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IRS Targets Captive Insurance Companies:
Structuring Section 831(b)-Compliant
Operating Documents Avoiding Tax Penalties, Navigating IRS Safe Harbors, and Ensuring Premium Deductibility
Today’s faculty features:
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TUESDAY, MAY 5, 2015
Presenting a live 90-minute webinar with interactive Q&A
Beckett G. Cantley, Professor of Tax Law, John Marshall Law School, Atlanta
John Colvin, Partner, Colvin & Hallett, Seattle
F. Hale Stewart, Owner, The Law Office of Hale Stewart, Houston
Robert J. Walling, III, Principal and Consulting Actuary, Pinnacle Actuarial Resources,
Bloomington, Ind.
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F. Hale Stewart, JD, LL.M.
Masters in Domestic and International taxation,
TJSL School of Law
Magna Cum Laude
Co-Author of US Captive Insurance Law, 2nd
Edition
Tax Analysts’ Author
Domestic and International Tax Structuring
at The Law Office of Hale Stewart and US
Global Tax
5
What is Insurance?
• Insurance Factors
– Definite Risk
– Fortuity
– Insurable Interest
– Risk Shifting
– Risk distribution
– Harper Test
• (1) whether the arrangement involves the existence of “insurance
risk”;
• (2) whether there was both risk shifting and risk distribution; and
• (3) whether the arrangement was for “insurance” in its commonly
accepted sense.
6
Captive Insurance
and Market Failure
• Starting in the 1950s, certain businesses either couldn’t find insurance, or could only find very expensive insurance.
– Flood Cases
– Oil and Gas
– Large Contractors (Stearns Rogers)
– Hospitals (Humana)
• In the 1970s, the US insurance industry was sued under four causes of action
– Asbestos
– Professional Liability (Med Mal)
– Environmental Claims
– Products Liability
• These cases were very expensive leading to some bankruptcies and major payouts.
• Starting in the late 1970s, the insurance industry started to greatly limit their actual exposure, slowly eliminating expensive insurance coverage.
7
All Common Insurance Policies
Have Large Exemptions
• CGL
– Employment Claims
– Employee Fidelity (employee theft)
– Cyber-Risk
– Products Liability
– Products Recall
– Loss of key contract/loss of key person
• Property
– Pollution
– Mold Remediation
– Flooding
– Windstorm Deductible
8
The Captive Insurance Story Arc
• From the late 1970s to the late 1980s, the IRS won
most of their cases.
• Why?
– Better Prepared
– Taxpayers put on terrible cases
– Courts were unsophisticated
– Lack of solid insurance definition
9
The Captive Insurance Story Arc
• From the latest 1980s to 2002, taxpayers won most of
the cases.
• Why?
– Better prepared
– IRS’ argument starts to unravel
– Courts are more sophisticated
10
Pre-UPS Risk
Subjective Intent
• 1.) Ocean Drilling and Exploration Co. v. United States, 24 Cl. Ct. 714, 715 (1991) (‘‘Because of the limited experience in insuring the new rigs and a number of substantial losses on these rigs, insurance rates increased sharply’’);
• 2.) Kidde Industries Inc. v. United States, 40 Fed. Cl. 42 (1977) (‘‘In 1976, in the midst of a products liability insurance crisis in which many insurance companies either ceased or significantly restricted their coverage of products liability. . . . Travelers informed Kidde that it would not renew Kidde’s products liability insurance policy for 1977’’);
• 3.) Malone and Hyde Inc. v. Commissioner, T.C. Memo. 1989-604 (‘‘By the mid-1970s, the Hyde Insurance Agency found that insurance premiums were increasing each year and certain insurance was not obtainable for some clients’’);
11
Pre-UPS Subjective
Intent: The
Humana Decision
Tree
1. Going naked: not an option when several successful
wrongful death claims could bankrupt the company
2. Forming a reserve: rejected because there were no
tax benefits
3. Forming a group captive: this was rejected out of
concern the other participants had financial problems
4. Forming a captive: accepted and approved
12
Objective Substance
of Early
Captive Structures
After Humana, taxpayers opted for one
of two strategies to create sufficient
substance:
The Presence of 3rd Party Risk
For example, Harper Group had 30%
Sears had 90%+
Sufficient Distribution Within the
Corporate Group
Humana 12+ entities
13
Safe Harbor Guidance,
Part I
Under Harper, a captive must comply
with a three prong test:
(1) whether the arrangement involves the existence of “insurance risk”;
(2) whether there was both risk shifting and risk distribution; and
(3) whether the arrangement was for “insurance” in its commonly accepted sense.
The duck test – does the company “walk and talk” like an insurance company?
