Navigating the Fundamentals of Captive Taxation

Transcription

1 Navigating the Fundamentals of Captive Taxation Matt Gravelin-Johnson Lambert Derick White-Strategic Risk Solutions Jeff Johnson- Primmer Piper Eggleston and Cramer, PC March 10, 2014 from 1:30-2:30pm

2 This presentation will focus on the: Basic federal income tax principles related to property & casualty insurance companies Book-tax differences Corporate structures and formation considerations Key elements of a good tax sharing agreement The content is designed for those who are new to the captive industry or are looking for a basic refresher 2

3 Authoritative Structure The Internal Revenue Code (IRC) o Written by Congress, not the IRS o Subchapter L, sections relate to insurance company taxation ( & relate to non-life) The IRS, with assistance from the U.S. Treasury interpret and regulate the IRC o IRC regulations o Revenue rulings o Revenue procedures o Private letter rulings (PLR) o Technical advice memoranda (TAM) 3

4 State Regulation State regulation and taxation of insurance o In 1945 the McCarran-Ferguson Act was signed into law (15 USC sections ). The federal government expressly authorizes each state to regulate and tax the business of insurance. o An Exception: the federal government may preempt state insurance regulatory and taxation laws when it acts expressly to do so. An example: The Liability Risk Retention Act of 1986: STATES regulate key aspects of an insurer s operations including solvency standards, capital requirements, policy form content, premium changes and consumer protection. States also establish premium tax rates and collect such taxes from insurers operating within their borders. Illinois imposes a corporate income tax in lieu of premium taxes. 4

5 What is an insurance company? 816(a) The term 'insurance company' means any company with more than half of the business during the taxable year is the issuing of insurance or annuity contracts or the reinsuring of risks underwritten by insurance companies (a)(1) The term insurance company means a company whose primary and predominant business activity during the taxable year is the issuing of insurance or annuity contracts or the reinsuring of risks underwritten by insurance companies. An insurance company for tax purposes is largely defined by judicial precedent 5

6 What is insurance? The word insurance has not been defined in the IRC, but was by the National Association of Insurance Commissioners (NAIC) in 2001 o 3301a insurance" means an agreement to indemnify or otherwise assume an obligation, provide services or any other thing of value on the happening of a particular event or contingency, or to provide indemnity for loss with respect to a specified subject by specified circumstances in return for a consideration. Without limiting the generality of the term, "insurance" shall include any business defined in section 3301 of this title, annuity contracts and the business of health maintenance organizations and continuing care retirement communities Whether or not a company can be treated as insurance for tax purpose should be evaluated annually Issue continues to be subject to controversy and litigation 6

7 What is insurance? Sears, Roebuck & Co. v. Commissioner, 972 F.2d 858 (1992) o The tax court developed a 3 prong framework, which remains relevant 1. Presence of insurance risk 2. Both risk shifting and risk distribution required 3. Common accepted notions of insurance Why is that question so important? o When premiums are paid to an affiliate which is not an insurance company, the IRS position is that such premium payments are not deductible. o In addition, an insurer is able to treat the reserves established to pay claims as a liability which reduces its taxable income. An entity that is not an insurer may only deduct claim obligations at the time of actual payment. 7

8 Presence of insurance risk Considers timing and uncertainty Result of a fortuitous event Risk of economic loss measured monetarily Cannot be business or investment risks o Business risk example: manufacturers warranty o Investment risk example: known loss with uncertainty on the timing of payments Helvering v. Le Gierse, 312 U.S. 531 (1941) 8

9 Risk shifting When a person or entity facing the possibility of an economic loss transfers some or all of the financial consequence to another Insurer must have sufficient capital and not be indemnified by another party Typically focuses on the terms to a contract Loan backs or circular cash flow transactions could jeopardize risk shifting Clougherty Packing Co. v. Commissioner, 811 F.2d 1297 (1987) 9

10 Risk shifting Humana, Inc. v. Commissioner, 881 F.2d 247 (1987) o Balance sheet approach adopted by IRS and courts Risk shifting present when captive insured risks of brother-sister entities; Does not extend to Parent: payment of a loss by captive to Parent would show up on Parent s balance sheet as a reduction in value of captive s stock; True insurance relieves the firm s balance sheet of any potential impact of the financial consequences of the insured peril ; Malone & Hyde, Inc. v. Commissioner, 62 F.3d 835 (1995) o The facts-and-circumstances test Brother-sister transactions did not constitute insurance because of: Parent s guarantee of captive s obligations; Captive s thin capitalization; Captive s being loosely regulated; and Annual aggregate limit on amount payable under policies issued by captive 10

