Section 831(b) Captive Nuances and Best Practices, Tax Risk Distribution/Sharing and. Accounting Risk Transfer Rules

Transcription

1 ACI s 2 nd Advanced Forum on Captive Insurance Section 831(b) Captive Nuances and Best Practices, Tax Risk Distribution/Sharing and April 24-25, 2014 Accounting Risk Transfer Rules Anne Marie Towle Senior Captive Consultant Willis Global Captive Practice Dan Kusaila Partner Saslow, Lufkin & Buggy, LLP Chaz Lavelle Partner Bingham Greenebaum Doll, LLP Tweeting about this conference?

2 831(b) Captives b) Captives Scoping the risks 2

3 Types of Risks TRADITIONAL EXPANDED EMERGING Workers Compensation Auto Liability General Liability Professional and Products Liability Director and Officer Liability Employment Practices Liability Environmental Liability Product or Service Extended Warranty Property and Business Interruption EE Benefits Terrorism (TRIA) Shipping Coverage Title and Private Mortgage Insurance Equipment Maintenance Construction Exposures Trade Credit Risk Cyber-Risk Managed Care Errors and Omissions Self-Insured Medical Stop- Loss (non-erisa) Reputation/Brand/Loss of Income Risks Intellectual Property (patent, trademark, copyright) Product Recall Coverage Medicare Fraud and Abuse Insurance Lease Residual Value Risk Punitive Damages Coverage International Kidnapping Protection 3

4 Small Insurance Company Optimization Low Frequency, high severity types of risks Endless possibilities Examples include: Cyber Cargo Crime Pollution Professional Business Interruption Reputational Risk Property 4

5 Common Structure Options for 831(b) Captives Shareholders A B C D E F Company XYZ 5 Risk & Premium 3 Insurance Policy Captive 831(b) 1 Shareh olders each con trib ute capital to th e 831(b)captive; 2 Company XYZ pays the cap tive a premium which includes th e losses, excess premiums (if applicab le) and taxes; 3 The captive Issues an insurance policy to Company XYZ 4 Company XYZ submits claims to the captive, wh o settles them; and 5 Captive reimburses Co mp an y XYZ for the losses

6 Common Structure Options for 831(b) Captives Shareholders A B C D E F Company XYZ Risk & Premium 3 Insurance Policies Captive 831(b) Captive 831(b) Captive 831(b) Captive 831(b) Captive 831(b) Captive 831(b) 5 1 Shareholders contribute capital to their individual 831(b)captive; 2 Company XYZ pays each captive a premium which includes the loss es, excess premiums (if applicable) and taxes associated with t hat captive s insurance offering; 3 Each captive Issues an insurance policy to Company XYZ 4 Company XYZ submit claims to the captives, who settle them; and 5 Captives reimburse Company XYZ for the losses

7 What is the Feasibility Process? Develop General Framework Structure & Pro Forma Outcomes Actuarial Analysis Domicile Analysis Tax & Legal Analysis

8 831(b) Captives b) Captives Small Insurance Company Captives 8

9 Alternative Tax for Small Insurance Companies 831(b) Captives Small Corporations can elect to be taxed on their taxable investment income. Must meet the tax qualifications to be taxed as an insurance company in order to make the election. 9

10 Alternative Tax for Small Insurance Companies (cont d.) What is Small? Section 831(b)(2)(A)(i) states that the net written premiums (or, if greater, direct written premiums) for the taxable year do not exceed $1,200,000 Company must elect and can only be revoked by the Commissioner or if the Company fails to meet the criteria 10

11 Alternative Tax for Small Insurance Companies (cont d.) Net written premiums and direct written premiums are not defined by the Internal Revenue Code or regulations. However, the IRS Manual has determined that the IRS will look to the NAIC definition of these terms. Direct written premiums = all premiums arising from policies issued by the company as the primary insurance carrier, adjusted for any return or additional premiums arising from endorsements, audits, and retrospective rating plans. Net written premiums = the sum of direct written premiums plus assumed reinsurance premiums, less ceded reinsurance premiums. 11