14
Safe Harbor Guidance,
Part II
The IRS has issued several Revenue
Rulings that provide further safe harbor
guidance
A captive must derive at least 50% of
its insurance revenue from a non-
parent.
Or, a captive must have at least 12
subsidiaries in order to have sufficient
risk distribution.
15
Slide Intentionally Left Blank
IRS TARGETS CAPTIVE INSURANCE COMPANIES: STRUCTURING
SECTION 831(B)-COMPLIANT OPERATING DOCUMENTS
MAY 5, 2015
BECKETT G. CANTLEY Atlanta’s John Marshall Law School &
Atlanta Law Group
IRS Judicial Weapons: Anti-Avoidance Rules
• Substance over form
• Business Purpose
• The Sham Transaction
• Economic Substance
• The Step Transaction
18
Substance Over Form
• The facts that make up the transaction is its “form”.
• The “substance” of the transaction is what is actually below the surface of the facts, sometimes where such facts are created solely for such substance.
• This doctrine disregards the form in favor of the true substance to disallow the tax benefits generated by the artificial nature of the transaction.
19
IRC 831(b) Example
• IRC 162 deduction for ordinary & necessary expenses, potentially including insurance.
• Assume a risk pool is used to create the insurance, & risk is being kidnapped.
• An oil and gas executive who spends 6 mos in Nigeria needs a kidnapping & ransom policy. A dentist in Boulder, Colorado does not.
• The form is the risk pool, the substance is an unnecessary expense creating a deduction.
20
The Economic Substance Doctrine Now Codified
• Prong 1: The transaction is rationally related to a plausible non-tax business purpose
• Prong 2: The transaction results in a meaningful and appreciable enhancement in the net economic position of the taxpayer other than to reduce tax.
• Code: penalties as high as 75% and there is no way to use a tax opinion to use “reasonable cause” as a defense.
21
IRC 831(b) Example Loan Backs
• Insured deducts premium paid to CIC. The insured (or its owner) immediately borrows significant funds back out without paying taxes on the money.
• Rev. Rul. 2002-89, the IRS Manual, and case law indicate such CIC loan backs are at least subject to strict scrutiny, and may be prohibited under certain circumstances.
• The IRS has asked for comments on the facts & circumstances that would give rise to loan back determinations.
• This issue has come up as a focus in audits.
• IRS may challenge as an improper tax-free distribution.
22
IRC 831(b) Example Loan Backs
• Prong One: Hard to argue that the transaction is rationally related to a useful non-tax business purpose. If you needed the money enough to have it loaned out shortly after paying it, why did you make the premium payment to start with other than to get the tax deduction?
23
IRC 831(b) Example Loan Backs (4 of 4)
• Prong Two: Transaction appears that there is no meaningful enhancement in the net economic position of the taxpayer other than to reduce tax. Your position is identical before and after the transaction with respect to the loaned funds. The only difference is that you have deducted the premium.
24
IRS Statutory Weapons
• Listed Transaction Designation
• Transaction of Interest Designation
• Promoter Investigations
• List Maintenance Requests
• Criminal Investigations
25
Listed Transaction Designation
• IRS can designate a transaction as “listed” and trigger reporting requirements and potentially severe penalties for taxpayers and advisors.
• IRS rarely does this, so it is usually reserved for transactions that are done across the US among numerous taxpayers.
• IRS states its position in the listing notice, and judiciary has taken this designation seriously.
26
IRC 831(b) Example
• In early 2000’s IRS designated a captive variant structure as a listed transaction.
• The IRS eventually withdrew the listing on a go forward basis, apparently in part because the deal was not widespread enough.
• Given the popularity of 831(b) captives, and the promoter exams that are ongoing, it seems like only a matter of time until something becomes a listed transaction.
27
Transaction of Interest Designation
• IRS can put a transaction with certain attributes on a sort of “watch list” where the IRS thinks the transaction is abusive, but is not ready to “list” the transaction permanently.
• Transactions of interest have similar reporting and penalty attributes to listed transactions.
• It is up to taxpayers and advisors to keep up with what the IRS posts to this list. There is no ignorance defense.
28
IRC 831(b) Example
• It would not be surprising to find a captive transaction that involves a captive being used as a tax deductible vehicle to fund some sort of investment, and either (a) severely overstates coverage costs, or (b) improperly distributes risk, as a transaction of interest.
29
Promoter Investigations
• If IRS finds several taxpayers who have a common advisor or pool that appear to be taking the same abusive activity, IRS may open a promoter examination of the advisor.
• If IRS determines the advisor is a promoter, IRS may penalize them as such at the close of the investigation.
