831(b) ELECTION

Transcription

1 A6: TAX & REGULATORY ISSUES FOR 831(b) CAPTIVES SIIA 33rd Annual National Educational Conference & Expo October 21 23, 2013 Sheraton Chicago Hotel and Towers Chicago, IL Charles J. ( Chaz ) Lavelle Ernie Achtien Bingham Greenebaum Doll LLP Captive Resources LLC 3500 National City Tower 201 E. Commerce Drive 101 S. Fifth Street Schaumburg, IL Louisville, KY / / eachtien@captiveresources.com clavelle@bgdlegal.com Jeffrey Simpson Gordon, Fournaris & Mammarella, P.A Lovering Avenue Wilmington, DE / jsimpson@gfmlaw.com 831(b) ELECTION IRC Section 831(b) provides that: Insurance companies with not greater than $1.2 million of annual written premium pay $0 income tax on insurance underwriting profits. Investment income is taxed as income to C corporation 831(b) status must be timely elected and cannot be revoked without the permission of the Secretary Exceeding $1.2 million disqualifies use for that year 2 1

2 IRC SEC. 831(b) CODE LANGUAGE 831(b) Alternative tax for certain small companies (1) In general: In lieu of the tax otherwise applicable under subsection (a), there is hereby imposed for each taxable year on the income of every insurance company to which this subsection applies a tax computed by multiplying the taxable investment income of such company for such taxable year by the rates provided in section 11(b) (2) Companies to which this subsection applies (A) In general: This subsection shall apply to every insurance company other than life (including interinsurers and reciprocal underwriters) if (i) the net written premiums (or, if greater, direct written premiums) for the taxable year do not exceed $1,200,000, and (ii) such company elects the application of this subsection for such taxable year 3 IRC SEC. 831(b) CODE LANGUAGE (cont d) The election under clause (ii) shall apply to the taxable year for which made and for all subsequent taxable years for which the requirements of clause (i) are met. Such an election, once made, may be revoked only with the consent of the Secretary 4 2

3 831(b) ELECTION INVESTMENT INCOME Section 834 defines taxable investment income Certain expenses deductible under Section 834 to determine taxable investment income. TAM discusses limit on deductible investment expenses 5 831(b) ELECTION CONTROLLED GROUP RULES Insurance companies owned by related parties aggregated one $1,200,000 limit Section 1563 governs, modified by using a 50% threshold versus 80% Rules are complex and must be reviewed in each case 6 3

4 QUALIFYING FACTORS First & foremost: this is an insurance company Non tax business purpose Risk shifting and risk distribution Not a sham Insurance risk 7 TAX BENEFITS Deductibility of premiums 162/ 212 Assuming premiums are market comparable or can be valued by an actuary or underwriter Taxation of CIC s profits 831(b) provides tax exemption from underwriting profit. Federal tax on investment income only Retirement/ buy out planning Certain investments and structures could allow client to access CIC invested funds tax efficiently. Estate/Gift Taxes Possible transfer of underwriting profits and investment income to heirs tax efficiently. 8 4

5 TAX TREATMENT OF PREMIUMS Profitable business pays up to $1,200,000 in premiums each year Profitable Business CIC Premiums may be deductible under sec. 162 Downside to the election underwriting net loss is not deductible and cannot be carried over or back 9 RISK DISTRIBUTION Risk Distribution does the insurance company distribute its risk to other insureds? Rev. Ruls (50%); (12 subs or no more than 15% of total premium); (Group Captive 15% of premium, vote or stock) Harper Group and Includable Subsidiaries v. Commissioner, 96 T.C. 45 (1991): Because the CIC had at least 30% unrelated third party risk, the arrangement constituted insurance Rev. Rul : risk distribution requirement is met if CIC has 12 or more insureds (10% unrelated risk distribution insufficient; DRE disregarded for RD) Affiliated companies count, but not single member LLCs Compare to Humana Inc. v. Commissioner, 881 F.2d 247 (6 th Cir. 1989) in which sums paid to parent company s Captive Insurance subsidiary, on behalf of several dozen parent company subsidiaries, was sufficient risk distribution to constitute insurance 10 5

