance for federal income tax purposes.

1. Number of insureds
The IRS has in one recent field service advice (FSA 200202002) indicated that the Humana, supra, line of cases applies only where there are multiple affiliated subsidiaries involved. Clearly, that position is adopted in Rev. Rul. 2002-90 establishing a safe harbor at 12.

2. Business purpose
Although not specified, the IRS noted that S was formed for a valid non-tax business purpose.

3. Adequate capitalization
The IRS indicated that P provided S with adequate capital, addressing a factor in Malone & Hyde, supra, that formed part of the basis for denying the deduction.

4. Arm’s-length premiums according to customary
industry formulas and normal insurance practices The IRS also noted that the parties conducted themselves in a manner consistent with standards applicable to an insurance arrangement between unrelated parties (for example, arm’s-length premiums, and no parental guarantees or loan-backs to P or 12 operating subsidiaries).

5. Concentration of risk
Rev. Rul. 2002-90 seems to take the position that no subsidiary should account for more than 15% of the total risk insured (perhaps this means that arguments are available that the number of insureds under the safe harbor could be seven not 12).

Rev. Rul. 2002-91 - ( Group Captives with 7 approximately equal shareholder/Insureds & Policy Provisions )

Rul. 2002-91 deals with a group captive arrangement. The only published prior guidance in this area was set forth in Rev. Rul. 78-338, 1978-2 C. B. 107, which dealt with a group of 31 unrelated participants. Rev. Rul. 2002-91 deals with a significantly smaller group of unrelated businesses in one concentrated industry that face significant liability hazards. Insurance is required by regulators and affordable insurance is not available from commercial insurers. D, the taxpayer, and a group of industry members form a group captive, GC, which only writes the risks of X and the other industry members. No member of GC owns more than 15% of GC and no member has more than 15% of the vote of GC on any corporate governance issue. Further, no member’s individual risk that is insured with GC exceeds 15% of the total risk insured by GC. GC uses actuarial techniques based on, in part, commercial  rates for similar risks to determine premiums to be charged. GC pools all premiums, investigates claims to determine the validity of claims. No member has an obligation to pay additional premium if its premium is insufficient to pay its losses for any period, or gets a refund if its premiums exceed losses. Premiums may be used to settle claims of other members. If a member terminates coverage or sells its interest in GC, it is not required to make additional premium payments or capital payments to cover losses that exceed the premiums it has paid, nor can a member in such circumstances receive a refund of premium if premium exceeded losses. The conclusion is that premiums are deductible and that GC is in the business of issuing insurance policies. Again, the IRS is providing a safe harbor with more substance than Rev. Rul. 78-338, which did not address the provisions of the policy.

1. Business purpose The IRS makes clear that they are looking for an independent business, as distinguished from a tax purpose, in forming the captive, by reference to the lack of affordable coverage for the industry that formed the captive.

2. Adequate capitalization One factor referred to in Malone & Hyde, supra, in denying the deduction to the operating entities involved was a lack of adequate capitalization of the captive involved. Here, the IRS indicates capital is adequate.

a. Size of the group The IRS seems to be reducing the safe harbor ‘size’ of the group from the 31 in Rev. Rul. 78-338, to seven approximately equal shareholders/insureds.

b. Arm’s-length premiums using recognized actuarial techniques and normal insurance practices  The IRS again indicates that premiums cannot be arbitrary, noting that GC uses recognized actuarial techniques based, in part, on commercial rates for similar coverage. The IRS again posits normal insurance practices as a standard, such as investigation of claims before payment and the separation of GC’s assets and business operations from those of its owners.

c. Policy provisions. The IRS apparently has become concerned with group captive policy provisions that could have the effect of reducing or eliminating risk transfer through:

(a) payment of additional premium by a member to cover its own losses, and refunding excess premiums paid by a member so that each member covers its own losses and pooling is decreased or eliminated;

(b) payment by an insured of additional amounts on termination of the insurance relationship with the group captive to cover the insured’s losses or a refund to the insured of the excess of premiums paid over insured loss. In addition, the IRS seems to be dealing with cases such as Commissioner v Lincoln Savings & Loan Ass’n, 403 U.S. 345 (1971), and Black Hills Corporation v Commissioner, 73 F.3d 799 (8th Cir. 1996), which dealt with the creation of a capital asset (deposit account) which the insured would receive on termination of its insurance relationship net of paid losses.