30
IRC 831(b) Example (1 of 2)
• IRS Personnel Statements Include:
– IRS planning on bringing “a great many” CIC cases
– IRS planning on “expanding” promoter exams
– IRS seems very interested in the “investments” as driver for CIC formation & operation
– IRS concerned with promotional material that focuses on tax benefits & investment return
– IRS hiring private sector forensic personnel required for ramping up caseload
31
IRC 831(b) Example (2 of 2)
• Forensic audits of taxpayers.
– IRS will drill down deep into a case
– Determining issues that should concern IRS
– Common touch points across other cases
– Specific professionals or risk pools in common
• Open 6700 promoter examinations of:
– Risk Pools
– CIC companies
32
List Maintenance Requests
• The IRS can request a list of all clients of an advisor, or pool participants if investigation is of a pool.
• Where IRS has found an offending taxpayer, this tool allows IRS to quickly locate a large number of potential taxpayers to audit that may have done the same thing.
• IRS will look for similar touch points among taxpayers to map out the web of promoters.
33
IRC 831(b) Example
• IRS finds one captive that has risk distributed improperly in a pool.
• IRS will request the pool to provide a list of all participants, and then will audit some or all of the participants, to see if the pool has improperly risk distributed all its participant captives.
34
Criminal Investigations
• CID investigations can now progress simultaneously with civil promoter examinations.
• A promoter exam can be referred to CID for potential criminal prosecution.
• This is obviously reserved for the worst actors.
• To date, these cases appear to involve “pretend we are doing it right” discussions with taxpayers.
35
IRC 831(b) Example
• Criminal warrants issued in cases in several states.
– Risk Pools
– Captive professionals
• Grand jury indictment in one advanced case.
– Clients told better not to make claims
– Promoters focused on tax savings (not insurance)
36
Dirty Dozen Listing
• Covering Ordinary or Implausible Risks
• Structured Maximized Premiums
• Poor Actuarial Substantiation
• Excessive Fees Charged to Unsophisticated Taxpayers
37
Senate Finance Committee
• Raise premium cap to $2.2m but lose 831(b) qualification if no more than 20% of premium from one insured.
• Proposal tabled, while IRS investigates estate planning in captives.
• Sen. Grassley is a very serious opponent to abusive tax avoidance transactions.
• IRS will take investigation seriously.
• Legislation is likely to result to curb abuses.
38
Where is this Going? IRS Investigation Pattern Familiar
• First: targeted forensic audits
• Discover common denominators
• Begin 6700 promoter investigations
• Begin criminal investigations
• Broad based warnings to taxpayers
• We are here
• Issue broad based guidance
• Start broad audit program based on guidance
39
THE END
FOR MORE INFO:
http://aegiscaptive.com/articles/
Slide Intentionally Left Blank
John M. Colvin Colvin + Hallett
T: (206) 223-0800
Email: [email protected]
Tax Controversy Issues Pertaining to Captive Insurance Companies
Issues with Risk Distribution: Related Insureds
Gulf Oil Corp. v. Comm’r, 89 T.C. 1010, 1025-26 (1987) (Dicta: “[U]nrelated risks need not be those of unrelated parties; a single insured can have sufficient unrelated risks to achieve adequate risk distribution.”)
IRS Position: Number of Exposure Units alone not sufficient PLR 200837041 IRS focuses on “number of policyholders” – not clear what this means, especially in group master policies, or situations where
there are multiple named insureds (e.g. doctors in a professional practice), all of whom presumably is a “policyholder”
Distribution among related parties: Number of insureds required? Rev. Rul. 2002-90 - 12 brother-sister insureds each with between 5-15% premium volume
Rev. Rul. 2002-91 - Suggests 7 group captive insureds are sufficient (equal owners - each with less than 15% ownership, vote and premium volume)
PLR 200837041 suggests 5 insureds are sufficient
Rev. Rul. 2005-40 –
One insured is not sufficient
12 disregarded LLCs held by one owner are not sufficient because just “one insured” for tax purposes.
12 LLCs are sufficient if classified as corporations (separate entities) for tax purposes.
43
Risk Distribution: Amount of Unrelated Risks Required
ODECO (Fed. Cl.): 44% unrelated is sufficient
Rev. Rul. 2002-89: 50% unrelated is sufficient
10% unrelated is not sufficient
PLR 201126038 30 percent of the company's risks was unrelated insurance through
reinsurance and a reinsurance pool
IRS suggested that an insurance company must have both sufficient number of insureds (per RevRuls) or sufficient unrelated business. If too concentrated will fail.