6 Operating Business A ACHIEVING RISK DISTRIBUTION UNDER REVENUE RULING Operating Business B Operating Business A s Captive Operating Business C Insurance Provider ( Pool ) Operating Business B s Captive Operating Business D Operating Business C s Captive Operating Business D s Captive 11 Each Operating Business will pay 50%+ of its captive premium to the Pool in return for coverage of named risks The Pool then reinsures its risk with each Operating Business Captive in the same percentage that the Operating business s premium represents Example: Assume Operating Business A pays $200k to the Pool and that $200k premium represents 2% of all premiums received by the Pool. The Pool will then pay Operating Business A s Captive $200k to reinsure 2% of the Pool s total risk (i.e. 2% of all of the other participating Operating Business s risk) ACHIEVING RISK DISTRIBUTION UNDER REVENUE RULING Related Entity 1* Related Entity 2* Related Entity 3* Related Entity 4* Captive Insurance Company ( Captive ) Related Entity 5* Related Entity 6* Related Entity 7* *Related entity must not be considered a disregarded entity Related entities pay premiums directly to the Captive for various lines of P&C insurance Each Related Entity s premium cannot be less than 5% nor more than 15% of the total premiums received by the Captive; at least 12 Related Entity s 12 6

7 WHAT DO WE REALLY MEAN BY 831(b)? Any Insurance Company that qualifies? OR Pure captive with all or most of these features Related to privately held business Covers high severity/low frequency risks Cover risks not typically addressed by commercial program Covers first party risks Facilitates estate planning or wealth transfer 13 HOW DO REGULATORS FEEL ABOUT 831(b) Do regulators: Acknowledge a class or category? Think differently about them? Treat them differently? Answer: Interview a bunch Interesting revelations 14 7

8 QUESTION: DO YOU KEEP TRACK OF THE NUMBER OF 831(b) CAPTIVES IN YOUR DOMICILE? True or False: Almost every regulator professed to have no idea how many of their captives are 831(b)! 15 QUESTION: DO YOU DISTINGUISH BETWEEN TRADITIONAL AND NON TRADITIONAL RISKS WHEN REVIEWING AN APPLICATION? True or False: Regulators were uniformly uncomfortable with nontraditional risks 16 8

9 QUESTION: DOES YOUR DOMICILE MAKE ANY EXCEPTIONS OR ACCOMMODATIONS TO ATTRACT 831(b) CAPTIVES? True or False: Every regulator said they do not, even the ones whose statutes provide some relaxed standards for small insurance companies 17 QUESTION: DO YOU SEE A REASON OR RATIONALE FOR VIEWING OR TREATING 831(b) CAPTIVES DIFFERENTLY THAN OTHERS? True or False: Only one regulator mentioned small business enterprise risk in answering this question 18 9

10 QUESTION: DO YOU ALLOW 831(b) TO BE OWNED OUTSIDE THE CORPORATE CHAIN, SUCH AS BY TRUST FOR THE BENEFIT OF THE FOUNDERS HEIRS? True or False: States that do significant 831(b) business uniformly said yes, and states that do not do significant business uniformly said they had never had to address the question 19 QUESTION: DO YOU CONSIDER IRS TAX GUIDANCE IN DECIDING WHAT TO PERMIT OR APPROVE? True or False: Every regulator professed to consider only solvency, liquidity and policy holder protection 20 10

11 QUESTION: IF A CAPTIVE S RISK WILL RUN THROUGH A POOL, DO YOU REVIEW OR EVALUATE THE POOL? True or False: Less than half of the regulators worried about the pool 21 SELECTED TOPICS Audit and Litigation Alternative Pooling Arrangements Homogeneity Insurance Risks Pricing of Premiums Investments Claims Formation and Operation 22 11

12 AUDIT AND LITIGATION IRS Audit Philosophy: For almost a decade, there has been heavy auditing of section 501(c)(15) insurance companies (totally tax exempt) Commercial and captive insurance companies have been subjected to excise tax audits in the last few years Captive insurance companies have often been audited in connection with the audit of the operating company 23 AUDIT AND LITIGATION (cont d) It appears the IRS has become much more active on a number of additional fronts Filling in the gaps in Revenue Rulings Concentration of risk in one subsidiary (i.e., 60 70% of the captive s risks are in one sister subsidiary) Abuse Salty Brine Residual Value Insurance Life Insurance Other Arrangements 24 12

13 AUDIT AND LITIGATION (cont d) CCA : disclosure of third party information in one exam can be made in another pattern evidence demonstrating that the arrangements did not take into account each participant's risk profile could be used to show that the arrangements were not insurance. For example, if the documents demonstrated that the arrangement entered into by the other taxpayers was not tailored to those taxpayers' individual situation and risk because the other taxpayers' insurance documents were identical to B 1's and C 1's documents, this pattern evidence would demonstrate the arrangement was not insurance 25 ALTERNATIVE POOLING ARRANGEMENTS Each captive insures its risks to a Pooling Company, which reinsures a pro rata portion of each risk to each respective captive RED CO. $45x of risk from Red Co. RED INSURANCE LTD. 45% of Layer 2 pooled risk YELLOW CO. $35x of risk from Yellow Co. Front 45X Red Co + 35X Yellow + 20X Blue Co YELLOW INSURANCE LTD. 35% of Layer 2 pooled risk BLUE CO. $20x of risk from Blue Co. BLUE INSURANCE LTD. 20% of Layer 2 pooled risk This slide illustrates pooling, but does not address the number of insureds or insurers needed for sufficient risk distribution

