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
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 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)
4
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
5
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
6
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
7
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
8
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
9
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”
10
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?
11
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)
12
IASA 87TH ANNUAL EDUCATIONAL CONFERENCE & BUSINESS SHOW
SECTION 831(b) COMPANIES
Operating
Company
Captive Insurance
Company
(831(b) Election)
Gen-1
or
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)
13
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
14
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
15
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
16
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
17
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
18
IASA 87TH ANNUAL EDUCATIONAL CONFERENCE & BUSINESS SHOW
Current Structure
Insurance Company
Owned by Father
Unrelated Reinsurer
19
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
of Premiums)
831(b) owned
by one adult
child
($1,200,000
of Premiums)
831(b) owned
by one adult
child
($1,200,000
of Premiums)
831(b) owned
by one adult
child
($1,200,000 of
Premiums)
20
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%
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 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 0 54 0
Total 100 100 46 22
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
23
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
24
IASA 87TH ANNUAL EDUCATIONAL CONFERENCE & BUSINESS SHOW
Thank you for attending!
Doug Youngren, CPA, JD, Tax Partner
312.980.2944
25
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.
26
IASA 87TH ANNUAL EDUCATIONAL CONFERENCE & BUSINESS SHOW
Captive Insurance
Overview
27
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
28
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
owned insurance companies
1861 1920s 1957 Today 2002 2004 2014
29
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
30
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
31
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
32
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
33
IASA 87TH ANNUAL EDUCATIONAL CONFERENCE & BUSINESS SHOW
How Does it Work?
Operating
Company
New Captive
of Oxford
Insurance
Company
Oxford
Fronting
Carrier Insurance Policy
Insurance Premium
Pre
miu
m
Rein
su
ran
ce
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
35
IASA 87TH ANNUAL EDUCATIONAL CONFERENCE & BUSINESS SHOW
Exposure to Claims
Oxford Fronting Carrier
All Other Captives
Share Risk on a Quota Share Basis
Captive which filed the Claim
$1,000,000 Claim from
Oxford Insured
Cla
im
Assumptions: • Your Captive Premium is $500,000 • Total Written Premium = $200MM • Your Quota Share of Claim Pool = 0.25%
Your Captive
$1,275
$1,0
00,0
00
36
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
37
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
38
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
39
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
owner
Across All Industries:
• Agriculture
• Automobile
• Construction
• Entertainment/Professional Athlete
• Medical
• Real Estate
• IT
• Oil Drilling
• Manufacturing
40
IASA 87TH ANNUAL EDUCATIONAL CONFERENCE & BUSINESS SHOW
Please Complete the Session Evaluation Form on the Conference App