44
Rent-A-Center: Facts
Insurance sub (Legacy) insured brother-sisters (15 subs)
Handled first layer – claims up to $350,000, then reinsured with a commercial
reinsurer for the excess – reasonable business arrangement for high
frequency, low severity claims
3,000 stores, 20,000 employees, 8,000 vehicles
No third party business
Relatively high risk concentration in one sub (RAC East , over 50%)
Premiums actuarially determined (monthly payroll, vehicles, stores)
45
Rent-A-Center: Potential Problems
RAC issued guarantee (of Legacy’s deferred tax asset DTA) in order to meet Bermuda solvency requirement The DTAs were deferred tax assets arising from timing differences in amount of taxes payable for tax versus financial
accounting purposes – would take effect if tax laws changed that impaired the tax asset Failure to qualify as an insurance company for US tax purposes might have impaired these assets? Guarantee limited to $25M – small in comparison to $264M in premium
Bermuda regulator gave Legacy permission to treat DTAs as general business assets At the end of 2006, RAC canceled the guarantee because Legacy met the regulator’s solvency margins without it
Payment of premiums and claims largely by journal entry Legacy did not have much 3P investments, buying RAC treasury stock, non-dividend paying (had
approval of regulator for this investment)
High premium to surplus ration (compared to commercial insurers) Bermuda requires $120,000 or 10% of loss and loss expense provisions, plus reserves or 20% of first $6 million of net
premiums up to $6M, 10% of premium over $6M $9.9M capital under % of premium formula
Tax consequences were considered in structuring arrangement
46
Rent-A-Center: Preliminary Matters
Netting of premiums/claims was permissible
Premiums actuarially determined and reasonable in amount
Valid business reasons for arrangement
Premium-to-surplus ration was not unreasonable – commercial insurers
make money on investment side (surplus). Captives need not do this.
Workers comp, automobile and general liability are true insurance risks
Arrangement similar to those “commonly accepted” as insurance. Legacy
issued policies, charged actuarially determined premiums and paid claims.
47
Rent-A-Center: Risk Shifting and Risk Distribution
Risk Shifting
Follows 6th Circuit in Humana (reversing Tax Court) in accepting that brother-sister arrangements
may shift risks
Need not be risk shifting “comparable to that provided by a commercial insurance company” as
suggested by IRS expert
Separate and viable entity capable of meeting obligations
R expert admitted that if respect form, then shifted risk
Guarantees and investment in parent’s stock did not alter this conclusion
Risk shifting from S perspective not altered by P guarantee
Risk Distribution
Agrees risk distribution was met based on number of risks (employees, locations, automobiles)
Did not analyze risk distribution based on number of entities or “level of concentration of risks”
48
Rent-A-Center: Concurring and Dissenting Opinions
Concurrence – (Buch) Agreed with analysis, but thought the discussion of sibling argument (Humana) was
unnecessary because IRS had abandoned that position in Rev. Rul. 2001-31 (Rauenhorst – IRS is deemed to have conceded arguments which are contrary to Revenue Rulings)
Dissent (Lauber) “Not arm’s length”
Inadequately capitalized – effect of parental guarantees
Not operate like a real insurance (COMMERCIAL) company would No non-RAC employees
Netting of premiums/loss payments – looks more like a bank account/reserve fund from which to pay “self insurance”
Dissent (Halpern) Should not have overruled prior conclusion in Humana.
49
Securitas Holdings, Inc. & Subs. v. Commissioner, T.C. Memo. 2014-225 – Facts
Operating subsidiaries employed 2000,000 people in 20 countries in security,
alarm and cash handling businesses
P acquired a Vermont captive (Protectors), which had been in runoff
Set up new Irish captive reinsurer (SGRL). Protectors reinsured all risks of
operating subs with SGRL
P guaranteed performance of Protectors with respect to policies issued to subs with
purpose of prevent losing §501(c)(15) status of other member of controlled group)
3 largest subs each had more than 15% of the risks/premium (20%, 25% and 37%)
Protectors lent all but $1 million of capital to P, with approval of VT regulators
50
Securitas: Risk Shifting
Holdings guarantee of Protectors’ obligation did not shift risk of loss to P
Purpose of guarantee was to preserve § 501(c)(15) status of other member of controlled group
No amounts were ever paid on guarantee
Protectors was not undercapitalized
Premium to surplus ration was very low considering “net insurance” premium (Protectors reinsured 100% of risks)
o SGRL was adequately capitalized
• Journal entry payment system did not result in P maintaining risk of loss
51
Securitas: Risk Distribution
Despite underlying premiums/risks related to dozens of entities, IRS argued that risk assumed by SGRL all came from Protectors (the initial insurer)
Court looks through entities to large number of employees, offices, vehicles and services, finding a large poop of statistically independent risks, which did not vanish because brought together in one entity
Note: The IRS argument in this case was contrary to its previously stated position that risk distribution in the reinsurance setting is determined by looking through to the insureds on the underlying policies. Rev. Rul. 2009-26 (direct), PLRs 200950016 and 200950017 (layers)
52
Consequences of Invalid Section 953(d) Election (AM 2014-002)
If the captive is foreign and there is a § 953(d) election in place, the election terminates if the company ceases to be “an insurance company.”