Rev. Proc. 2002-75 - ( IRS will issue Private Letter Rulings (PLR's) on Captive Insurance Companies regarding the Deductibility of Premiums paid by insureds to the Captive and  whether the Captive entity will be treated as an insurance company for federal tax purposes )

Finally, the IRS published Rev. Proc. 2002-75, which indicates that the IRS will now provide guidance through ruling letters on captives relating to:

i. Whether there is requisite risk shifting and risk distribution necessary to constitute insurance for purposes of determining the deductibility of premiums as ordinary and necessary business expenses: and

ii. Whether the requisite risk shifting and risk distribution are present for determining whether an entity is an insurance company for federal income tax purposes.

Although acknowledging that rulings may now be considered, the Revenue Procedure does note that: “some questions arising in the context of a captive ruling request are so inherently factual... that contact should be made with the appropriate Service function prior to the preparation of such request to determine whether the Service will issue the requested ruling.” Accordingly, although the topic is off the ‘no ruling list’, the IRS may still decline to rule based on the facts. The question obviously is whether the IRS will entertain requests that do not meet all of the requirements of the recently published revenue rulings or will use these merely as guides in their ruling posture.      (Learn More)

Rev. Rul. 2005–40  - ( Single Member LLC's are Disregarded Entities and therefore do not count as separate insured brother/sister entities )

Rev. Rule 2005-40 was issued by the IRS on July 5, 2005  in Internal Revenue Bulletin No. 2005-27

Do the arrangements described below constitute insurance for federal income tax purposes? If so, are amounts paid to the issuer deductible as insurance premiums and does the issuer qualify as an insurance company?

FACTS

Situation 1. X, a domestic corporation, operates a courier transport business covering a large portion of the United States. X owns and operates a large fleet of automotive vehicles representing a significant volume of independent, homogeneous risks. For valid, non-tax business purposes, X entered into an arrangement with Y, an unrelated domestic corporation, whereby in exchange for an agreed amount of “premiums,” Y “insures” X against the risk of loss arising out of the operation of its fleet in the conduct of its courier business. The amount of “premiums” under the arrangement is determined at arm’s length according to customary insurance industry rating formulas. Y possesses adequate capital to fulfill its obligations to X under the agreement, and in all respects operates in accordance with the applicable requirements of state law. There are no guarantees of any kind in favor of Y with respect to the agreement, nor are any of the “premiums” paid by X to Y in turn loaned back to X. X has no obligation to pay Y additional premiums if X’s actual losses during any period of coverage exceed the “premiums” paid by X. X will not be entitled to any refund of “premiums” paid if X’s actual losses are lower than the “premiums” paid during any period. In all respects, the parties conduct themselves consistent with the standards applicable to an insurance arrangement between unrelated parties, except that Y does not “insure” any entity other than X.

Situation 2. The facts are the same as in Situation 1 except that, in addition to its arrangement with X, Y enters into an arrangement with Z, a domestic corporation unrelated to X or Y, whereby in exchange for an agreed amount of “premiums,” Y also “insures” Z against the risk of loss arising out of the operation of its own fleet in connection with the conduct of a courier business substantially similar to that of X. The amounts Y earns from its arrangements with Z constitute 10% of Y’s total amounts earned during the taxable year on both a gross and net basis. The arrangement with Z accounts for 10% of the total risks borne by Y.

Situation 3. X, a domestic corporation, operates a courier transport business covering a large portion of the United States. X conducts the courier transport business through 12 limited liability companies (LLCs) of which it is the single member. The LLCs are disregarded as entities separate from X under the provisions of § 301.7701–3 of the Procedure and Administration Regulations. The LLCs own and operate a large fleet of automotive vehicles, collectively representing a significant volume of independent, homogeneous risks. For valid, non-tax business purposes, the LLCs entered into arrangements with Y, an unrelated domestic corporation, whereby in exchange for an agreed amount of “premiums,” Y “insures” the LLCs against the risk of loss arising out of the operation of the fleet in the conduct of their courier business. None of the LLCs account for less than 5%, or more than 15%, of the total risk assumed by Y under the agreements.

