Traditionally viewed as a vehicle for Fortune 500 companies, more and more mid-sized businesses are realizing that they may benefit from captive insurance arrangements as well. Use of a captive insurance company may help a company control insurance costs, increase flexibility and broaden insurance coverage. The creation and management of a captive insurance arrangement must be carefully executed to ensure that the arrangement is respected and that unintended tax consequences are not triggered.

A captive insurance company is an insurer that is organized by one or more entities for the primary purpose of providing insurance protection to its owners or persons related to such owners. A captive's policyholders may be related in a number of ways, including by common ownership, common risk profile, or by participation in a common industry.

In order for captive insurance premiums to be deductible for federal tax purposes, the premiums must be for paid for true insurance, and be ordinary and necessary business expenses. In the captive insurance world, the IRS has sought for years to clarify what it considers to be "insurance" for which premiums would be deductible. For any captive insurance arrangement to be respected, the fundamental tenants of an insurance relationship must be present – risk shifting and risk distribution. 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 is not borne completely by the insured (as it is offset by the insurance payment). Risk distribution applies the law of large numbers and requires that the insurer insures a sufficiently large number of independent risks. In doing so, the insurer reduces the possibility that a single costly claim will exceed the amount received in premiums and set aside for the payment of such claims. Risk shifting assumes the risk of economic loss from the individual or business, and shares it with others, while risk distribution requires such a large insurance pool, that one single claim will not risk bankrupting the pool (while simultaneously exposing each insured's premium to the pool's risk).

A "pure" or single parent captive is a structure whereby the captive insurance company is a subsidiary of the parent company and only provides insurance coverage to its parent. The courts and the IRS have stated that certain intercompany arrangements can constitute insurance if certain requirements are met. The risk shifting and distribution occurs by way of reinsurance.

In a pure captive situation, the parent and subsidiary must form an agreement which conforms to the IRS standard of what constitutes insurance. The premiums paid (by the parent) should be pooled with those of unrelated parties. Such pooling will ensure (i) insurance risk is present, (ii) risk is shifted and distributed, and (iii) the transaction is of the type that is insurance in the commonly accepted sense of the term.

The IRS used to hold that risk shifting and distribution did not exist in the context of a single economic family (a parent-subsidiary relationship), requiring more than 31 unrelated parties pooling their risks together to constitute risk shifting and distribution. Rev. Rul. 2001-31 highlights the change in the IRS position, allowing deductions for premiums paid to a wholly owned captive insurance company where the captive and taxpayer are members of the same "economic family."

While the IRS recognizes that arrangements between parents and subsidiaries can constitute insurance, the parent's premiums must be pooled with those of unrelated parties. The IRS has maintained that the parent may deduct its payments to a subsidiary if the parent's premium constitutes less than 50 percent of the total premiums received by the insurance company. In those instances, the IRS has deemed there to be sufficient risk distribution. The courts have been more lenient, concluding that the parent’s premium can constitute close to 70 percent of the total premiums received.

Brother-sister subsidiary corporations (i.e., subsidiary corporations of the same parent) can establish an arrangement and qualify as insurance for federal income tax purposes even when there are no additional policy-holders beyond the affiliated group. The key, once again, is that both risk shifting and risk distribution are present. Rev. Rul. 2002-90 found there to be deductible insurance premiums paid when there was a single (common) parent (a holding company) which was a captive insurance provider to 12 subsidiaries. Beyond requiring adequate capitalization of the insurer, no parent guarantees of insurance payments, and no loans back to the insureds, the IRS sought to ensure proper risk shifting and risk distribution. To meet these requirements, the IRS held that no subsidiary could account for more than 15 percent or less than five percent of the premiums paid.

