August 10, Comments on the Definition of Insurance for Tax Purposes. Dear Associate Chief Counsel Hubbard:

Transcription

1 Page: 1 of 18 Section of Taxation OFFICERS Chair William H. Caudill Houston, TX Chair-Elect Karen L. Hawkins Yachats, OR Vice Chairs Administration Charles P. Rettig Beverly Hills, CA Committee Operations Scott D. Michel Continuing Legal Education Joan C. Arnold Philadelphia, PA Government Relations Julian Y. Kim Pro Bono and Outreach Bahar A. Schippel Phoenix, AZ Publications Julie A. Divola San Francisco, CA Secretary Catherine B. Engell New York, NY Assistant Secretary Katherine E. David San Antonio, TX COUNCIL Section Delegates to the House of Delegates Richard M. Lipton Chicago, IL Armando Gomez Last Retiring Chair George C. Howell, III Richmond, VA Members Alan I. Appel New York, NY Larry A. Campagna Houston, TX T. Keith Fogg Villanova, PA Kurt L.P. Lawson R. David Wheat Dallas, TX John F. Bergner Dallas, TX Thomas D. Greenaway Boston, MA Roberta F. Mann Eugene, OR Carol P. Tello Gary B. Wilcox Adam M. Cohen Denver, CO Sheri A. Dillon Ronald A. Levitt Birmingham, AL Christopher S. Rizek Melissa Wiley LIAISONS Board of Governors Pamela A. Bresnahan Young Lawyers Division Vlad Frants Newark, NJ Law Student Division Scott Woody University Park, NM DIRECTOR John Thorner Suite Connecticut Avenue, NW FAX: tax@americanbar.org August 10, 2017 Helen M. Hubbard Associate Chief Counsel (Financial Institutions & Products) Internal Revenue Service 1111 Constitution Avenue, NW., Room Re: Comments on the Definition of Insurance for Tax Purposes Dear Associate Chief Counsel Hubbard: Enclosed please find comments on the definition of insurance for tax purposes ( Comments ). These Comments are submitted on behalf of the American Bar Association Section of Taxation and have not been approved by the House of Delegates or the Board of Governors of the American Bar Association. Accordingly, they should not be construed as representing the position of the American Bar Association. The Section of Taxation would be pleased to discuss the Comments with you or your staff if that would be helpful. Sincerely, William H. Caudill Chair, Section of Taxation Enclosure cc: Hon. John A. Koskinen, Commissioner, Internal Revenue Service Hon. David Kautter, Assistant Secretary (Tax Policy), Department of the Treasury William M. Paul, Acting Chief Counsel and Deputy Chief Counsel (Technical), Internal Revenue Service Alexis MacIvor, Branch 4 Chief, Office of Associate Chief Counsel (Financial Institutions & Products), Internal Revenue Service Dana L. Trier, Deputy Assistant Secretary (Tax Policy), Department of the Treasury Thomas West, Tax Legislative Counsel, Department of the Treasury

2 Page: 2 of 18 AMERICAN BAR ASSOCIATION SECTION OF TAXATION COMMITTEE ON INSURANCE COMPANIES COMMENTS ON THE DEFINITION OF INSURANCE FOR TAX PURPOSES These comments ("Comments") are submitted on behalf of the American Bar Association Section of Taxation (the Section ) and have not been approved by the House of Delegates or Board of Governors of the American Bar Association. Accordingly, they should not be construed as representing the position of the American Bar Association. These Comments were drafted at the invitation of the Office of Associate Chief Counsel (Financial Institutions & Products). Principal responsibility for preparing these Comments was exercised by a working group consisting of Kristan Rizzolo, Chair of the Section s Insurance Companies Committee (the Committee ), Saren Goldner, Graham Green, Charles Lavelle, Fred Campbell-Mohn, and Mark Smith. The Comments were reviewed by Susan Seabrook on behalf of the Section s Committee on Government Submissions. The Comments were further reviewed by Melissa Wiley, the Section s Council Director for the Committee, and Julian Y. Kim, the Section s Vice Chair (Government Relations). Although the members of the Section of Taxation who participated in preparing these Comments have clients who might be affected by the federal income tax principles addressed by these Comments, no such member or the firm or organization to which such member belongs has been engaged by a client to make a government submission with respect to, or otherwise to influence the development or outcome of, the specific subject matter of these Comments. Contacts: Kristan Rizzolo Phone: (202) Fax: (202) kristanrizzolo@eversheds-sutherland.com Date: August 10, 2017