12 Alternative Tax for Small Insurance Companies (cont d.) 1. Investment expenses also can include general expenses properly allocable to investment activities. 2. Section (c)(2) (ii) defines general expenses to mean any expense paid or incurred for the benefit of more than one department of the company rather than for the benefit of a particular department thereof. 1. Auditing Expenses 2. Management Fees 3. Tax Fees 4. Etc. See Letter Ruling

13 Small Insurance Company : 831(b) Investment Expenses Limitation If general expenses are allocated to investment expenses the deduction is subject to a limitation under IRC 834(c)(2) The total deduction cannot exceed the sum of (1) 1/4 of one percent of the mean of the book value of the invested assets held at the beginning and end of the tax year, plus (2) 1/4 of the amount by which taxable investment income (computed without the deduction for investment expenses, tax-exempt interest or dividends received) exceeds 3 3/4 percent of the book value of the mean of the invested assets held at the beginning and end of the tax year 13

14 Small Insurance Company : 831(b) Investment Expense Limitation (cont d.) 14

15 Alternative Tax for Small Insurance Companies (cont d.) Controlled Group: If there is more than 1 insurance company that is part of a consolidated return or member of a controlled group, the premiums of all insurance companies must be aggregated in order to determine if the $1.2 million threshold has been exceeded. See Section 831(b)(2)(B) 15

16 Alternative Tax for Small Insurance Companies (cont d.) 1563(f)(5)Brother-sister controlled group definition 1563(f)(5)(A)(2)Two or more corporations if 5 or fewer persons who are individuals, estates, or trusts own (within the meaning of subsection (d)(2) stock possessing 1563(f)(5)(A)(2)(A) at least 80 percent [more than 50% IRC Sec 831(b)(2)(B)] of the total combined voting power of stock or at least 80 percent [more than 50% IRC Sec 831(b)(2)(B)] of the total value of shares of all classes of stock, of each corporation, and 1563(f)(5)(A)(2)(B) more than 50 percent of the total combined voting power of stock or more than 50 percent of the total value of stock of each corporation, taking into account the stock ownership of each such person only to the extent such stock ownership is identical with respect to each such corporation 16

17 Alternative Tax for Small Insurance Companies (cont d.) Brother/sister controlled group example: Individuals Red Co Blue Co Green Co John Sara Nick Unrelated Total John, Sara and Nick combined own more than 50% of the stock of each company thus they constitute a brother sister corporation. 17

18 Alternative Tax for Small Insurance Companies (cont d.) Net Operating Losses: Cannot be carried to or from a year in which the company is taxed under Section 831(b) Cannot be carried to any taxable year if, between the taxable year from which such loss is being carried and such taxable year, there is an intervening taxable year for which the insurance company was not subject to the tax imposed by subsection (a). 18

19 831(b) Captives b) Captives Common Pitfalls 19

20 Alternative Tax for Small Insurance Companies (cont d.) C Corporation TI: $100,000 C Corporation TI: $200,000 C Corporation TI: $300, (b) Company $1.2 million of premium In the above scenario, the 15% tax rate for the 831(b) Company will be stepped up to a 34% tax rate due to the controlled group. 20

21 Other Pitfalls Business or Investment Risk rather than insurance risk; Too much time spent on investments; Are you in the business of insurance or investing? Premium Credits Advanced Premium 21

22 Alternative Tax for Small Insurance Companies (cont d.) Frequently asked Questions: Once the election is made, can I decide not to make the election due to losses? Can you flip/flop between 831(b) years and traditional years? Are the 831(b) captives more vulnerable to IRS scrutiny? Will Congress increase the premium threshold anytime soon? 22

23 831(b) Captives b) Captives Recent Guidance 23

24 Renewed Vigor : Same Tests The IRS is very active in auditing captive insurance companies. They are auditing for excise tax compliance, whether the arrangement is insurance for Federal income tax purposes, whether the section 501(c)(15) and 831(b) rules have been met, etc. But the tests remain the same