Being an “insurance company” means more than half of the business during the taxable year is issuing insurance or annuity contracts. § 816(a) via § 831(c). PLR 201019001
Exception for companies in runoff? Must insurer continue to take in premium to qualify?
Consequences of termination include:
§ 367 tax event – deemed transfer of the company’s assets to a foreign corporation and an exchange that is taxable to the domestic corporation (Chapman Glen, Ltd. v. CIR, 140 T.C. No. 15 (2013) in Tax Court and Rev.Rul. 2003-47) on first day of subsequent taxable year
Subpart F inclusions in later years (or PFIC treatment if more widely owned)
Foreign Insurance Excise Tax under 4371
Essentially any deferral benefits end when stops taking in significant premium, but perhaps before all of the insured risks have been resolved.
Filing of Form 1120 does not protect shareholders because no Form 5471 was filed by shareholders (statute extended pursuant to § 6501(c)(8)). AM 2014-002.
53
Risks of Failure to Maintain 831(b) Status
Generally to maintain § 831(b) status, more than half of TP business is the issuance of insurance contracts The legislative history of 2004 revisions to insurance provisions provides, "[i]t is not intended that a company whose sole
activity is the run-off of risks under the company's insurance contracts be treated as a company other than an insurance company, even if the company has little or no premium income." H.R. Conf. Rep. No. 108-457, 2d Sess. 50-51 (2004).
PLR 201031001 – Exception for taxpayer in runoff status Insurance company was in receivership under control of state insurance commissioner and not taking in any new premium;
“[A]t no time during the period Taxpayer has been in liquidation could Taxpayer's investment activity be considered in excess of its requirements to pay claims.”
TP remains eligible for §831(b) status
What if investment activity is significantly in excess of amounts needed to pay claims and/or risk exposure terminates? Inclusion of prior premium in income to extent not required to reserve?
54
Failure to Qualify as § 501(c)(15) - TAM 201517018
Facts Captive for group of companies in real estate development and petroleum business, providing “non-
traditional coverages,” covering risks that are not covered by commercial insurers. “Administrative actions” “employment practices” “excess general liability” and “special
risks/medical” coverages, primarily issued to two entities Insurance amounted to 1% to 2% of total revenue in two years and 24% in a third year Held real estate as investment assets (and paid management fees to related parties) Paid a claim, but may have been outside policy coverage
Ruling Insurance was not primary and predominant activity – majority of business was related to
businesses other than insurance. Treasury Reg. § 1.831-3(a) Analyze type of risks separately (homogeneity) – insufficient distribution because only one policy
holder in each type of coverage for two of the coverages Claim payment appears to have been a business cost for real estate development ventures.
(Business risk not insurance risk)
55
Homogeneity
Risks in the same line of coverage
Is risk distribution tested in the aggregate or line-by-line?
No court has required homogeneity
FSA 1998-578 (April 1, 2002), Rev. Rul. 2002-89 and Rev. Rul. 2005-40 all
suggest that the IRS requires homogeneity
Notice 2005-49 sought comments on the relevance of homogeneity
ILM 200849013 (July 24, 2008) instructed Exam to determine whether
homogeneity is a relevant factor
56
Amount of Premium
Premiums based on arm's length commercial rates (always good fact in cases) or high quality actuarial work
IRS gets suspicious if premiums appear to be based on the $1.2 million section 831(b) amount. NSAR 20020160 (April 17, 2002)
Premiums should not be based on deduction sought and/or the owner's available cash flow. Salty Brine I, Ltd. v. U.S., Docket No. 10-cv-108 (N.D. Tex. May 16, 2013)
57
Adequate Capitalization
Guarantees from owner(s)
Indemnification or hold-harmless agreements
Letters of credit from owner(s)
Circular cash flows/loan-backs
Recent cases suggest that courts will be receptive to captives that depart from commercial premium/capital ratios (4:1 to 2:1)
Often captives have low capital in early years (funded primarily with deductible premium), then capital increases as profits accumulate
Accumulated Earnings Tax Issues
58
Risk Pooling
ILM 200844011 (Oct. 31, 2008) Contractual pooling arrangement
“Pool” constitutes a foreign entity such that premiums paid are subject to Federal Excise Tax
PLR 200907006 Company that participated in a reinsurance pool with several unrelated insurers qualified as an
insurance company
PLRs 201224018, and 201030014 Each taxpayer's risks for each line of business were those of at least 12 underlying insureds with no
single underlying insured representing more than 15 percent of taxpayer's total risk
PLRs 201219009, 201219010 and 201219011 Originally TPs received favorable rulings
IRS examined later and found language in contacts that appeared to preclude an individual captive entity from making a claim without having to repay the pool with interest (negated risk shifting).