The amount of “premiums” under the arrangement is determined at arm’s length according to customary insurance industry rating formulas. Y possesses adequate capital to fulfill its obligations to the LLCs under the agreement, and in all respects operates in accordance with the licensing and other requirements of state law. There are no guarantees of any kind in favor of Y with respect to the agreements, nor are any of the “premiums” paid by the LLCs to Y in turn loaned back to X or to the LLCs. No LLC has any obligation to pay Y additional premiums if that LLC’s actual losses during the arrangement exceed the “premiums” paid by that LLC. No LLC will be entitled to a refund of “premiums” paid if that LLC’s actual losses are lower than the “premiums” paid during any period. Y retains the risks that it assumes under the agreement. In all respects, the parties conduct themselves consistent with the standards applicable to an insurance arrangement between unrelated parties, except that Y does not “insure” any entity other than the LLCs.

Situation 4. The facts are the same as in Situation 3, except that each of the 12 LLCs elects pursuant to § 301.7701–3(a) to be classified as an association.

LAW

Section 831(a) of the Internal Revenue Code provides that taxes, computed as provided in § 11, are imposed for each taxable year on the taxable income of each insurance company other than a life insurance company. Section 831(c) provides that, for purposes of § 831, the term “insurance company” has the meaning given to such term by § 816(a). Under § 816(a), the term “insurance company” means any company more than half of the business of which during the taxable year is the issuing of insurance or annuity contracts or the reinsuring of risks underwritten by insurance companies.

Section 162(a) provides, in part, that there shall be allowed as a deduction all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business. Section 1.162–1(a) of the Income Tax Regulations provides, in part, that among the items included in business expenses are insurance premiums against fire, storms, theft, accident, or other similar losses in the case of a business.

Neither the Code nor the regulations define the terms “insurance” or “insurance contract.” The United States Supreme Court, however, has explained that in order for an arrangement to constitute insurance for federal income tax purposes, both risk shifting and risk distribution must be present. Helvering v. Le Gierse, 312 U.S. 531 (1941).

The risk transferred must be risk of economicloss. Allied Fidelity Corp. v. Commissioner, 572 F.2d 1190, 1193 (7th Cir.), cert. denied, 439 U.S. 835 (1978). The risk must contemplate the fortuitous occurrence of a stated contingency, Commissioner v. Treganowan, 183 F.2d 288, 290–91 (2d Cir.), cert. denied, 340 U.S. 853 (1950), and must not be merely an investment or business risk. Le Gierse, at 542; Rev. Rul. 89–96, 1989–2 C.B. 114.

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, 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. Distributing risk 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 smoothes out losses to match more closely its receipt of premiums. Clougherty Packing Co. v. Commissioner, 811 F.2d 1297, 1300 (9th Cir. 1987).

Courts have recognized that 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. Commissioner, 881 F.2d 247, 257 (6th Cir. 1989). See also Ocean Drilling & Exploration Co. v. United States, 988 F.2d 1135, 1153 (Fed. Cir. 1993) (“Risk distribution involves spreading the risk of loss among policyholders.”); Beech Aircraft Corp. v. United States, 797 F.2d 920, 922 (10th Cir. 1986) (“‘Risk distributing’ means that the party assuming the risk distributes his potential liability, in part, among others.”); Treganowan, at 291 (quoting Note, The New York Stock Exchange Gratuity Fund: Insurance that Isn’t Insurance, 59 Yale L. J. 780, 784 (1950)) (“‘By diffusing the risks through a mass of separate risk shifting contracts, the insurer casts his lot with the law of averages. The process of risk distribution, therefore, is the very essence of insurance.’”); Crawford Fitting Co. v. United States, 606 F. Supp. 136, 147 (N.D. Ohio 1985) (“The court finds . . . that various nonaffiliated persons or entities facing risks similar but independent of those faced by plaintiff were named insureds under the policy, enabling the distribution of the risk thereunder.”); AMERCO and Subsidiaries v. Commissioner, 96 T.C. 18, 41 (1991), aff ’d, 979 F.2d 162 (9th Cir. 1992) (“The concept of risk-distributing emphasizes the pooling aspect of insurance: that it is the nature of an insurance contract to be part of a larger collection of coverages, combined to distribute risk between insureds.”).