3 Page: 3 of 18 Executive Summary The characterization of a transaction as insurance, or something other than insurance, can have significant federal tax consequences to each of the stakeholders involved. However, the term insurance is not defined in the Code1 or in the Treasury regulations promulgated thereunder.2 Guided by the development of the common law,3 the Internal Revenue Service (the Service ) has, over time, provided guidance as to the characterization of transactions as insurance, or not, for federal income tax purposes.4 To that end, the Tax Court has described a three-pronged test for analyzing whether a transaction constitutes insurance: (1) is insurance risk present in the transaction; (2) is there risk shifting and risk distribution; and (3) does the transaction comport with commonly accepted notions of insurance?5 The purpose of these Comments is to request respectfully that the Service update existing published guidance to align it with recent developments in the common law (described herein) and to address certain gaps in insurance-related guidance for the benefit of both the Service and taxpayers. The Committee welcomes the invitation from the Office of Chief Counsel (Financial Institutions & Products) to provide such input and recommends the following: With respect to defining insurance risk, we recommend that the Service reconsider Revenue Ruling to the extent the Service considers insurance risk in general, and provide appropriate clarification on the following points: o That, although not controlling, a regulatory determination of whether a risk is an insurance risk is a significant factor in determining whether it is an insurance risk for tax purposes; and References to the Code are to the Internal Revenue Code of 1986, as amended. Regulation section (b)(66) contains a definition of insurance policy, but the applicability of that definition is explicitly limited to sections 1441 through References to a section are to a section of the Code or of the Treasury regulations promulgated thereunder, unless otherwise indicated. 3 For example, a Service official speaking at a Federal Bar Association conference in 2011 indicated that Rev. Rul , C.B. 4, contains a "gray area" of "concentration cases," which involve two or three insurers sharing the risk related to insurance contracts. The official indicated that several cases had been docketed and that eventually the decisions could shed light on the correctness of the guidance. IRS Definition of Insurance to Be Challenged in Court, Official Says, Tax Notes Today (2011 TNT 103-8) (May 27, 2011). Another Service official indicated that the question of what is insurance and what can be the subject of insurance is a complicated question, and that the Service is forced to look to the common law although there is very little precedent. ABA Meeting: IRS Considering Options on Rent-A-Center Captive Insurer Decision, Tax Notes Today (2014 TNT 18-10) (January 28, 2014). 4 See, e.g., Rev. Rul , C.B. 984; Rev. Rul , C.B. 985; Rev. Rul , C.B. 991; Rev. Rul , C.B. 4; Rev. Rul , C.B AMERCO v. Commissioner, 96 T.C. 18 (1991), aff d, 979 F.2d 162 (9th Cir. 1992); Harper Group v. Commissioner, 96 T.C. 45 (1991), aff d, 979 F.2d 1341 (9th Cir. 1992); and Sears Roebuck and Co. v. Commissioner, 96 T.C. 61 (1991), aff d in part, rev d in part, 972 F.2d 858 (7th Cir. 1992) C.B

4 Page: 4 of 18 o That multiple types of risks, including business risks and financial risks, can be insurance risks provided the risks are structured appropriately (e.g., they involve fortuity, indemnity, and an insurable interest). With respect to risk distribution, we recommend that the Service retain the revenue rulings issued in setting forth safe harbors concerning the number of insureds and percentage of premiums paid, while: o Clarifying that fewer insureds or variance in the percentage of premiums paid will not preclude the arrangement from resulting in risk distribution; and o Prescribing safe harbors for identifying the relevant exposure units, as well as the basis by which the sufficiency of the exposure units will be measured. Additionally, with respect to risk distribution, we recommend that the Service revise Revenue Ruling to delete Situations 3 and 4 and provide guidance clarifying that state law governs whether an LLC is an insured under an insurance policy (regardless of whether the LLC is disregarded for tax purposes). We recommend that the Service provide guidance establishing a framework for evaluating whether new products covering insurance risk are insurance in the commonly accepted sense for purposes of determining their characterization for federal tax purposes, and recognizing that a product structured as insurance can be insurance in the commonly accepted sense even if it has some features that are different from traditional insurance. Finally, we recommend that the Service issue guidance to memorialize its longstanding ruling position that extended warranty risks of consumers are insurance risks, that contracts that insure those risks may qualify as insurance contracts, and that companies that issue such contracts may qualify as insurance companies for federal income tax purposes. Introduction In one of the first cases to address the definition of insurance for federal income tax purposes, the Supreme Court reasoned in Helvering v. Le Gierse9 that, in the absence of any statutory or regulatory definition, it should be assumed that Congress used the term insurance in 7 Rev. Rul , C.B. 984; Rev. Rul , C.B. 985; Rev. Rul , C.B C.B U.S. 531 (1941). 3

5 Page: 5 of 18 its commonly accepted sense. 10 Moreover, the Court noted that [h]istorically and commonly insurance involves risk-shifting and risk-distributing. 11 The Tax Court in 1991, following the Le Gierse case, announced a three-prong test for insurance characterization in the context of determining which premiums a company pays to an affiliate insurance company should be treated as deductible insurance premiums for U.S. federal tax purposes: (1) is insurance risk present in the transaction; (2) is there risk shifting and risk distribution; and (3) does the transaction comport with commonly accepted notions of insurance?12 This three-prong test has been the foundation for determining whether a transaction is properly characterized as insurance for federal tax purposes. Much of the guidance in this area has been in the context of affiliated insurance companies, commonly referred to as captive insurance companies, or simply captives. The Service continued to challenge insurance arrangements for many years after the Tax Court first announced the three-prong test for insurance characterization. However, in 2001 and 2002, after many years of applying an economic family approach to the analysis for insurance characterization that was rejected by the courts, the Service reconsidered its position and provided very helpful guidance, initially by issuing Revenue Ruling that obsoleted prior revenue rulings in conflict with the courts analysis, and indicated that the Service would follow a facts and circumstances analysis to insurance characterization. In 2002, the Service issued three safe harbor rulings (described below) providing tax certainty for those arrangements that fell within the parameters of one of the rulings, thus relieving the Service of some audit burden. Each ruling dealt with a particular line of analysis previously developed or considered by the courts i.e., unrelated business (e.g., the 1991 cases where the three-prong test was enunciated), brother/sister business (e.g., the Humana14 case), and group business (e.g., Crawford Fitting,15 and Revenue Ruling ). In Revenue Ruling ,17 an unrelated business analysis, the Service concluded that when more than 50 percent of the net and gross premiums earned by an intra-group insurance company (i.e., a captive) for a taxable year were from persons unrelated to the captive (i.e., not from the captive s parent or its brothers and sisters) all of the captive s insurance transactions (including those with its parent) were properly characterized as insurance for federal tax purposes and, conversely, that when the captive had net and gross premiums earned of only 10 percent from unrelated persons, the transaction with its parent was not properly characterized as insurance for federal tax purposes Id. at 540. Id. at 539. AMERCO, 96 T.C. 18; Harper Group, 96 T.C. 45; and Sears, 96 T.C C.B Humana, Inc. v. Commissioner, 88 T.C. 197 (1987), aff d in part, rev d in part, 881 F.2d 247 (6th Cir. 1989) Crawford Fitting Co. v. United States, 606 F. Supp. 136 (N.D. Ohio 1985). Rev. Rul , C.B C.B