59
Insurance Risk vs. Business/Investment Risk
IRS Position: Not all contracts that transfer risk are insurance policies. Contracts that protect against the failure to achieve a desired investment return protect against investment risk, not insurance risk. Insurance risk requires a fortuitous event or hazard and not a mere timing or investment risk. A fortuitous event (such as a fire or accident) is at the heart of any contract of insurance. CIR v. Treganowan, 183 F.2d 288, 290-91 (2d Cir. 1950)
LeGierse, 312 U.S. at 542 (the risk must not be merely an investment risk)
SEC v. United Benefit Life Insurance Co., 387 U.S. 202, 211 (1967) (the transfer of an investment risk cannot by itself create insurance)
Rev. Rul. 89-96, 1989-2 C.B. 114 (risks transferred were in the nature of investment risk, not insurance risk);
Rev. Rul. 68-27, 1968-1 C.B. 315 (although an element of risk existed, it was predominantly a normal business risk of an organization engaged in furnishing medical services on a fixed price basis rather than an insurance risk)
Rev. Rul. 2007-47, 2007-30 I.R.B. 127 (the arrangement lacked the requisite insurance risk to constitute insurance because the arrangement lacked fortuity and the risk at issue was akin to the timing and investment risks of Rev. Rul. 89-96).
60
Insurance Risk vs. Business/Investment Risk: Foreign Exchange Insurance
Foreign Exchange Risk not insurance risk. ILM 201511021
Statement of Statutory Accounting No. 60, “Financial Guaranty Insurance,” describes such insurance as providing “protection against financial loss as a result of . . . fluctuations in exchange rates between currencies.”
Subs entered into contracts with the captive insurance company to mitigate risk in foreign currency exchange rate fluctuations through indemnification of loss of earnings caused by the fluctuations.
The contracts had many features found in insurance policies, and an outside actuary performed an actuarial review.
IRS rules not insurance risk: currency fluctuation risk is part of general business risk
61
Insurance Risk vs. Business/Investment Risk: Residual Value Insurance
RVI Guaranty Co., Ltd. & Subs. v. CIR, Tax Court Docket No. 27319-12, TAM 201149021
Case has been tried and briefed
Coverage at issue provides payments if assets (real estate, commercial vehicles, equipment) have a residual value less than expected at the end of a lease term
Stay tuned!
62
IRS Warning IR 2015-19 (February 3, 2015) Some Captives Are Abusive
“In the abusive structure, unscrupulous promoters persuade closely held entities to participate in this scheme by assisting entities to create captive insurance companies onshore or offshore, drafting organizational documents and preparing initial filings to state insurance authorities and the IRS. The promoters assist with creating and ‘selling’ to the entities often times poorly drafted ‘insurance’ binders and policies to cover ordinary business risks or esoteric, implausible risks for exorbitant ‘premiums,’ while maintaining their economical commercial coverage with traditional insurers.”
“Total amounts of annual premiums often equal the amount of deductions business
entities need to reduce income for the year; or, for a wealthy entity, total premiums amount to $1.2 million annually to take full advantage of the Code provision [§ 831(b)]. Underwriting and actuarial substantiation for the insurance premiums paid are either missing or insufficient. The promoters manage the entities’ captive insurance companies year after year for hefty fees, assisting taxpayers unsophisticated in insurance to continue the charade.”
63
IRS Disclosure of Similar Captive Arrangements in Audit/Litigation ILM 201250020
The IRS suggests that third party pattern evidence demonstrating that the arrangements did not take into account each participant’s individual risk profile could be used to show that the arrangements were not insurance. For example, if the documents demonstrated that the arrangement entered into by the other taxpayers was not tailored to those taxpayers' individual situation and risk because the other taxpayers' insurance documents were identical to B-1's and C-1's documents, this pattern evidence would demonstrate the arrangement was not “insurance” in the other taxpayers' case and would satisfy the “item test [of Section 6103(h)(4)(B)].”
