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

IASA 87TH ANNUAL EDUCATIONAL CONFERENCE & BUSINESS SHOW

Captives What Benefits Do They Provide?

Session 606

IASA 87TH 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

• rdinary 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.

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IASA 87TH 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)

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IASA 87TH 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

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IASA 87TH 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

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IASA 87TH 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

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IASA 87TH 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

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IASA 87TH 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

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IASA 87TH 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”

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IASA 87TH 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?

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IASA 87TH 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)

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IASA 87TH ANNUAL EDUCATIONAL CONFERENCE & BUSINESS SHOW

SECTION 831(b) COMPANIES

Operating Company

Captive Insurance Company (831(b) Election) Gen-1

• r

Gen-2

Up to $1,200,000 in Premiums (Deductible at Ordinary Tax Rates) Losses & Fees Paid from Premiums Dividends Paid (Taxed at Qualified Dividend Rates)

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IASA 87TH 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

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IASA 87TH 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

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IASA 87TH 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

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IASA 87TH 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

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IASA 87TH 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

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IASA 87TH ANNUAL EDUCATIONAL CONFERENCE & BUSINESS SHOW

Current Structure

Insurance Company Owned by Father Unrelated Reinsurer

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IASA 87TH ANNUAL EDUCATIONAL CONFERENCE & BUSINESS SHOW

With Insertion of 831(b) captives

Insurance Company Owned by Father Unrelated Reinsurer

831(b) owned by one adult child ($1,200,000

• f Premiums)

831(b) owned by one adult child ($1,200,000

• f Premiums)

831(b) owned by one adult child ($1,200,000

• f Premiums)

831(b) owned by one adult child ($1,200,000 of Premiums)

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IASA 87TH 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%

• f 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.

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IASA 87TH 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 54 Total 100 100 46

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IASA 87TH 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

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IASA 87TH 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

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IASA 87TH ANNUAL EDUCATIONAL CONFERENCE & BUSINESS SHOW

Thank you for attending!

Doug Y Doug Young

• ungren,

en, CP CPA, JD, T A, JD, Tax P ax Par artner tner 312.980.2944 doug.youngren@plantemoran.com

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IASA 87TH ANNUAL EDUCATIONAL CONFERENCE & BUSINESS SHOW

Disclaimer

This presentation is part of Plante Moran marketing of professional services, and is not written advice directed at the specific facts and circumstances of any person and/or entity. This presentation is not intended or written to be used, and cannot be used, for the purpose of avoiding taxes and penalties that may be imposed for any purpose or transaction.

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IASA 87TH ANNUAL EDUCATIONAL CONFERENCE & BUSINESS SHOW

Captive Insurance Overview

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IASA 87TH ANNUAL EDUCATIONAL CONFERENCE & BUSINESS SHOW

What is a Captive?

• Property & Casualty Insurance Company
• Formed to cover the unique risks of an operating company
• Provides coverage for specialized risks which may not be

available or may be too costly to obtain through traditional insurance providers

• A bona fide insurance company, subject to approval and

regulatory oversight by the insurance regulators in a chosen domicile

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IASA 87TH ANNUAL EDUCATIONAL CONFERENCE & BUSINESS SHOW

History of Captives

Tooley Street Fire Fred Reiss forms first captive in Cleveland, Ohio for the Youngstown Sheet and Tube Company Captives accessible to small to mid-size marketplace 831(b) Captives no longer a listed transaction IRS Issues Safe Harbor Rulings Over 50% of domestic domiciles offer specialized captive statutes Large corporations begin forming wholly

• wned insurance

companies

1861 1920s 1957 Today 2002 2004 2014

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IASA 87TH ANNUAL EDUCATIONAL CONFERENCE & BUSINESS SHOW

Insurable Risks That May Result in Loss of Business Income

• Business Interruption
• Contract Penalty and

Failure to Perform on Contract

• Deductible

Reimbursement

• Defense Cost

Reimbursement

• Difference in Conditions
• Loss of Franchise
• Loss of Key Employee
• Loss of Licensure
• Legislative and Regulatory

Changes

• Reputational Risk
• Suppliers/Supply Chain

Interruption

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IASA 87TH ANNUAL EDUCATIONAL CONFERENCE & BUSINESS SHOW

Underwriting

• Assemble Current Insurance Information
• Review Current Policies and Endorsements
• Analyze Five Year Loss Runs
• Three Year Summary of Coverage
• Identify Trends in Premium History
• Underwriting
• Understanding the operating company
• Discuss reasonable coverage applicable to industry and unique

business

• Identify Self-Insured Exposures
• Identify Uninsured Loss Experience
• Adequacy of Policy Limits