11 Risk distribution Statistical phenomenon known as the law of large numbers The Harper Group v. Commissioner, 979 F.2d 1341 (1991) o Brother/sister context, but involves 30% unrelated risk Malone & Hyde, Inc. v. Commissioner, 62 F.3d 835 (1995) o No risk distribution when: Only two brother/sister companies; and One accounting for 86-88% of captive s premium and majority of risks Revenue Ruling o 12 or more brother/sister subsidiaries (different legal entities) charged arm s length premiums with no one entity representing less than 5%, or more than 15% of the total risk 11

12 Common accepted notions of insurance Organized and operating as an insurance company Adequate capital Regulated as an insurance company by the state Valid, binding policies issued at arm s length Kidde Industries v. United States, 40 Fed. Cl. 42 (1997) 12

13 Small insurance company election [ 831(b)] Must qualify for insurance treatment as previously discussed Premiums less than $1.2M Taxed on investment income, less allowable investment expenses or certain general and administrative expenses Election is irrevocable unless approved by the IRS and requirements are determined annually Currently receiving a lot of attention and scrutiny from the service and general public (financial planners, attorneys, accountants, etc.) 13

14 Recent court cases involving captives Wendy s International, Inc., 518 Fed. Appx. 580 (2013) o Illinois state income tax case state challenged insurance position in attempt to include income with combined return (apportionment) o IRS previously audited and accepted insurance position o IL Appeals Court relied on IRS and VT regulators 14

15 Recent court cases involving captives Rent-A-Center, 142 T.C. No. 1 (2014) o U.S. Tax Court concluded that premiums paid from its subsidiaries to an insurance subsidiary (an off-shore captive) in the same group were deductible expenses o Insurance subsidiary was created for legitimate non-tax reasons, which was the key fact pattern o Does not change rules regarding risk shifting and distribution o Interesting point focus by Judge Foley on number exposure units (employees, vehicles, stores) rather than number of subsidiaries 15

16 Recent court cases involving captives Rent-A-Center, 142 T.C. No. 1 (2014) continued o Facts and circumstances that captives should avoid: Parental guarantee on behalf of captive (even if only to meet regulatory requirements rather than blanket guarantee issued to 3rd party insurance carrier); Less than 12 brother/sister subsidiaries with majority of premiums from one; Substantial portion of capitalization based upon ownership of treasury stock of Parent and parental guarantee of deferred tax assets; Having premiums based upon estimates of loss exposure rather than actuarially determined; Having no directors or employees (other than those of the Parent); and Operating for any period of time without an insurance license o Captives should invest conservatively; pay claims as they come due; o Captives should be capitalized beyond Bermudan lax standards 16

17 IRS focus for Revenue ruling addressing health insurance arrangements sponsored by a single employer Final regulations regarding Series LLC and cell companies (proposed regulations in September 2010) Continue to see IRS activity auditing captives and challenging tax-exempt status 17

18 Basis for separate tax treatment Insurance business and products are fundamentally different from other corporations Long tradition of different rules (dating back to the early 1900 s) follow the 1986 Act today Tax treatment generally follows the all-events test and economic performance rules, but allow deduction for loss reserves Follows the NAIC methods, unless in conflict with federal accrual rules [ 811(a)] 18

19 Federal income tax calculation Start with pre-tax book income Adjust for statutory items (if GAAP statements) o Prepaid, deferred acquisition costs, etc. Adjust for differences between book and tax (insurance companies only) o 20% haircut for unearned premiums o Discounting of unpaid loss reserves o Proration adjustment (15% of tax exempt & DRD) 19

20 Adjust for traditional difference between book and tax (most corporations) o Tax exempt interest o Dividends received from U.S. equities o Capital losses (C/F or excess over gains) o Meals and entertainment o OTTI losses o Charitable contributions (limited) o Depreciation/amortization o Penalties o Bad debts o Certain accruals 20

21 Benefits to insurance company treatment Deduct loss reserve estimate at roughly 85-95% Defer tax on 80% of premiums received and unearned Payee can deduct 100% of premiums paid Savings per $1,000 of premium and losses at 35% tax rate o Insurance company Losses at 85% discount $297 Premiums 280 Total $577 o Insured Premiums $350 21

22 Deferred tax assets Deferred taxes o Arise when book expenses are higher than tax Example: Losses incurred (5-15%), bad debt expense Deferred tax liability o Arise when allowed tax expenses are higher than book Example: Unearned premiums (80%), accelerated depreciation Must be a reasonable likelihood that the tax deferrals can be recognized in future years 22

23 Temporary differences Deferred taxes o Example: Incurred losses, book vs. tax Losses incurred for book: $1,000,000 Losses incurred for tax: 900,000 Temporary difference $ 100,000 Tax rate 34% Deferred tax asset $ 34,000 23