ANALYSIS

In order to determine the nature of an arrangement for federal income tax purposes, it is necessary to consider all the facts and circumstances in a particular case, including not only the terms of the arrangement, but also the entire course of conduct of the parties. Thus, an arrangement that purports to be an insurance contract but lacks the requisite risk distribution may instead be characterized as a deposit arrangement, a loan, a contribution to capital (to the extent of net value, if any), an indemnity arrangement that is not an insurance contract, or otherwise, based on the substance of the arrangement between the parties. The proper characterization of the arrangement may determine whether the issuer qualifies as an insurance company and whether amounts paid under the arrangement may be deductible. In Situation 1, Y enters into an “insurance” arrangement with X. The arrangement with X represents Y’s only such agreement. Although the arrangement may shift the risks of X to Y, those risks are not, in turn, distributed among other insureds or policyholders. Therefore, the arrangement between X and Y does not constitute insurance for federal income tax purposes. In Situation 2, the fact that Y also enters into an arrangement with Z does not change the conclusion that the arrangement between X and Y lacks the requisite risk distribution to constitute insurance. Y’s contract with Z represents only 10% of the total amounts earned by Y, and 10% of total risks assumed, under all its arrangements. This creates an insufficient pool of other premiums to distribute X’s risk. See Rev. Rul. 2002–89, 2002–2 C.B. 984 (concluding that risks from unrelated parties representing 10% of total risks borne by subsidiary are insufficient to qualify arrangement between parent and subsidiary as insurance).

In Situation 3, Y contracts only with 12 single member LLC's through which X conducts a courier transport business. The LLC's are disregarded as entities separate from X pursuant to § 301.7701–3. Section 301.7701–2(a) provides that if an entity is disregarded, its activities are treated in the same manner as a sole proprietorship, branch or division of the owner. Applying this rule in Situation 3, Y has entered into an “insurance” arrangement only with X. Therefore, for the reasons set forth in Situation 1 above, the arrangement between X and Y does not constitute insurance for federal income tax purposes.

In Situation 4, the 12 LLC's are not disregarded as entities separate from X, but instead are classified as associations for federal income tax purposes. The arrangements between Y and each LLC thus shift a risk of loss from each LLC to Y. The risks of the LLC's are distributed among the various other LLC's that are insured under similar arrangements. Therefore the arrangements between the 12 LLC's and Y constitute insurance for federal income tax purposes. See Rev. Rul. 2002–90, 2002–2 C.B. 985 (similar arrangements between affiliated entities constituted insurance). Because the arrangements with the 12 LLC's represent Y’s only business, and those arrangements are insurance contracts for federal income tax purposes, Y is an insurance company within the meaning of §§ 831(c) and 816(a). In addition, the 12 LLC's may be entitled to deduct amounts paid under those arrangements as insurance premiums under § 162 if the requirements for deduction are otherwise satisfied.

HOLDINGS

In Situations 1, 2 and 3, the arrangements do not constitute insurance for federal income tax purposes.

In Situation 4, the arrangements constitute insurance for federal income tax purposes and the issuer qualifies as an insurance company. The amounts paid to the issuer may be deductible as insurance premiums under § 162 if the requirements for deduction are otherwise satisfied.

In this ruling, the IRS is providing further guidance regarding the amount of risk distribution which must be present in order for transaction to constitute insurance. Specifically, the IRS requires the presence of a "large number of independent homogenous risks" as well as an adequate number of independent insureds. The term homogenous refers to the extent to which risks are similar with regard to line, limit, premium rate, liability layer, term, etc.  The question of how many risks are needed to constitute a "large number of independent homogenous risks" is not defined however, the IRS will accept the opinion of a licensed actuary regarding whether or not the number of risks insured is sufficient to permit the application of the "law of large numbers" and statistical inference.  The IRS does however, reaffirm the safe harbor set forth in Rev. Rul. 2002-90 that there must be at least 12 domestic corporate insureds; no one of which may account for less than 5% or more than 15% of the total risk assumed by the insurer. 

The case of a Limited Liability Company with a single member that did not make an election to be taxed as an association i.e.. "Corporation" for tax purposes also reinforces the fact that all of the IRS Safe Harbor rulings listed on this page have dealt with insurers and insureds who are domestic corporations, not partnerships, subchapter S corporations, or sole proprietorships, trusts, etc for US tax purposes. In cases where the insureds are not domestic US corporations for tax purposes, the IRS will probably look closely at the ownership % of each shareholder, partner, etc. in an attempt to argue that an insured entity although not technically disregarded pursuant to § 301.7701–3, should none the less be be indistinguishable from its owner.  Under this strategy, otherwise separate pass through entities which are insureds, could be consolidated by ownership and thereby fail to meet the minimum of 12 separate entities, no one of which accounts for less than 5% or more than 15% of the risks assumed by the insurer.  A brief summary of the options which are available to a Limited Liability Company  regarding how it will be classified for US tax purposes appears below.