With respect to the argument that specific captive insurance arrangements lack economic substance, “pattern evidence” from other participants showing that all the arrangements were designed, implemented, and operated identically can be used to demonstrate that the arrangement was not designed with a specific taxpayer's business needs in mind and therefore lacked a bona fide business purpose other than tax benefits.
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FATCA/IGAs
For captives domiciled outside the U.S., even if a § 953(d) election is in place, the entity will be either An FFI, if provides cash value life insurance/annuity products; or
An NFFE, if only provides casualty insurance
February 2014 revisions to FATCA regulations now permit foreign captive insurance companies with 953(d) election in place to avoid foreign treatment, provided licensed to do business in at least one state
The entity will likely have to fill out the painful new Form W-8(BEN-E) for FATCA purposes, even though W-9 required for all other purposes (§§ 6041-6049).
Financial Institutions who have to report to the IRS will do due diligence (based on account size) on the captive and its owners. NFEEs - “substantial ownership” (Regs 10%) vs. ”controlling persons” (IGA follows FATF – ordinarily 25% but falls to 10% for high risk customers)
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Captive Insurance: IRS Guidance Plan
The IRS apparently plans to issue additional guidance on captive
insurance issues. On August 26, 2014, the IRS placed “captive
insurance issues” in its priority guidance plan for the 2014/2015 fiscal
year. (Topic No. 7 in Insurance issues)
http://www.irs.gov/file_source/pub/irs-utl/2014-2015_pgp_initial.pdf
http://www.irs.gov/file_source/pub/irs-utl/2014-
2015_pgp_2nd_quarter_update.pdf (January 29, 2015)
Stay tuned!
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Slide Intentionally Left Blank
Robert J. Walling III, FCAS, MAAA, CERA
309.807.2320
Avoiding IRS Scrutiny in Captive Insurance
Companies –
An Actuarial Perspective
May 5, 2015
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The Captive Trend
Why Form a Captive?
What Makes it a Captive INSURANCE COMPANY?
Funding Approaches
Outline
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Continued Growth of Captives
Source: Business Insurance – March 17, 2014
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Rank Domicile 2013 2012 Change (#) Change (%)
1 Bermuda 831 856 -25 -3%
2 Cayman 759 740 19 3%
3 Vermont 588 586 2 0%
4 Guernsey 344 333 11 3%
5 Utah 342 287 55 19%
6 Delaware 298 212 86 41%
7 Anguilla 295 291 4 1%
8 Nevis 276 203 73 36%
9 Barbados 264 261 3 1%
10 Luxembourg 225 238 -13 -5%
Changes by Domicile
Source: Business Insurance – March 17, 2014
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More Risk Sophistication In Middle Market
Drives Growth of Cell, Series and Group Captives
U.S. Healthcare Changes
Increased Benefits Coverage in Captives
Maturation of Captives
Increased Expansion of Captive Programs (e.g. Small Captives and Group Captives)
Softening of U.S. Property/Casualty Market
Increased Interest in Captives (e.g. CA Workers Compensation)
Increased Use of Captives by Insurers (e.g. Agency Captives, RRG purchases)
Increased Taxation
Increased Use of Series Captives by Smaller Companies
Increased IRS Scrutiny of Risk Transfer and Risk Distribution
Key Drivers and Trends
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Control...of Claims Costs (Risk Management/Loss Prevention)
Control...of Underwriting Expenses
Control...of Underwriting Profits
Control...of Insurance Costs (and Access to Reinsurance)
Control...of Coverage (Customizable)
Control...of Collateral and Cash Flow
Control...of Investment of Assets/Investment Income
Control...of Insured vs. Uninsured Losses
Control...of Tax Position
Why Form a Captive?
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Primary business activity must be insurance
(a.k.a. Legitimate Business Purpose)
Needs to be operated like an insurance company
Have Sufficient Capitalization
Underwrite Coverage
Issue Policies
Provide Loss Prevention/Loss Control
Collect Premiums
Pay Claims
Maintain Appropriate Loss Reserves for Unpaid Claims
Invest Assets
Produce Financial Statements
Many of the Professional Services are Typically Out-Sourced
What makes it a Captive INSURANCE COMPANY?
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Premiums and policies must be
Market-comparable
Risk-based
Established at arms length
Actuarial support is strongly encouraged
Initial capitalization must be adequate
4:1 (premiums to capital)
Often Minimum Capital Requirements ($100K, $250K, or $1M)
Insurance transaction
Risk Transfer
Risk Distribution
What makes it a Captive INSURANCE COMPANY?
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Risk Transfer
Must involve shifting of risk
Must involve significant chance of a significant economic loss
Risk Distribution
Brother-Sister Model
“Unrelated Related” Model
Risk Transfer and Distribution
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Experience Rating
Rely on insured(s) experience to the greatest extent possible.