14 Alternative Pooling Arrangements (cont d) Red Operating Company insures 100% of its risks to Red Captive (related); Operating Companies Yellow, Blue, etc. also insure 100% of their respective risks to Captives Yellow, Blue, etc. respectively; each of the Captives insures with Pool Ins. Co., which retrocedes a pro rata portion to the Captives. BEFORE AFTER Red Co. Group RED INSURANCE LTD. $45x of risk from Red Co. RED INSURANCE LTD. 45% of pooled risk Yellow Co. Group YELLOW INSURANCE LTD. $35x of risk from Yellow Co. Pool Ins. Co. 45X Red Co Risks + 35X Yellow Risks + 20X Blue Co Risks YELLOW INSURANCE LTD. 35% of pooled risk Blue Co. Group BLUE INSURANCE LTD. $20x of risk from Blue Co. BLUE INSURANCE LTD. 20% of pooled risk This slide illustrates pooling, but does not address the number of insureds or insurers needed for sufficient risk distribution. 27 Alternative Pooling Arrangements (cont d) Each Captive enters into a contract with every other Captive so that each Captive bears a pro rata portion of the risks of all the insureds P ship A & Corp A Operating Entities Corporation B Operating Entity Partnership C Operating Entity CAPTIVE A* CAPTIVE B* CAPTIVE C* Contractual Pool; no captive exceeded 15% This slide illustrates pooling, but does not address the number of insureds or show the number of insurers resulting in risk distribution

15 ALTERNATIVE POOLING ARRANGEMENTS The Pool reinsures a pro rata portion of all its risks to each of the captives The Pool reinsures 100% of a layer of coverage (say, the first $100,000) of Operating Company A s risks to related Captive A; and a pro rata portion of the remaining risks (say $100,000 to $250,000) to each Captive The Pool reinsures a pro rata portion of all its risks of a layer coverage (say the first $100,000) to the captives; and 100% of an upper layer (say $100,000 to $250,000) of Operating Company A s risks to related Captive A Each Operating Company insures 49% of its risks with the Captive and 51% with the Pool, which reinsures a pro rata share with all captives 29 HOMOGENEITY Do the unrelated risks have to be the same as the related party risks? Are the percentages (50% unrelated; 12 subsidiaries between 5% and 15% of the premiums) computed on a line of coverage by line of coverage basis, or on a captive wide basis? 30 15

16 INSURANCE RISKS Must be a risk (possibility it will occur) Cannot be an eventuality (may not occur) Not an investment risk Not a business risk Not much authority relating to business risk Embedded and extended warranties Prepaid income Residual value insurance 31 INSURANCE RISKS (cont d) Fire, flood, windstorm, workers compensation, general liability, etc. Cyber risk? Loss of key customer, loss of key supplier? Bad debt expense? 32 16

17 PRICING OF PREMIUMS Market based premiums Actuarially computed premiums Underwriter determined premiums 33 INVESTMENTS Sufficient liquidity to pay claims as and when they come due Investment standards placed upon commercial insurance carriers Loan backs to insureds; their affiliates? Life insurance policies? 34 17

18 CLAIMS Make claims if loss occurs Pay claims if they are valid Consequence of no related losses; no unrelated losses 35 FORMATION AND OPERATION Non-tax Business Purpose Capitalization (Surplus Notes? Letters of Credit?) No Guarantees Regulation Policy Terms Reserves Separate Operation and Corporate Formalities State Tax/Self Procurement/Dodd Frank 36 18

19 QUESTIONS Charles J. ( Chaz ) Lavelle Bingham Greenebaum Doll LLP 3500 National City Tower 101 S. Fifth Street Louisville, KY / clavelle@bgdlegal.com Ernie Achtien Captive Resources LLC 201 E. Commerce Drive Schaumburg, IL / eachtien@captiveresources.com Jeffrey Simpson Gordon, Fournaris & Mammarella, P.A Lovering Avenue Wilmington, DE / jsimpson@gfmlaw.com 19