Captives What Benefits Do They Provide? Session 606 IASA 87 TH - PowerPoint PPT Presentation

Captives What Benefits Do They Provide? Session 606 IASA 87 TH ANNUAL EDUCATIONAL CONFERENCE & BUSINESS SHOW

Douglas Youngren, CPA, JD Doug is a tax partner in Plante Moran’s insurance practice who oversees all aspects of the firm’s Chicago insurance tax practice. He started his accounting career as an auditor; he has a unique hands-on style that incorporates his knowledge and experience as a CPA as well as an attorney. He has written articles on subjects ranging from offshore captive reinsurance to how a P & C company can convert its capital losses into ordinary losses. He has spoken on numerous occasions including at the Federal Bar Associations Insurance Tax Seminar as well as at the Farm Bureau Insurance Accounting conference. 3 IASA 87 TH ANNUAL EDUCATIONAL CONFERENCE & BUSINESS SHOW

WHAT IS INSURANCE? Risk Shifting and Risk Distribution  The tax definition of insurance is based on judicial principals first discussed in Helvering v. LeGierse, 312 U.S. 531 (1941)  Economic Family Doctrine  SEE HUMANA, HCA, MALONE & HYDE  REV. RUL. 2002-90 – 12 entity safe harbor  LIMITATIONS ON Economic Family Doctrine  REV. RUL. 2005-40, 2005-27 IRB 4 (LOOK THROUGH SINGLE MEMBER LLC, BUT NOT MULTI-OWNER LLC)  PLR 200952061, TAM 200816029 (RISK ATTRIBUTED TO GENERAL PARTNER) 4 IASA 87 TH ANNUAL EDUCATIONAL CONFERENCE & BUSINESS SHOW

WHAT IS INSURANCE? Risk Shifting and Risk Distribution  Third-party business • See HARPER GROUP, ODECO • 50% Safe Harbor - REV. RUL. 2002-89, 2002-2 IRB 984 • Sources of Unrelated Business • CUSTOMERS, e.g., EXTENDED WARRANTY (SEE PLR 201419007) • EMPLOYEE COVERAGES (e.g., H.O., AUTO, UMBRELLA) • EMPLOYEE BENEFITS, SEE REV. RUL. 92-93, 1992-2 C.B. 45 • MEDICAL STOP LOSS (?), REV. RUL. 2014-15, 2014-22 IRB 1 5 IASA 87 TH ANNUAL EDUCATIONAL CONFERENCE & BUSINESS SHOW

WHAT IS INSURANCE? Risk Shifting and Risk Distribution  Unrelated Business  Pooling Arrangements  Concentration of Risks  REV. RUL. 2005-40, 2005-27 IRB 4  REV. RUL. 2009-26, 2009-38 IRB 366 6 IASA 87 TH ANNUAL EDUCATIONAL CONFERENCE & BUSINESS SHOW

WHAT IS INSURANCE? Other Issues  Premiums were not for “insurance”  Retroactive Insurance, e.g., REV. RUL. 89-96  Imbedded Warranty  Residual Value Insurance  TAM 201149021, RVI GUARANTY COMPANY LTD.  ENTERPRISE RISK  Fortuitous Events 7 IASA 87 TH ANNUAL EDUCATIONAL CONFERENCE & BUSINESS SHOW

WHAT IS INSURANCE? Recent Case Law Rent-A-Center v. Commissioner, 142 T.C. 1 (January 14, 2014) • Dividend opinion in favor of taxpayer • Deduction for premium was allowed for all amounts paid by subsidiaries – deduction for premium paid by parent was disallowed • Big Three Coverages: Workers Compensation, Auto Liability, General Liability • 15 Affiliates were covered with largest accounting for 65% of premiums paid 8 IASA 87 TH ANNUAL EDUCATIONAL CONFERENCE & BUSINESS SHOW

WHAT IS INSURANCE? Rent-A-Center v. Commissioner • IRS focuses on the business practices of the Captive • Guaranty of Deferred Tax Asset • Guaranty/Keepwell by Parent • Purchase of Treasury Stock of Parent – subject to a Put 9 IASA 87 TH ANNUAL EDUCATIONAL CONFERENCE & BUSINESS SHOW

WHAT IS INSURANCE? Rent-A-Center v. Commissioner • Majority opinion agreed with 6th Circuit in Humana • Guaranty was by parent, not by insureds • Guaranty was not in favor of a third party • Guaranty amount was small • Majority opinion focused on exposure units that were “statistically independent risks” 10 IASA 87 TH ANNUAL EDUCATIONAL CONFERENCE & BUSINESS SHOW

WHAT IS INSURANCE? Rent-A-Center v. Commissioner • Dissent • Ownership of parent’s treasury shares by the Captive were an issues – if the parent was insolvent the put would not have been enforceable • There was no shifting of risk because of the parent’s guaranty and low capitalization • Assets did not create income • Will the IRS Appeal? 11 IASA 87 TH ANNUAL EDUCATIONAL CONFERENCE & BUSINESS SHOW

DOMESTIC TAX ISSUES Insurance Companies generally benefit from book-to-tax differences that non-insurance companies are not entitled to:  Deduction for Loss reserves  Modified Premium Recognition Rules  Small Company Elections – 831(b), 501(c)(15) 12 IASA 87 TH ANNUAL EDUCATIONAL CONFERENCE & BUSINESS SHOW