6 Page: 6 of 18 In Revenue Ruling ,18 a brother/sister analysis, the Service concluded that when a captive provides insurance coverage for professional liability risks of 12 of its sister companies, where each sister company represented neither less than five percent nor more than 15 percent of the total risk insured by the captive, the transactions between the captive and its sisters were properly characterized as insurance for federal tax purposes. In Revenue Ruling ,19 a group business analysis, the Service concluded that when a captive provided insurance coverage for liability risks of a group of unrelated businesses where each business owned 15 percent or less of the captive and provided 15 percent or less of the risk covered by the captive, the transactions between the captive and its shareholders were properly characterized as insurance for federal tax purposes. Subsequently in 2005, the Service provided additional guidance, in Revenue Ruling ,20 on risk distribution and the status of LLCs as insureds. The ruling was in the context of an insurance company providing insurance coverage to unrelated insureds. The Service concluded that when an insurer has only one insured, the transaction between the insurer and the insured is not properly characterized as insurance for federal tax purposes. Similarly, the Service concluded that when an insurer has two insureds, with the second insured representing only 10 percent of its premiums, the transaction between the insurer and the insureds is not properly characterized as insurance for federal tax purposes. The Service in Revenue Ruling also concluded that single member LLCs that are treated as disregarded entities for federal income tax purposes are not characterized as separate insureds for purposes of determining whether there is a sufficient number of insureds to allow for adequate risk distribution,21 but that LLCs that elected to be treated as corporations are characterized as separate insureds for such purposes. Recent cases have addressed, among other issues, key aspects of the Tax Court s test for insurance characterization, including refining the determination of risk distribution and of insurance risk. In Rent-A-Center, Inc. v. Commissioner,22 the Tax Court held that a captive s insurance arrangements with its sister companies were properly characterized as insurance for federal tax purposes. In reaching its holding, the court determined that there was risk distribution based on the number of statistically independent exposure units. Consistent with its holding in Rent-A-Center, in Securitas Holdings, Inc. v. Commissioner23 the court held again that a brother-sister insurance arrangement was properly characterized as insurance for federal tax purposes, concluding that risk distribution was present as a result of an adequate number of statistically independent exposure units. In R.V.I. Guaranty Co., Ltd. v. Commissioner,24 the Tax C.B C.B C.B The Service s analysis in TAM (Dec. 3, 2007) is not easy to reconcile with this conclusion. In the TAM, the Service looked to state law to determine whether an entity should be treated as the insured party for federal tax purposes, and concluded that where the entity itself was the person liable for the insured loss under state law, the entity should be characterized as the insured T.C. 1 (2014). 23 T.C. Memo (Oct. 29, 2014); 109 T.C.M. (CCH) 490; 2014 RIA TC Memo T.C. 209 (2015). 19 5

7 Page: 7 of 18 Court, applying the three-prong test and focusing on the issue of insurance risk, concluded that insurance was present. In its analysis, the court found the state law treatment of the policies as insurance to be an important factor in determining if a risk is an insurance risk. In light of Rent-A-Center, Securitas, and R.V.I., we recommend that the Service take action similar to what it did in 2001 and 2002, by obsoleting, or otherwise negating, certain conclusions in prior Service guidance inconsistent with these cases, and by providing safe harbor criteria to take account of these recent cases. Aligning published guidance with recent case law would benefit both the Service and taxpayers. The absence of Service published guidance reflecting the courts analysis of insurance characterization for federal tax purposes creates unnecessary controversy because, in our experience, Service agents continue to propose adjustments at odds with these recent judicial authorities. For taxpayers, the absence of published guidance creates needless uncertainty for planning purposes.25 Insurance Risk Like the term insurance, insurance risk also lacks a definition in the Code or the applicable Treasury regulations. Rather, over the years, the courts have considered a variety of types of insurance products to determine whether they provide coverage for insurance risk. In general, the cases have identified an insurance risk as a contingent loss event, the risk of which gives rise to an economic loss. The cases generally have focused on three aspects of insurance risk: indemnity, fortuity, and insurable interest. For example, the Seventh Circuit described insurance as a contract under which one party agrees to indemnify another against loss arising from contingent perils.26 The Second Circuit has noted that insurance contemplates the fortuitous occurrence of a stated contingency (emphasizing that fortuity involves an uncertain occurrence that is beyond the insured s control).27 In another tax case, the Seventh Circuit observed that, in common understanding, the risk transferred under a contract of insurance must be the risk of economic loss arising from a defined contingency, requiring the insured to have an insurable interest in the insurable risk.28 In Epmeier, the employer, an insurance company, provided employee health benefits. The court noted that the benefit plan was not in the form of an insurance policy, but concluded that the essence of the arrangement was health insurance.29 Similarly, in United States v. Home Title Insurance Co.,30 the Supreme Court held that title insurance was a type of insurance and noted that the title guaranty company was organized as an insurance company under state law, subject to the laws applicable to title and credit guaranty companies and maintained the required insurance guaranty fund. In Allied Fidelity, the Seventh Circuit held that a company that was 25 It is important to note that we consider the 2002 safe harbors to be consistent with earlier judicial determinations and believe that they can be reconciled with the recent cases. Companies have been operating within the safe harbors for many years and have been able to achieve a certain level of certainty regarding their insurance arrangements by relying on those safe harbors. Therefore, we believe that those safe harbors should be retained. 26 Epmeier v. United States,199 F.2d 508, 510 (7th Cir. 1952). 27 Commissioner v. Treganowan, 183 F.2d 288, (2d Cir. 1950). 28 Allied Fid. Corp. v. Commissioner, 572 F.2d 1190, 1193 (7th Cir. 1978). 29 Epmeier, 199 F.2d at U.S. 191, 192 (1932). 6