24 Choice of entity considerations Sole proprietorship C- Corporation Partnership Limited Liability Company (LLC) S- Corporations (not covered as shareholders must be individuals, which is not typical for captives) 24

25 Sole Proprietorships No liability protection for the owner, and for that reason not advisable Income is reported by and taxed to the owner Default classification unless the owner forms a corporate entity 25

26 C- Corporations Shareholders are shielded from liabilities Decisions are made by the board of directors, who delegate day-to-day management functions May have multiple classes of stock Income is subject to double taxation o Taxed at the corporate level when received and o Taxed at the shareholder level when distributed Tax rates range from 15-35%, with effective rate of 34% reached quickly when taxable income exceeds $100k 26

27 C- Corporations (continued) Treatment of cash distributions o Dividends to the extent of earnings and profits (E&P) Ordinary income to individual shareholders May qualify for dividend received deduction (DRD) for corporate shareholders (must be U.S. entity) 100% if member of the same affiliated group 80% if member owns 20% or more of corporation 70% for all other o After current and accumulated E&P is exhausted, remaining is treated as a return of capital (not taxed) until shareholder s basis is exhausted o Excess of above is treated as a capital gain 27

28 Partnerships Partners are liable for acts of the partnership, unless it is a limited partnership Taxable income, deductions, credits, etc. flow through to the partners (typically no entity tax) Partners basis increases and decreases, but not below zero, based on income, deductions, etc. Distributions are not taxable, unless in excess of partner s basis which would be a gain to the partner 28

29 Limited Liability Companies (LLC) The hybrid of a partnership and a corporation Single member LLC is a disregarded entity Multiple member LLC is taxed as a partnership unless electing to be taxed as a corporation Members are shielded from liability Operating agreement determines allocations May have different classes of interests Can be managed by members or by a manager 29

30 Choice of entity considerations Regardless of the legal structure, a company that satisfies the requirements to be treated as an insurance company for federal income taxes is by default treated as a c-corporation 30

31 Typical captive structures Example 1 Parent Corporation 100% Owned Captive Insurer Third-party non-affiliated reinsurer May be formed for risk management purposes or to access reinsurance market Absent at least 30% or more unrelated risk, it is highly unlikely that insurance treatment is available 31

32 Typical captive structures Example 2 Parent Corporation CAPTIVE INSURER Sub A Sub B Sub C Sub D Sub E Sub F Sub G Sub C1 Sub C2 The subsidiaries have no direct ownership in the captive and each pays a pro-rata portion of the total premium to the captive generally valid insurance under the Brother-Sister Doctrine. 32

33 Typical captive structures Example 3 Parent Corporation Captive Insurer 70 % of captive s premium and risk is directly related to the parent corporation 30% of captive s premium and risk is from unrelated 3 rd parties examples include minority owned joint ventures, pools, employee benefits, etc. Given the level of 3 rd party risk, the captive should be viewed as an insurance company. Note that a level of 3 rd party risk between 30-50% is a gray area less than 30% is not good, more than 50% is fairly certain. 33

34 Tax sharing agreements Applicable when a captive is a subsidiary in a consolidated group filing ASU 740 (GAAP) and SSAP 101 (STAT) require a tax expense on stand-alone statements Legal binding contract to protect separate legal entities in a related party structure 34

35 Key components of a tax sharing agreement Determination of how tax liability is determined (should consider federal and state) Timing of tax settlements or estimates Mutually agree on use of deferred tax assets (credits, NOL s, capital losses, etc.) Refunds or overpayments will the captive get their money back? Treatment of audit adjustments or amendments Indemnification 35

36 Proper governance Arms length transactions Concluding thoughts Respect the separate corporate entity Transparency Assess tax position annually, especially when changes to the program or ownership structure Avoid large loan-backs or circular cash flow IRS CIRCULAR 230 DISCLOSURE Pursuant to U.S. Treasury Department Regulations, we are now required to advise you that any federal tax advice contained in this communication, including attachments and enclosures, is not intended by the Sender to constitute a covered opinion pursuant to regulation section or to be used for the purpose of (i) avoiding tax-related penalties under Internal Revenue Code or (ii) promoting, marketing, or recommending to another party any tax-related matters addressed herein. 36

37 Contact information Questions? Matt Gravelin (802) Derick White (802) Jeff Johnson (802)

38 A man was floating along in a balloon and had lost his bearings. Finally he spotted a man standing on a hilltop and shouted out: Where am I. The man on the hilltop responded: You are in a balloon about 75 feet up. The man in the balloon responded: You must be a tax lawyer because what you told me is totally accurate and totally useless. The tax lawyer on the hilltop responded: You must be a tax accountant. You don t know where you are or where you are going and now you are blaming the tax lawyer. 38