An alternative to creating your own captive insurance subsidiary is participating in a group captive plan where the insurance company is owned by a number of different "parent companies," usually from the same industry. In order for the "group captive" to meet IRS requirements, no member firm should own more than 15 percent of the voting power of the captive. Simultaneously, no member firm should account for more than 15 percent of the premium payments made to the captive (thereby ensuring that each insured doesn't bear more than 15 percent of the risk). To fully comply with the IRS requirements, there should be no refunds paid for overpayments of premiums and each insured should have a valid non-tax business purpose for participating in the captive plan.

A protected cell company ("PCC") utilizes two main parts; the core (which is owned by the PCC sponsor) and the cells (which can be an unlimited group working off the core which benefit the participants). The common stock of the cells is held by the PCC. PCC participants make a capital contribution into the cell in exchange for non-voting, preferred shares in the cell. In order for there to be deductible insurance premium payments, the subsidiaries of the cell's participant must make annual premium payments into the cell in exchange for insurance.

The IRS has ruled that there is sufficient risk shifting and risk distribution because the subsidiaries of the participant shift their professional liability to the insuring cell in exchange for premiums that are determined at arms-length. This outcome is possible because the premiums of numerous subsidiaries are pooled to ensure that a loss by one subsidiary is not, in substantial part, paid from its own premiums. This outcome would be different however, if the cell's participant held a single subsidiary and made premium payments on its subsidiary's behalf. In such an instance, the Service found that there was not sufficient risk shifting and risk distribution for the insurance premiums to be deductible.

The deductibility of the premiums is not the sole tax consideration when contemplating where (geographically) to form a captive. Typically, when there is a foreign corporation which is at least 50 percent owned by U.S. persons, additional subpart-F / controlled foreign corporation ("CFC") concerns must be resolved. In the context of insurance companies, the 50 percent U.S. shareholder requirement is reduced to 25 percent.

To avoid the effects of subpart-F, an offshore insurance company may elect to be taxed as a U.S. insurance company. Beyond avoiding CFC treatment, the foreign insurance company may derive additional U.S. federal income tax benefits, such as:

• Availing itself of U.S. federal income tax rates on insurance companies, which can be as low as 20 percent;
• Avoiding U.S. federal excise taxes on pass-through income;
• Avoiding the branch profits tax;
• Becoming exempt from the passive foreign investment company rules; and
• Reducing administrative paperwork by no longer needing to file IRS Forms 5471 for all U.S. shareholders.

In the event that a foreign captive makes such an election, the entity is likely to have filing obligations for FATCA purposes. This could include an array of obligations, ranging from filing TDF 90-22.1 forms (FBARs) if the captive has U.S. shareholders, officers and directors (reporting their foreign bank accounts), to registering with the IRS as a foreign financial institution. Registration with the IRS would require disclosure of the foreign captive's U.S. bank accounts. Failure to disclose could subject the captive to a 30 percent withholding penalty on U.S. sourced payments to foreign payees.

As is evident from the above, additional considerations should be given to the location of the captive (onshore vs. offshore). Further, taxpayers and their advisors should be aware of how the IRS can use information developed during the audit of a taxpayer (as a member or participant in a captive plan or with a common promoter) for the Service's benefit when auditing an unrelated company. To help mitigate this risk, it is imperative that any captive insurance program be tailored to the specific needs of the taxpayer and not be "cookie-cutter" (i.e., where a promoter uses a one-size-fits-all approach). If you have concerns about your insurance coverage or the size of your premiums, consult your local CBIZ MHM tax advisor who can connect you with one of our captive insurance specialists.

The authors acknowledge the contributions from an article used with the publisher's permission from GLOBAL TAX WEEKLY—A CLOSER LOOK, a weekly journal published by CCH, a Wolters Kluwer business. Copying or distribution without the publisher’s permission is prohibited. To subscribe to the GLOBAL TAX WEEKLY—A CLOSER LOOK or other CCH Journals please call 800-449-8114 or visit www.CCHGroup.com. All views expressed in the articles and columns are those of the author and not necessarily those of CCH.

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