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IASA 87TH ANNUAL EDUCATIONAL CONFERENCE & BUSINESS SHOW

Third Party Review and Analysis

• Independent Third Party Risk Analysis
• Coverage Chart
• Gap Identification
• Total Cost of Risk (TCOR) Analysis
• Enterprise Risk Exposure Review
• Risk Selection
• Identify Relevant Coverage
• Avoid Duplicate Coverage
• Independent Third Party Actuarial Analysis
• Rate Promulgation
• Peer Review of Pricing Methodology
• Feasibility Study

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IASA 87TH ANNUAL EDUCATIONAL CONFERENCE & BUSINESS SHOW

Middle Market Captive Opportunities under IRC Section 831(b)

• Under IRC Section 162, premium payments made by the operating

company allow the client to further manage business risk and should be tax-deductible as ordinary and necessary business expenses

• Captives which make an annual election under IRC Section 831(b)

are tax-exempt under the annual $1.2MM premium test

• Captive underwriting profits and surplus accumulation are also tax-

exempt; only investment income is taxable annually

• A Captive elects to be taxed as a C-Corporation
• Distributions are treated as Qualifying Dividends
• Liquidation of a Captive is treated as a Long-Term Capital Gain

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IASA 87TH ANNUAL EDUCATIONAL CONFERENCE & BUSINESS SHOW

How Does it Work?

Operating Company New Captive

• f Oxford

Insurance Company Oxford Fronting Carrier

Insurance Policy Insurance Premium Premium Reinsurance

Captive Owner Flexible Ownership Options

*Less Claims and Expenses

Underwriting Profit * 34

IASA 87TH ANNUAL EDUCATIONAL CONFERENCE & BUSINESS SHOW

Oxford Structures

Oxford Fronting Carrier Oxford Series

Share Class B Share Class D Share Class C Share Class A

Oxford Stand Alone Operating Company

Oxford Insurance

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IASA 87TH ANNUAL EDUCATIONAL CONFERENCE & BUSINESS SHOW

Exposure to Claims Oxford Fronting Carrier

All Other Captives Share Risk

• n a Quota

Share Basis Captive which filed the Claim

$1,000,000 Claim from Oxford Insured

Claim

Assumptions:

• Your Captive Premium is $500,000
• Total Written Premium = $200MM
• Your Quota Share of Claim Pool = 0.25%

Your Captive

$1,275

$1,000,000

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IASA 87TH ANNUAL EDUCATIONAL CONFERENCE & BUSINESS SHOW

IRS Scrutiny of Abusive Structures

• Not Following the Safe Harbor

Guidelines

• No Real Distribution of Risk
• No Claims Experience or Claims

Layering

• High Deductible Risk Pools or

Retroactive Policy Issuance

• Lack of Business Purpose
• Implementing a Captive to

Obtain Tax Deductible Life Insurance

• Tax Opinion Written by an

Interested Party

• Insuring Unreasonable Risks
• Paying Excessive Premium for

your Coverage

• Treating Captive Assets as a

Personal Checkbook

• Circular Transactions
• Investment Plans that Don’t Make

Sense

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IASA 87TH ANNUAL EDUCATIONAL CONFERENCE & BUSINESS SHOW

Captive Advisory Group

Captive Manage Legal Counsel

Risk Analysis Firm Financial Advisor Tax Counsel Audit Firm Actuarial Firm

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IASA 87TH ANNUAL EDUCATIONAL CONFERENCE & BUSINESS SHOW

Captive Implementation Process

Initial Consultation Informal Feasibility Analysis Domicile Selection Engagement Process Risk Analysis, Underwriting and Compliance Complete Feasibility Study Application to Insurance Regulators Approval Process Closing Procedure

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IASA 87TH ANNUAL EDUCATIONAL CONFERENCE & BUSINESS SHOW

Client Profile

• Annual Revenue $3MM+
• Enterprise Risk Exposure
• Willing to invest time to

explore risk management solutions

• Sophisticated business
• wner
• Across All Industries:
• Agriculture
• Automobile
• Construction
• Entertainment/Professional Athlete
• Medical
• Real Estate
• IT
• Oil Drilling
• Manufacturing

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IASA 87TH ANNUAL EDUCATIONAL CONFERENCE & BUSINESS SHOW

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