8 Page: 8 of 18 primarily in the business of writing bail bonds was not covering insurance risks. In contrast to an insurance contract s reimbursement for a financial loss, the loss to the state if a person accused of a crime flees the jurisdiction of the court system is not merely a pecuniary one, it also may be a social, legal or moral loss. As a result, the court held that the risks were not insurance risks.31 In general, courts have distinguished between insurance risk and investment risk in addressing what constitutes insurance for federal income tax purposes. One of the key issues considered by the Supreme Court in Le Gierse was whether the risk of loss assumed in the transaction was an insurance risk or an investment risk. In that case, a taxpayer purchased a life insurance contract and an annuity contract. The court observed that the contracts, when taken in combination, exhibited no actual insurance risk because whatever the time of death, any loss on one contract would be necessarily offset by gain on the other. The only risk assumed by the insurance company was whether it would earn a sufficient return on investment to fund the payments under the annuity policy. The Court accordingly held that the risk assumed by the insurance company was not an insurance risk.32 Over the years, the Service has also issued guidance regarding what qualifies as insurance risk. Early rulings focus on insurance risk in contrast to investment risk or non-pecuniary risk. In Revenue Ruling ,33 the Service concluded that bail bonds were not insurance because of the state s non-pecuniary interest. In Revenue Ruling 89-96,34 the Service found that the risk transferred to a casualty insurance company consisted only of investment risk. In the 1989 ruling, the insured purchased additional liability insurance coverage for a loss event that had already occurred and for which a minimum amount of compensatory damages was known. The only uncertainty was timing for when damages would be paid. The Service concluded that, because there was no uncertainty on the occurrence or the minimum amount of the losses, the agreement transferred only investment risk, not insurance risk. The Service extended the scope of Revenue Ruling in Revenue Ruling In Revenue Ruling , the Service focused on fortuity as one of the indicia of insurance risk. In that ruling, the taxpayer engaged in an inherently harmful business process which would require environmental clean-up at the conclusion of the business. The taxpayer entered into an agreement with an insurance company to reimburse the taxpayer for the future remediation costs subject to a cap. The amount and timing of the remediation costs were dependent on numerous factors, including future costs of wages, material, potential regulatory changes, and the timing of the future costs. The Service focused on the fact that the remediation costs were certain to occur, and only the timing and amount of those costs were in doubt. The Service distinguished these facts from an accident or hurricane hazard and concluded that the risk assumed was whether the estimated present value of the remediation costs would exceed the greater of the insurer s costs or the contractual cap. Based on this characterization, the Service concluded that the risk was analogous to the risk in Revenue Ruling and was not an insurance risk F.2d at U.S. at C.B C.B C.B

9 Page: 9 of 18 As noted above, an analysis of insurance risk was most recently conducted in R.V.I.36 The Tax Court in R.V.I. directly addressed whether the contracts issued by R.V.I. covered insurance risks and qualified as insurance in the commonly accepted sense. The Tax Court concluded that the taxpayer s residual value insurance contracts constituted contracts of insurance for tax purposes. The court determined that R.V.I. s policies involved an insurance risk as R.V.I. s loss could vary from zero to the full insured value. Because the premium R.V.I. charged was around four percent of the insured value, R.V.I. was exposed to the underwriting risk that the premiums would not cover the claims.37 Similarly, the Tax Court found that fortuity was present because the events that caused losses (e.g., recessions, interest rate spikes, or bank failures) were random, fortuitous and outside of the control of the insurer and insured. The Tax Court noted that the fortuitous events covered by the residual value policies were similar to the fortuitous events covered by municipal bond insurance policies.38 The Tax Court also found that there was insurance risk from the insured s perspective. The court rejected the Service s argument that the contract provided protection against investment losses because the losses were associated with the risk of a greater than expected decline in the market value of the leased assets.39 Of significance to the Tax Court was the non-tax treatment of residual value insurance. The court found that for more than 80 years, states have regulated contracts which provide coverage against the decline in the market values of particular assets. Similarly, the court cited state law precedent, regulatory guidance and outside financial auditors that consistently recognized residual value insurance as insurance. Congress delegation of the regulation of insurance to the states also was persuasive to the court.40 The Tax Court emphasis on state regulation is consistent with subchapter L s reliance on the NAIC annual statement as a basis for computing taxable income under sections 816 and 832. In R.V.I., the Tax Court found unpersuasive the Service s argument that insurance risk must involve only pure risk and noted that mortgage insurance and municipal bond insurance provide coverage against what the government s expert considered to be speculative risk. Finally, the court rejected the Service s argument that the residual value insurance policies were economically equivalent to a put option, noting that the argument was little more than a simile. 41 The residual value insurance policies could not be taxed as put options under the Code because they did not satisfy the requirements of put options. More generally, the court observed that the existence of competing products that are not identified as insurance is not a reason to say that the residual value contract is not insurance. When it comes to mitigating risk, there may be more than one way to skin the cat. The existence of other strategies does not mean that the strategy chosen is not insurance or that the product purchased involves no insurance risk T.C. 209 (2015). Id. at 236. Id. at 246. Id. at Id. at 238. Id. at 244. Id. at

