captives - iasa 2015/sessions...•captives which make an annual election under irc section 831(b)...

IASA 87TH ANNUAL EDUCATIONAL CONFERENCE & BUSINESS SHOW

Captives What Benefits Do They Provide?

Session 606


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


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


WHAT IS INSURANCE?


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


WHAT IS INSURANCE?


Unrelated Business

Pooling Arrangements

Concentration of Risks

REV. RUL. 2005-40, 2005-27 IRB 4

REV. RUL. 2009-26, 2009-38 IRB 366

6


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


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


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


WHAT IS INSURANCE?


• 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


WHAT IS INSURANCE?


• 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


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


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


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


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



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



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


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


Current Structure

Insurance Company

Owned by Father

Unrelated Reinsurer

19


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


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


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


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


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


Thank you for attending!

Doug Youngren, CPA, JD, Tax Partner

312.980.2944

[email protected]

25


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


Captive Insurance

Overview

27


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


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


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


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


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


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


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


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


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


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


Captive Advisory Group

Captive Manage

Legal Counsel

Risk Analysis

Firm

Financial Advisor

Tax Counsel

Audit

Firm

Actuarial

Firm

38


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


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


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captives - iasa 2015/sessions...•captives which make an annual election under irc section 831(b)...

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