25 Renewed Vigor : Same Tests (cont d.) To have a valid insurance arrangement, each of the following must be present: 1) Insurance Risk 2) Risk Shifting enough capital and no guarantees 3) Risk Distribution 4) Common Notions of Insurance

26 Insurance Risk A risk (it may occur) Not an eventuality (it may not occur) Not an investment risk Not a business risk

27 Business Risk An insurance risk cannot be a business risk, but drawing the line between the two is often difficult CCA ruled that an embedded express limited warranty was a business risk and not an insurance risk. The risk was part of the manufacturing process It was, to some degree, required by law It was part of the purchase price of the item It could not be declined by the purchaser in exchange for a refund The insured controlled the manufacturing process so the risk lacked fortuity

28 Business Risk (cont d.) By contrast, an extended warranty is an insurance risk. CCA It only arises after the embedded warranty expires It is purchased separately for a price It can be accepted or declined It covers what would be the consumer s liability, not the manufacturer s

29 PLR Two Obligor companies that sell vehicle service contracts were insurance companies for Federal income tax purposes In those states where it is required, each Obligor will purchase a contractual liability policy or obtain a surety bond from an unrelated party The arrangements met all the insurance tax tests

30 PLR (cont d.) The Obligor companies will follow the insurance tax treatment Neither Obligor company was regulated or licensed as an insurance company Each Obligor company paid its parent a charge for administrative and support services PLR involved roadside assistance (towing, flat tire changes, battery jump starts, fuel and coolant delivery, and lockout services)

31 Insurance Risk PLR PLR residual value risk is not an insurance risk This was not insurance in its commonly accepted sense because it did not cover physical damages, but rather the value of the product vs. a target at the lease s end (a function of supply and demand) There was no risk distribution because the same economic conditions that affect resale value would affect all units This is currently being litigated

32 Types of Risks TRADITIONAL EXPANDED EMERGING Workers Compensation Auto Liability General Liability Professional and Products Liability Director and Officer Liability Employment Practices Liability Environmental Liability Product or Service Extended Warranty Property and Business Interruption EE Benefits Terrorism (TRIA) Shipping Coverage Title and Private Mortgage Insurance Equipment Maintenance Construction Exposures Trade Credit Risk Cyber-Risk Managed Care Errors and Omissions Self-Insured Medical Stop- Loss (non-erisa) Reputation/Brand/Loss of Income Risks Intellectual Property (patent, trademark, copyright) Product Recall Coverage Medicare Fraud and Abuse Insurance Lease Residual Value Risk Punitive Damages Coverage International Kidnapping Protection 32

33 Investment Risk An insurance risk cannot be an investment risk An investment risk is illustrated by Rev. Rul which is said to be based on the MGM Las Vegas (current Bally s) fire of the mid 1980s M was insured for 30X of coverage. A fire caused more than 130x of damage. M bought coverage for the 30x to 130x layer for 50x, with all parties anticipating that the 130x level would be exceeded

34 Investment Risk (cont d.) The Ruling ruled that the insurance company had assumed an investment risk, and not an insurance risk: because the amount to be paid is known, the only unknown was whether the insurance company would earn enough, quickly enough, to make a profit after the payment of claims and expenses

35 Risk Distribution The IRS has litigated with a public company whether there is risk distribution where one insured represents 60-70% of the captive s premium In Rent-A-Center, the Tax Court (by 10-6) seemed to focus on exposure units in a brother-sister context rather than number of entities The IRS has questioned some pools

36 Common Notions of Insurance The insurance arrangement should be reasonable and well documented; the parties should comply with the documentation Investments Loan backs PLRs involved good pooling arrangements Further no opinion is expressed as to the Federal income tax consequences of the transaction described above if Company makes loans to its affiliated insureds or parties related thereto Life Insurance the IRS has challenged arrangements where the captive purchased life insurance on the lives of an owner

37 Questions 37