10 Page: 10 of 18 Recommendations: 1. Importance of Regulatory Determination. We recommend that the Service issue guidance that acknowledges that, although not controlling, a regulatory determination of whether a risk is an insurance risk is a significant factor in determining whether it is an insurance risk for tax purposes. 2. Fortuity and Business and Financial Risk. We recommend that the Service issue guidance, consistent with the Tax Court opinion in R.V.I., that recognizes (1) the concept of fortuity encompasses any unexpected event, not just events like car crashes and acts of God; and (2) multiple types of risks, including business risks and financial risks, can be insurance risks provided the risk is structured appropriately (e.g., it involves fortuity, indemnity, and an insurable interest). In short, we recommend that the Service reconsider Revenue Ruling to the extent the Service considers insurance risk in general. Risk Distribution A. Basis for Determining Risk Distribution As noted above, Revenue Ruling provides that an insurance company achieves risk distribution if a dozen insureds insure their risks with that insurance company, and no insured has liability coverage for less than five percent, nor more than 15 percent, of the total risk insured by the insurance company. The remaining facts in Revenue Ruling are straightforward, including that the 12 insureds had a significant volume of independent risks. At the other end of the risk distribution spectrum is Revenue Ruling Revenue Ruling concluded that there can be no insurance when there is only one insured, or two insureds where one represents 90 percent of the risks and premiums (both gross and net premiums). The Tax Court, however, has looked beyond the number of insureds to the number of exposure units. Exposure units (also called risk events or risk units) are the sources of the risks that are being insured, such as automobiles, employees, or business locations. In Malone & Hyde, Inc. v. Commissioner,43 the Service argued that the presence of eight subsidiary-insureds was insufficient to support risk distribution. Although the court referred to eight subsidiaries in 1979, the first of two years at issue, only five subsidiaries paid premiums, and two of them represented 60 percent and 30.5 percent of the total premiums, respectively. The court concluded that although an insurance company can adequately distribute its risk by having an adequate number of insureds, covering a sufficient number of exposure units is an alternative method to satisfy the risk distribution requirement: Without holding that a specific number of subsidiaries or risk events are required, we conclude in this case that the eight Malone & Hyde subsidiaries sufficiently contributed to the pool of premiums. During the years at issue, Eastland provided worker s compensation coverage for 6,700 to 7,100 employees of Malone & Hyde, its subsidiaries and divisions; automobile liability coverage for 1, T.C. Memo (Dec. 14, 1993), rev d. on other grounds, 62 F.3d 835 (6th Cir. 1995). 9

11 Page: 11 of 18 automobiles, trucks, and trailers; and general liability coverage for most of petitioner s warehouses and retail stores.44 The Tax Court rejected the Service s argument that the Humana case mandated a large number of insureds for risk distribution to be present, noting: It is clear from the Sixth Circuit s opinion that, when several separate corporations are present, risk distribution ordinarily is present. However, we do not think that the Sixth Circuit meant to foreclose the ability of a few insureds with many different insurable risks to demonstrate that they also had achieved risk distribution. 45 Thus, the court concluded that the petitioner in that case demonstrated the presence of risk distribution In Rent-A-Center, the Tax Court found that the arrangement at issue was insurance for federal income tax purposes. Although the opinion does not address the number of insured subsidiaries, the Brief for Petitioners states in paragraph 58 on page 16 that: in 2003, Legacy (the affiliated insurance company) insured only four subsidiaries. The four subsidiaries paid 69.7 percent, 15.8 percent, 13.6 percent and 9 percent of the premiums, respectively. In 2007, the four subsidiaries with the largest concentration of premium represented 55.3 percent, 16.0 percent, 10.7 percent and 9.3 percent of the premiums, with seven subsidiaries paying the remaining 8.7 percent of the premiums in the aggregate. In discussing risk distribution, the Tax Court s opinion did not identify the number of insured subsidiaries, but instead, it recited the types of coverage and number of exposure units the captive insured. Citing Humana, the Tax Court concluded, Thus, by insuring RAC s subsidiaries, Legacy achieved adequate risk distribution. 47 In Securitas, the Tax Court agreed that the identity of the owner(s) of the risks is not crucial in determining if risk distribution exists. Accordingly, although many of the operating companies insured by the captive merged into a single insured subsidiary, the Tax Court concluded that risk distribution was still present. Rather than concentrate on the number of entities insured, the Tax Court addressed the exposure units. The court found that risk distribution could be present if there were a sufficient number of exposure units, even if the number of insured entities had been reduced through merger: Risk distribution is viewed from the insurer s perspective. As a result of the large number of employees, offices, vehicles, and services provided by the U.S. and non-u.s. operating subsidiaries, SGRL was exposed to a large pool of statistically independent risk exposures. This does not change merely because multiple companies merged into one. The risks associated with those companies did not vanish once they all fell under the same umbrella Id., 66 T.C.M. (CCH) 1551 at 14; 1993 RIA TC Memo 93,585, p Id. 46 Id. Malone & Hyde was reversed by the Sixth Circuit based on other grounds. The Sixth Circuit did not address risk distribution: the Commissioner only contests the finding that there was risk shifting. 62 F.3d at Rent-A-Center, 142 T.C. at T.C. Memo at 26 (Oct. 29, 2014); 109 T.C.M. (CCH) 490 at 26; 2014 RIA TC Memo , p