A Limited liability company (LLC)  is an entity organized under the laws of a state or foreign country as a limited liability company. For Federal tax purposes, an LLC may be treated as a partnership or corporation or be disregarded as an entity separate from its owner.

By default, a domestic LLC with only one member is disregarded as an entity separate from its owner and must include all of its income and expenses on the owner's tax return (e.g., Schedule C (Form 1040)). Also by default, a domestic LLC with two or more members is treated as a partnership. A domestic LLC may file Form 8832, Entity Classification Election to avoid either default classification and elect to be classified as an association taxable as a corporation.


Insurance premium. This ruling holds that an arrangement that provides for the reimbursement of inevitable future costs does not involve the requisite insurance risk for purposes of determining (i) whether the amount paid for the arrangement is deductible as an insurance premium and (ii) whether the assuming entity may account for the arrangement as an ‘insurance contract’ for purposes of subchapter L of the Code. Stakeholders are asked to comment on the application of the rationale of the revenue ruling outside of its facts. Rev. Rul. 89-96 amplified.

Does the arrangement described below involve the requisite insurance risk to constitute insurance for purposes of determining (i) whether X may deduct the amount paid under the arrangement as an “insurance premium” under § 162 of the Internal Revenue Code, and (ii) whether IC may account for the arrangement as an “insurance contract” for purposes of subchapter L of the Code?

X, a domestic corporation that uses an accrual method of accounting, is engaged in a Business Process that is inherently harmful to people and property. Applicable governmental regulations require X to take action to remediate that harm. Doing so will require X to incur Future Costs to undertake specific measures to restore X’s business location to its condition before Business Process began; the Future Costs will be incurred when X ceases to engage in Business Process. The exact amount and timing of the Future Costs are a function of many factors, including the future cost of wages, future cost of materials, future changes in the regulation of Business Process, and the timing of X’s discontinuation of Business Process. There is no uncertainty, however, that the Future Costs will be incurred.

When X began Business Process in Year 1, it estimated that the present value of Future Costs was $150x, based on its evaluation of the factors identified above and an appropriate discount rate based on economic projections. At that time, X entered into an arrangement with IC, an unrelated domestic insurance company taxable under § 831. Under the arrangement, X agreed to pay IC $150x, and IC agreed to reimburse X for its Future Costs, up to a limit of $300x. The arrangement had no limits on its duration.

Section 162(a) provides, in part, that there shall be allowed as a deduction all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business. Section 1.162-1(a) of the Income Tax Regulations provides, in part, that among the items included in deductible business expenses are insurance premiums against fire, storm, theft, accident, or other similar losses in the case of a business.

Section 461 provides that the amount of any deduction shall be taken for the taxable year which is the proper taxable year under the method of accounting used by the taxpayer in computing taxable income. Under § 1.461-1(a)(2), a liability is incurred and generally is taken into account under an accrual method of accounting in the taxable year in which all the events have occurred that establish the fact of the liability, the amount of the liability can be determined with reasonable accuracy, and economic performance has occurred with respect to the liability. Section 1.461-4(g)(5) provides that if a liability arises out of the provision to the taxpayer of insurance, economic performance occurs as payment is made to the person to which the liability is owed. If the period of coverage extends substantially beyond the close of the taxable year, however, the amount permitted to be taken into account in the year of payment is determined under the capitalization rules of § 263.  Section 1.461-4(g)(8)(Ex. 6); § 1.263-4(d)(3)(i).

Characterization of an arrangement as insurance has consequences for the issuer, as well. Section 831(a) provides that taxes, computed as provided in § 11, are imposed for each taxable year on the taxable income of each insurance company other than a life insurance company. Section 832(a) provides that for this purpose, taxable income means the gross income as defined in § 832(b)(1) less the deductions allowed by § 832(c). Gross income includes underwriting income, which is defined in § 832(b)(3) as premiums earned on insurance contracts during the taxable year, less losses incurred and expenses incurred. Premiums earned and losses incurred on insurance contracts are computed taking into account reserves for unearned premiums under § 832(b)(4) and for discounted unpaid losses under § 832(b)(5), respectively. If an arrangement is not an insurance contract, no reserves are permitted for unearned premiums or for discounted unpaid losses with respect to the arrangement. Even if an arrangement is an insurance contract, no reserve is permitted for discounted unpaid losses until a loss has been “incurred.”