SECTION 831(b) COMPANIES Gen-1 or Gen-2 Dividends Paid (Taxed at Qualified Dividend Rates) Operating Company Captive Insurance Company (831(b) Election) Up to $1,200,000 in Premiums (Deductible at Ordinary Losses & Fees Paid from Tax Rates) Premiums 13 IASA 87 TH ANNUAL EDUCATIONAL CONFERENCE & BUSINESS SHOW

SECTION 831(b) COMPANIES What is an 831(b) election? • Premiums must be less than $1,200,000 (greater of direct or net written) • Multiple “micro - captives” may be formed if there is no attribution between them • Must qualify as an “insurance company” • Underwriting Income is not taxed • Election is irrevocable without IRS consent • NOL carryovers/carrybacks lost • Income Tax Benefits • Tax free income • Tax rate arbitrage – ordinary rates for deductions, qualified dividend rates for income • Possible Wealth Transfer Structure • Nature of Risk must be addressed • Change in branch • Consider IRS positions in PLRs 201219009, 201219010, 201219011 14 IASA 87 TH ANNUAL EDUCATIONAL CONFERENCE & BUSINESS SHOW

PROTECTED CELL COMPANIES BACKGROUND  Preferred Status  Participation Agreement  Independently incorporated  Cells are generally Bankruptcy Remote from other cells and from the General Account GENERAL ACCOUNT CELL 1 CELL 2 CELL 3 CELL 4 CELL 5 CELL 6 15 IASA 87 TH ANNUAL EDUCATIONAL CONFERENCE & BUSINESS SHOW

PROTECTED CELL COMPANIES Deduction for Premiums Paid  Rev Rul 2008-8 – in general, individual cells may be treated as if it were a separate captive insurance company  Brother/Sister  Unrelated Business test 16 IASA 87 TH ANNUAL EDUCATIONAL CONFERENCE & BUSINESS SHOW

PROTECTED CELL COMPANIES Taxation of Cell Companies  Proposed Regulations (REG-119921-09) issued in 2009  Domestic cell companies (or series LLC companies) will generally be treated as separate companies  Foreign cell companies (or series LLC companies) will generally be treated as separate companies 17 IASA 87 TH ANNUAL EDUCATIONAL CONFERENCE & BUSINESS SHOW

Captive Insurance For Established Closely Held Insurance Companies Basic Structure  Assumptions: • Insurance Company with underwriting profits • Currently being reinsured with unrelated reinsurer • Insurance company owned by older generation • Younger generation consists of 4 adult children 18 IASA 87 TH ANNUAL EDUCATIONAL CONFERENCE & BUSINESS SHOW

Current Structure Insurance Company Owned by Father Unrelated Reinsurer 19 IASA 87 TH ANNUAL EDUCATIONAL CONFERENCE & BUSINESS SHOW

With Insertion of 831(b) captives Insurance Company Owned by Father 831(b) owned 831(b) owned 831(b) owned 831(b) owned by one adult by one adult by one adult by one adult child child child child ($1,200,000 ($1,200,000 ($1,200,000 ($1,200,000 of of Premiums) of Premiums) of Premiums) Premiums) Unrelated Reinsurer 20 IASA 87 TH ANNUAL EDUCATIONAL CONFERENCE & BUSINESS SHOW

The Family Attribution Rules under 831(b) The tax rules state that one type of controlled group that causes the premiums of the “Parent” insurance company to be combined with the 831(b) captives is the Brother- Sister controlled group the definition of which is as follows: Two or more corporations if 5 or fewer persons who are individuals, estates or trusts own stock possessing more than 50% of the total value of shares of all classes of stock entitled to vote or more than 50% of the total value of all classes of stock of each corporation, taking into account the stock ownership of each such person only to the extent that such stock ownership is identical with respect to each such corporation. 21 IASA 87 TH ANNUAL EDUCATIONAL CONFERENCE & BUSINESS SHOW

How is the 50% determined Brother - Sister Controlled Group Individuals Corporate Ownership % Identical X Y Ownership A 9 9 9 B 9 9 9 C 9 9 9 D 9 9 9 E 9 2 2 F 9 2 2 G 9 2 2 H 9 2 2 I 28 2 2 J 0 54 0 Total 100 100 46 22 IASA 87 TH ANNUAL EDUCATIONAL CONFERENCE & BUSINESS SHOW

What are the family attribution rules?  An individual is treated as owning all of the stock of his spouse as well as his children who have not attained the age of 21  If an individual is treated as owning more than 50% of the stock of a corporation as a result of the above rule then that individual will be treated as owning all of the stock of his parents, grandparents, grand children and children who have reached 21 years of age 23 IASA 87 TH ANNUAL EDUCATIONAL CONFERENCE & BUSINESS SHOW

Other items to consider  Lower frequency and higher severity risks are more suitable for this type of structure because they allow for a more tax efficient build up of surplus  Normally best suited to short tail lines of business(such as property risks)  Other ownership structures create problems because of attribution rules 24 IASA 87 TH ANNUAL EDUCATIONAL CONFERENCE & BUSINESS SHOW