12 Page: 12 of 18 The focus in these cases on the number of exposure units, rather than the number of insureds, is the non-tax approach to risk distribution. As one commentator has noted: [W]hen an insurer has a sufficiently large number of risks such that great variations in aggregate losses are unlikely, and the premiums received plus its capital make it a viable risk bearer, one can say that risk distribution is present regardless of the number of insureds covered. 49 Rent-A-Center provides that risk distribution is possible if there are a statistically significant number of independent risks. 50 No case has defined the minimum number of exposure units needed to achieve risk distribution. Identifying the appropriate exposure unit is the first challenge. For instance, in one of the years in issue in Humana, 59 hospitals were insured for medical malpractice. Is each hospital the correct exposure unit? Once the exposure unit is determined, determining the number of statistically independent risks must be determined. Thereafter, one must determine if there are a sufficient number of such risks. Recommendations: 1. Retain the 2002 Safe Harbor Rulings. We recommend that the Service retain the 2002 Revenue Rulings containing safe harbors concerning the number of insureds and percentage of premiums paid, while issuing guidance clarifying that fewer insureds or variance in the percentage of premiums paid will not preclude the arrangement from resulting in risk distribution. 2. Safe Harbor with Respect to Exposure Units and Risk Distribution. To align with the Tax Court s reliance on exposure units, rather than number of insureds, in its recent cases, we recommend that the Service issue guidance providing a safe harbor method for determining what constitutes a statistically significant number of independent risks. Specifically, we request guidance providing safe harbors to identify the relevant exposure units and the basis by which the sufficiency of the exposure units will be measured. B. Treatment of a Single Member LLC as a Separate Insured In Revenue Ruling , the Service concluded that multiple single member LLCs should be disregarded for purposes of determining whether a captive arrangement had sufficient risk distribution. This conclusion was based on the general rule that a single member LLC is disregarded as an entity separate from its member unless it elects to be treated as a corporation. 51 However, the Service has provided subsequent technical advice concerning the proper person to be considered the insured in the partnership context, which contains analysis that we believe is more appropriate for identifying the insured under an insurance policy. In that 2007 technical advice, the Service considered which partner, if any, in a partnership should be treated as holding risks transferred to an insurer. The Service reasoned 49 Donald Arthur Winslow, Tax Avoidance and the Definition of Insurance: The Continuing Examination of Captive Insurance Companies, 40 Ca. W. Res. L. Rev. 79, 152 (1989) T.C. at Treas. Reg (a), (b)(ii). 11

13 Page: 13 of 18 that state law governs whether an entity or its owners are liable for an insured loss. Thus, the Service concluded, in part: If the entity classified as a partnership for federal income tax purposes is of the type that does not have a general partner(s); that is, under applicable law no liability of the entity can in the ordinary course attach to anyone other than the entity, it is the entity that should be considered the insured under liability coverage for purposes of evaluating whether an arrangement constitutes insurance for federal income tax purposes.52 The Service concluded that the risk of loss for federal tax purposes follows the state law treatment of the general partner(s) as the person(s) ultimately liable for the liabilities of the partnership. The Service observed that in the case of a multiple member LLC, generally under state law, none of the members are exposed to liability in excess of the LLC s assets and, consequently, it is the entity and not the members that should be treated as the insured person for purposes of determining whether an arrangement constitutes insurance. This same analysis should be equally applicable for purposes of determining whether a single member LLC that has not elected to be a corporation should be treated as a separate insured under an insurance policy for federal tax purposes. In addition, it is consistent with the general emphasis in the cases and in the Code on following the regulatory treatment of insurance companies when determining the treatment of insurance companies for federal tax purposes. Thus, although we acknowledge that the Treasury regulations provide that the disregarded entity classification is effective for all federal tax purposes, 53 we believe that the determination of the insureds under an insurance policy is akin to the following circumstances in which an otherwise disregarded single member LLC is treated as distinct from its member for federal tax purposes. In one circumstance, the Service considered whether it could collect taxes owed by an individual who was the sole member of an LLC by filing a lien against the LLC on the ground that the LLC was disregarded for federal tax purposes. The member had performed services in his individual capacity, and not on behalf of the LLC, and had directed the person for whom he performed the services to pay the LLC rather than him.54 The Service noted that although the check-the-box regulations determine how the LLC should be treated for federal tax purposes, state law governs the nature of a person s interest in property for purposes of determining whether a tax lien or levy attaches. Accordingly, the Service looked to the applicable state law and determined that the member of the LLC had no interest in the property owned by the LLC; he had a property interest only in his membership interest and in any distributions due to him from the LLC. Accordingly, the Service determined TAM (Dec. 3, 2007). See Treas. Reg (a). I.L.M (July 30, 1999). 12