Neither the Code nor the regulations define the terms “insurance” or “insurance contract.” The Supreme Court of the United States has explained that in order for an arrangement to constitute insurance for federal income tax purposes, both risk shifting and risk distribution must be present. Helvering v. Le Gierse, 312 U.S. 531 (1941). The risk transferred must be risk of economic loss. Allied Fidelity Corp. v. Commissioner, 572 F.2d 1190, 1193 (7th Cir. 1978). The risk must contemplate the fortuitous occurrence of a stated contingency, Commissioner v. Treganowan, 183 F.2d 288, 290-91 (2d Cir. 1950), and must not be merely an investment or business risk. Le Gierse, 312 U.S. at 542; Rev. Rul. 89-96, 1989-2 C.B. 114.

In Le Gierse, the Court found that complementary annuity and insurance contracts did not involve an insurance risk but rather an investment risk because the risk assumed by the issuer was only that the amount the taxpayer paid for the contracts would earn less than the amount paid to the taxpayer as an annuity; the total amount paid by the taxpayer exceeded the face value of the life insurance contract. This risk, the Court said, “was an investment risk similar to the risk assumed by a bank; it was not an insurance risk.” Le Gierse, 312 U.S. at 542.

In Treganowan, the court held that a program under which the surviving members of the New York Stock Exchange paid a certain sum to the families of deceased members constituted insurance; the court distinguished the holding of Le Gierse as follows:

The holding [of Le Gierse] really highlights the situation here where the payment is actually conditioned upon death, whenever occurring, in the true terms of insurance. “From an insurance standpoint there is no risk unless there is uncertainty, or, to use a better term, fortuitousness. It may be uncertain whether the risk will materialize in any particular case. Even death may be considered fortuitous, because the time of its occurrence is beyond control.” 8 Ency.Soc.Sc. 95. That fortuitousness, whether we speak of death generally or premature death, as the Tax Court wished to emphasize, seems perfectly embodied here to fit both branches of the Supreme Court’s test.

Treganowan, 183 F.2d at 290-91. See also Allied Fidelity Corp., 572 F.2d at 1193 (“[T]he insurer undertakes no present duty of performance but stands ready to assume financial burden of any covered loss,” citing Couch on Insurance § 1:2 (1959)).

The Supreme Court has applied a similar standard to determine what constitutes “the business of insurance” for purposes of § 2(b) of the McCarran-Ferguson Act, 59 Stat. 34, as amended, 61 Stat. 448, 15 U.S.C. § 1012(b). In Group Life & Health Ins. Co. v. Royal Drug Co., 440 U.S. 205, 211 (1979), the Court concluded that agreements between Blue Shield of Texas and three pharmacies for the provision of prescription drugs to Blue Shield policyholders did not constitute “the business of insurance” within the meaning of the McCarran-Ferguson Act, noting that “[t]he primary elements of an insurance contract are the spreading and underwriting of a policyholder’s risk.” The Court considered the legislative history of the Act, quoting approvingly from one of the early House Reports, as follows: “‘The theory of insurance is the distribution of risk according to hazard, experience, and the laws of averages. These factors are not within the control of insuring companies in the sense that the producer or manufacturer may control cost factors.’” Group Life & Health Ins. Co., 440 U.S. at 221 (quoting H.R. Rep. No. 873, 78th Cong., 1st Sess., 8-9 (1943)). Non-tax insurance treatises further confirm that arrangements entered into to manage losses that are at least substantially certain to occur, or that are not the result of fortuitous events, do not constitute insurance. See, e.g., Couch on Insurance, § 102:8 (losses that exist at the time of the insuring agreement, or that are so probable or imminent that there is insufficient “risk” being transferred between the insured and insurer, are not proper subjects of insurance); 1 Appleman on Insurance 2d, § 1.4 (“The fortuity principle is central to the notion of what constitutes insurance. The insurer will not and should not be asked to provide coverage for a loss that is reasonably certain or expected to occur within the policy period.”); 43 Am. Jur. 2d Insurance, § 479 (2005). See also Warren Freedman, Freedman’s Richards on Insurance § 1:2 (6th ed. 1990) (insurance is an aleatory contract); Restatement (First) of Contracts § 291 (1932) (aleatory contract is one premised on happening of fortuitous event; that time or amount of performance depends on fortuitous event does not mean contract is aleatory).