Exposure Rating
Market Comparable Pricing
Industry Benchmarks (ISO, NCCI, etc.)
Frequency & Severity
Reinsurance Techniques (Rate on Line)
Approaches to Funding Studies
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Experience Rating
Loss Initial Reported Incurred Losses Expected Estimated Ultimate Losses Selected
Line of Evaluation Loss Total Excess of % of Ult. Loss Dev B - F Ultimate
Coverage Policy Period Date Cost Limits $250,000 Reported Method Method Losses
(1) (2) (3) (4) (5a) (5b) (6) (7) (8) (9)
WC 12/31/12 - 12/31/13 03/29/13 1.09 213,192 0 13.92% 1,531,463 1,070,043 1,070,043
12/31/11 - 12/31/12 03/29/13 1.08 942,757 0 77.98% 1,208,900 1,149,397 1,149,397
12/31/10 - 12/31/11 03/29/13 1.07 950,826 0 88.57% 1,073,504 1,053,698 1,063,601
12/31/09 - 12/31/10 03/29/13 1.06 724,760 0 91.39% 793,009 805,458 799,233
12/31/08 - 12/31/09 03/29/13 1.05 411,026 0 92.99% 442,001 465,307 465,307
12/31/07 - 12/31/08 03/29/13 1.04 791,333 67,190 94.49% 766,399 763,952 765,175
Total 1.06 4,033,894 67,190 5,815,276 5,307,856 5,312,758
Selected Benefit
Line of Ultimate Level Loss Trend Trended
Coverage Policy Period Losses Factor Exposure Cost Factor Loss Cost Weights
(1) (2) (9) (10) (11) (12) (13) (14) (15)
WC 12/31/12 - 12/31/13 1,070,043 1.0000 946,226 1.13 1.010 1.14 0.240
12/31/11 - 12/31/12 1,149,397 1.0000 901,168 1.28 1.020 1.30 1.000
12/31/10 - 12/31/11 1,063,601 1.0015 872,932 1.22 1.030 1.26 1.000
12/31/09 - 12/31/10 799,233 1.0020 918,359 0.87 1.041 0.91 1.000
12/31/08 - 12/31/09 465,307 1.0045 766,211 0.61 1.051 0.64 0.500 *
12/31/07 - 12/31/08 765,175 1.0110 721,371 1.07 1.062 1.14 1.000
Total 5,312,758 5,126,267 1.04 1.10
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Experience Rating
Anticipated
Indicated Credit for Indicated Indicated
Line of SIR Projected $250,000 Claims Management $250,000 Indicated Excess Total
Coverage Level Exposure Loss Cost Savings Loss Fund Loss Layer Ratio Funding Funding
(1a) (1b) (2) (3) (4) (5) (6a) (6b) (6c) (7)
WC 250,000 993,538 1.10 0.900 984,297 984,297
350,000 100 x 250 3.5% 34,450 1,018,747
500,000 250 x 250 6.0% 59,058 1,043,354
Column
(2) Exposure base: WC is Payroll (00's)
(3) Exhibit B, Total Col (14)
(4) Reflects credit for claims management savings
(5) Col (2) x Col (3) x Col (4)
(6a) Provided by MO School District
(6b) Exhibit C, Total Col (13)
(6c) Col (5) x Col (6b)
(7) Col (5) + Col (6c)
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Customer is interested in placing product recall coverage in a small captive.
Their agent/broker received a quote of $20,000 for ISO-based coverage.
Market Price $20,000
Expected Loss Ratio 75%
Expected Loss $15,000
Risk Margin 25%
Expense Load 15%
Indicated Premium $21,000
Market Pricing
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Customer is interested in placing product recall coverage in a small captive.
Company Revenues $45M Benchmark Products Loss Cost per (000) 1.40
Deductible/Increased Limits 1.50
Product Recall as a % of Products Liability 25%
Expected Loss $23,625
Risk Margin 25%
Expense Load 15%
Indicated Premium $33,075
Benchmark Pricing
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Customer is interested in placing product recall coverage in a small captive with a $500,000 per occurrence and aggregate limit.
Expected Claims per Year 0.125
Expected Average Severity $250,000
Expected Loss $31,250
Risk Margin 25%
Expense Load 15%
Indicated Premium $43,750
Frequency & Severity
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Customer is interested in placing product recall coverage in a small captive.
Coverage Limit $500,000
Rate on Line 6.25%
Expected Loss $31,250
Risk Margin 25%
Expense Load 15%
Indicated Premium $43,750
6.25% rate on line is equivalent to a 16 year return period.
Rate on Line