14 Page: 14 of 18 that it was prohibited from filing a lien against the LLC in an effort to collect taxes of the member.55 In Suzanne J. Pierre v. Commissioner,56 the Tax Court considered whether an LLC holding cash and publicly traded securities that had not elected to be taxed as a corporation should be disregarded for gift tax purposes. In that case, the sole member transferred membership interests in the LLC to trusts for the benefit of the member s descendants. In order to reduce the gift tax on the gratuitous transfers, the member claimed that she had only transferred membership interests in the LLC to the trusts and not the underlying assets held by the LLC. The membership interests were subject to valuation discounts for lack of marketability and control that did not apply to the underlying assets. The question in the case was whether the LLC should be disregarded for purposes of determining the value of the gifts.57 Noting that state law should govern the nature of the property transferred, the court held that the member should be treated as transferring the membership interests in the LLC rather than transferring the underlying assets.58 In reaching this conclusion, the court first analyzed the treatment of the property transferred under state law and, accordingly, valued the transfers based on the value of the membership interests and not the value of the underlying assets.59 The court then applied the Code to determine the gift tax treatment of the property transfers.60 The court respected the LLC as separate from its member for gift tax purposes even though no election had been made under the check-the-box regulations to treat the LLC as a corporation separate from its member.61 The foregoing authorities show that the rule that disregarded entity classification is effective for all federal tax purposes is not absolute. There are certain circumstances in which a single member LLC that has not elected to be treated as a corporation separate from its member for tax purposes nevertheless is regarded as a separate entity for purposes of evaluating the tax consequences of a transaction involving the LLC and/or its member. We believe that a similar focus on state law for determining the insured under a policy of insurance is warranted given the general influence of state regulation on the tax treatment of insurance companies. Recommendation: We recommend that the Service issue guidance that provides that state law governs whether an LLC is an insured under an insurance policy, and that even if the LLC is disregarded for tax purposes it will be considered for purposes of a risk distribution analysis. This approach would provide consistent treatment for all LLCs. Accordingly, we also recommend that Situations 3 and 4 of Revenue Ruling be deleted. 55 The Service memorandum noted that the membership interest and any distributions paid to the member arising out of that interest could be reached by lien and levy T.C. 24 (2009). 57 Id. at Id. at Id. at Id. at Id. at 35. See also, ReRI Holdings I, LLC v. Commissioner, T.C. Memo (May 22, 2014); 107 T.C.M. (CCH) 1488; 2014 RIA TC Memo

15 Page: 15 of 18 Insurance in the Commonly Accepted Sense Hand in hand with the evaluation of insurance risk is whether the arrangement whereby risk is transferred is insurance in its commonly accepted sense. 62 Historically, the concept of insurance in the commonly accepted sense has received less discussion than risk shifting and risk distribution. The Tax Court, in Allied Fidelity Corp., noted, [i]n common understanding, an insurance contract is an agreement to protect the insured (or a third-party beneficiary) against a direct or indirect economic loss arising from a defined contingency. 63 Similarly, the Seventh Circuit noted, one of the essential features of insurance is this assumption of another s economic risk of loss. 64 Courts have focused on various criteria in analyzing whether a transaction involves insurance in its commonly accepted sense. Most significantly, the courts look to whether the transaction is recognized as insurance for state insurance law purposes. This factor repeatedly has been emphasized in the courts precedents, including in the Tax Court s most recent decisions on the issue.65 Recent cases have evaluated whether a contract qualified as insurance in the commonly accepted sense by focusing on a series of objective factors. In Kidde Industries, Inc. v. United States,66 the taxpayer set up a Bermuda captive to reinsure the group s workers compensation, automobile, and general liability. The Court of Federal Claims found that the agreements qualified as insurance in the commonly accepted sense. The court noted that the written agreements were consistent with insurance in its commonly accepted sense; that premiums were calculated based on generally established means; and that the insurance company s claims procedures were consistent with industry norms. Similarly, in AMERCO, the Tax Court emphasized that the company was adequately capitalized, charged arm s-length premiums, and issued policies constituting binding insurance contracts.67 In Sears, the Tax Court focused on the insurance company s relationship with the insured, and the separateness of the insurance company and its insureds.68 The Tax Court s discussion in Harper Group provides a good summary of the types of characteristics that the court has considered important in determining whether a transaction is insurance in the commonly accepted sense. In this regard, the Tax Court found as follows: Rampart was both organized and operated as an insurance company. It was regulated by the Insurance Registry of Hong Kong. The adequacy of Rampart s capitalization is not in dispute. The premiums charged by Rampart to its 62 See Le Gierse, 312 U.S. at 540; Harper Group, 96 T.C. at 60; AMERCO; 96 T.C. 18, Sears, 96 T.C. 61; Kidde Industries v. United States, 40 Fed.Cl. 42 (1997). 63 Allied Fid.Corp., 66 T.C. at Allied Fid. Corp., 572 F.2d at 1193 (citing COUCH 2d 1:3 (1978)). 65 AMERCO, 96 T.C. at 42; see Harper Group, 96 T.C. at 60; Sears, 96 T.C. at 101; Rent-A-Center, 142 T.C. at 16; Securitas Holdings, Inc. v. Commissioner, T.C. Memo at 27-28; 109 T.C.M. (CCH) 490; 2014 RIA TC Memo , p Fed. Cl. 42 (1997) T.C. at T.C. at