In Rev. Rul. 89-96, 1989-2 C.B. 114, Y, a taxpayer that had already experienced a catastrophic loss, entered into a “liability insurance” contract with Z, an unrelated casualty insurance company. The exact amount of Y’s liability to injured persons as a result of the catastrophe could not be ascertained, but was expected to be substantially in excess of $130x. At the time the catastrophe occurred, Y’s liability insurance coverage totaled $30x. Under the contract between Y and Z, Y paid a premium of $50x in exchange for additional “liability insurance” coverage of $100x. That is, Z promised to pay on behalf of Y amounts in excess of $30x for which Y would become liable, subject to the contract’s limit of $100x. The $50x “premium” charged Y was an amount that, together with Z’s investment earnings and tax savings, would yield at least Z’s maximum anticipated liability of $100x by the time claims were liquidated. The ruling concludes that the arrangement does not involve the requisite risk shifting necessary for insurance, because the catastrophe had already occurred and the economic terms of the contract demonstrate the absence of any risk apart from an investment risk (that is, the risk Z would be required to pay out $100x earlier than anticipated, or that actual investment yield would be lower than forecast).

In order to determine the nature of an arrangement for federal income tax purposes, it is necessary to consider all the facts and circumstances in a particular case, including not only the terms of the arrangement, but also the entire course of conduct of the parties. Thus, an arrangement that purports to be an insurance contract but that lacks the requisite insurance risk, or fortuity, may instead be characterized as a deposit arrangement, a loan, a contribution to capital (to the extent of net value, if any), an option or indemnity contract, or otherwise, based on the substance of the arrangement between the parties. The proper characterization of the arrangement may determine whether the issuer qualifies as an insurance company and whether amounts paid under the arrangement may be deductible.

In the present case, the requirement that X incur Future Costs attached at the time X began Business Process; no insurance risk or hazard, such as a hurricane or an accident, exists as to whether X will have to incur those costs; it is certain that IC will have to perform under the arrangement with X by reimbursing X for the costs incurred to perform the measures, subject to the contract limit of $300x. Economically, the arrangement is a prefunding by X of its future obligations. Although IC assumed the risks of (i) the scope of the required measures, (ii) projections of future labor and material costs, (iii) the likely time frame when Future Costs would be incurred, and (iv) an appropriate discount rate based on projections of future investment earnings, the overall risk assumed by IC was whether the estimated present value of the cost of performing the measures ($150x) would accrue to exceed the greater of X’s costs to perform the required measures or the contract limit of $300x. This risk is akin to the timing and investment risks that Rev. Rul. 89-96 concludes are not insurance risks. Accordingly, the arrangement between X and IC lacks the requisite insurance risk to constitute insurance under the authorities set forth above.

The arrangement between X and IC lacks the requisite insurance risk to constitute insurance for purposes of determining (i) whether X may deduct the amount paid under the arrangement as an “insurance premium” under § 162 of the Internal Revenue Code, and (ii) whether IC may account for the arrangement as an “insurance contract” for purposes of subchapter L of the Code.

Rev. Rul. 89-96, 1989-2 C.B. 114, is amplified.

A revenue ruling represents the conclusion of the Internal Revenue Service (IRS) on the application of the law to the pivotal facts stated therein. Accordingly, this revenue ruling does not apply to reinsurance arrangements (including retroactive reinsurance, such as loss portfolio transfers), arrangements covering unanticipated environmental exposures, arrangements covering unanticipated cost overruns, or arrangements involving product warranties. The IRS may apply, or not apply, the authorities cited in this ruling to such arrangements, according to the facts and circumstances presented on a case-by-case basis. Comments are requested concerning the need for guidance in these and other areas. Comments should be submitted by October 22, 2007. Comments may be submitted by mail addressed to: Internal Revenue Service, CC:PA:LPD:PR (Rev. Rul. 2007-47), P.O. Box 7604, Ben Franklin Station, Washington, DC 20044; by hand delivery (Monday through Friday between the hours of 8:00 a.m. through 4:00 p.m.) addressed to: Courier’s Desk, Internal Revenue Service, Attn.: CC:PA:LPD:PR (Rev. Rul. 2007-47), Room 5203, 1111 Constitution Avenue, NW, Washington, DC 20224; or by email addressed to: Notice.Comments@irscounsel.treas.gov. Commentators should include the identification number of the publication (Rev. Rul. 2007-47) in both the email subject line and the body of the comment.

 

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