16 Page: 16 of 18 affiliates, as well as to its shippers, were the result of arm s-length transactions. The policies issued by Rampart were valid and binding. In sum, such policies were insurance policies, and the arrangements between the Harper domestic subsidiaries and Rampart constituted insurance, in the commonly accepted sense.69 It is important to note that the types of characteristics that the courts have considered important on this point are those that demonstrate that the parties to the transaction in question as well as third parties, other than the Service, respect the transaction as insurance and that the transaction functions like an arm s-length insurance transaction. The Service s safe harbor ruling similarly focused on these types of objective indicia to determine whether an arrangement is insurance in the commonly accepted sense. In Revenue Ruling ,70 the Service concluded that coverage provided by a group captive qualified as insurance in the commonly accepted sense. The group captive in the ruling was adequately capitalized, issued insurance contracts, charged premiums and paid claims after investigating the validity of the claims. The group captive did not engage in any business activities other than issuing and administering insurance contracts. Premiums charged by the group captive were actuarially determined using recognized actuarial techniques, and were based, in part, on commercial rates. Based on these objective facts, the Service concluded that the group captive was an insurance company. Other Service guidance has focused on similar factors.71 More recent informal Service guidance, however, has expanded the list of potentially relevant criteria beyond the factors identified by the courts, without providing a framework for applying criteria or explaining how they fit with the types of characteristics previously identified by the courts. In CCA ,72 the Service considered whether the foreign currency insurance arrangements at issue constituted insurance in its commonly accepted sense. Although other insurance companies offer similar products and the contracts at issue had many features commonly found in insurance contracts, the Service concluded that the contracts were not insurance in the commonly accepted sense because they did not contemplate a casualty event. This analysis is similar to the approach taken by the Service in TAM On facts analogous to the facts in R.V.I., the Service concluded that the residual value insurance policies at issue did not constitute insurance in the commonly accepted sense because they did not contemplate a casualty event and because a number of features of the policies were unusual T.C. at 60. See also Rent-A-Center, 142 T.C. at 39; Securitas Holdings, T.C. Memo at 27-28; 109 T.C.M. (CCH) 490; 2014 RIA TC Memo , p (noting that this Court has looked to factors such as whether: (1) the insurer was organized, operated, and regulated as an insurance company; (2) the insurer was adequately capitalized; (3) the insurance policies were valid and binding; (4) the premiums were reasonable; and (5) the premiums were paid and the losses were satisfied. ) C.B See CCA (May 6, 2015) (concluding that an arrangement was not insurance in the commonly accepted sense because the premiums were not actuarially determined and because the arrangement was designed to provide a specific rate of return on investment for the insured entities). 72 (Dec. 1, 2014). 73 (Aug. 30, 2011). 15

17 Page: 17 of 18 The Tax Court in R.V.I. rejected the Service s approach to analyzing insurance in the commonly accepted sense and detailed five factors that prior cases had used to determine whether an arrangement constitutes insurance in its commonly accepted sense. These factors were: (1) whether the insurer is organized, operated, and regulated as an insurance company by the states in which it does business; (2) whether the insurer is adequately capitalized; (3) whether the insurance policies are valid and binding; (4) whether the premiums are reasonable in relation to the risk of loss; and (5) whether premiums are duly paid and loss claims are duly satisfied.74 Analyzing R.V.I. s residual value insurance policies based on these factors, the court concluded that the policies constituted insurance in the commonly accepted sense. The factors identified by the courts in R.V.I. and the cases that preceded it provide an objective basis for analyzing whether an insurance arrangement constitutes insurance in the commonly accepted sense. It is important to have these types of objective standards because new risks emerge as businesses and technologies innovate.75 For instance, risks from cyber breaches are a relatively new potential loss. As the insurance industry creates new products and coverages for new and emerging risks, insurance companies will need clear guidance regarding how to determine if those products constitute insurance in the commonly accepted sense. Recommendation: We recommend that the Service provide guidance that establishes a framework for evaluating whether new products are insurance in the commonly accepted sense for purposes of determining their characterization for federal tax purposes. We recommend that such guidance focus on the non-tax treatment of the product as well as the other factors identified by the courts as relevant to the identification of insurance in the commonly accepted sense. We also recommend that the guidance recognize that a product structured as insurance can be insurance in the commonly accepted sense even if it has some features that are different from traditional insurance. Extended Warranty Extended warranties and vehicle service contracts cover risks of mechanical breakdown that are risks of the individual consumers. The risks are unrelated to the sale of the product and unrelated to the business responsibilities of the manufacturer or seller. A significant number of private letter rulings76 and technical advice memoranda77 conclude that extended warranties purchased by a consumer cover insurance risks, and are insurance contracts for federal income tax purposes. The Service s position on this issue has been consistent over many years. One goal of published guidance is to reduce the resources devoted to private letter rulings and other non-precedential advice, particularly where the legal conclusions at issue are not controversial. At this point, the Service s position that extended warranty risks may qualify as 74 R.V.I., 145 T.C. at 231 (citing Harper Group, 96 T.C. at 60 and Securitas, T.C. Memo ). This objective standard approach can be contrasted with the ad hoc approach taken in certain private letter rulings (see, e.g., PLR (Dec. 3, 2015)) in which the Service provides summary conclusions on whether a series of transferred risks were insurance or investment risks without explanation. 76 See, e.g., PLR (Oct. 19, 2009), PLR (Nov. 17, 2004), PLR (July 1, 2003), PLR (June 5, 2002), PLR (July 9, 2001), PLR (June 20, 2001), PLR (Feb. 8, 2001), PLR (July 21, 2000), PLR (April 14, 2000). 77 See, e.g., TAM (Dec. 29, 2004) and TAM (Oct. 6, 2004)