Captive Insurance Tax Panel

Captive Insurance Tax Panel Thomas M. Jones McDermott Will & Emery LLP Chicago, Illinois Phone: (312) 984-7536 Email: tjones@mwe.com Daniel Kusaila Saslow, Lufkin & Buggy, LLP Avon, Connecticut (860) 470-2122 dkusaila@slbcpa.com Sarah Stubbs Johnson Lambert & Co. LLP Raleigh, North Carolina (919) 719-6426 Sarah.stubbs@jlco.com

Agenda Recent IRS Rulings & Guidance PLR s TAMs Court Cases Common IRS Audit Issues The Non Admitted Reinsurance and Reform Act

Emerging Tax Issues for 2012 and Beyond Looking back, Notice 2005-49, IRS requested taxpayer comments on 4 captive related subjects: Finite risk policies as insurance (in captive arrangements) Proper characterization of cell captive structures as insurance and mechanics of making elections Tax consequences of loan-backs from a captive to its owner(s) Homogeneity of risk as a key element of risk distribution

IRS 2009-10 Priority Guidance Plan Released 11/24/09 Captive related matters listed: Guidance on the classification of certain cell captive insurance arrangements. Previous guidance was published in Notice 2008-19. Proposed Treasury regs issued 9/13/10 Revenue ruling providing guidance on reinsurance arrangements entered into with a single ceding company. Issued: Rev. Rul. 2009-26 Guidance concerning the classification of series LLCs and cell companies under 7701. Proposed regs issued 9/13/10

IRS 2011-12 Priority Guidance Plan Released 9/2/11 Captive related matters listed: Revenue ruling under 801 addressing the application of Revenue Ruling 2005-40 to health insurance arrangements that are sponsored by a single employer. Awaiting IRS PLR probably later this year

Recent IRS Rulings & Guidance

Rev. Rul. 2009-26: Scenario 1 10,000 Policyholders Commercial multiline 10 states Insurance Company Y 90% risks 90% premiums Reinsurer Z Assumptions: Z is adequately capitalized Z operates at arms length with Y Z operates in accordance with state law Ruling: Z is an insurance company because it has risk distribution as if it had insured 10,000 policyholders directly

Rev. Rul. 2009-26: Scenario 2 X-1 Y-1 X-2 Y-2 Z X-3 Y-3 X-3 risk Assume each X operating company is one of many insureds of its respective Y insurance company Only risks of each X are reinsured with Z. All risks are the same risk in the same line of business Had Z insured each of the X entities directly, it would have qualified as an insurance company Ruling: Z is an insurance company Same result in PLRs 200950016 and 200950017 (12/11/09)

PLR 201101029 (10/15/10) Risk Distribution 4 owner-insureds paid 41.7%, 32%, 13.2% and 13.1% of the premiums to a group mutual The IRS determined no insurance because 15% limit of total premiums for a single entity was exceeded 15% is a safe harbor in Rev. Rul. 2002-91, not a litmus test Litmus test is 1 insured with 90% of the premiums In Rev. Rul. 2002-89, a single insured could have 49% of the risk and still not pay its own losses See also 201025077 (6/25/10) IRS said no insurance with 69.4% related risks and 30.6% unrelated risks

PLR 201126038 (7/1/11) Risk Distribution Taxpayer, denied insurance company status, provided P&C insurance It entered into 2 types of reinsurance contracts: Assumed insurance contracts from an unrelated commercial insurer Participated in a pooling arrangement in which it insured direct and then reinsured entire book on a quota share basis with numerous unrelated pool participants TP relied on Harper Group for idea as much as 71% of premiums can come from a single related party IRS disagrees stating the 71% in Harper came from 13 brother-sister entities not only one as in this case Same result, mixing unrelated and brother-sister doctrines, in PLR 201126036 (9/1/11)

PLR 201224018 Insured sole proprietorship- surgery Corp 1- owns patent rights and licensing rights to medical appliance Corp 2-operates labs and performs its own billing to insurance plans and collects co-pays and deductibles Corp 3-hiring, staffing, and training and out of plan billing Corp 4- US assembly of sub-components manufactured over seas Corp 5- marketing and customer support for doctors offices Ruled that they qualify as insurance due to adequate capitalization and participation in reinsurance pool

Florida Independent Colleges and Universities Risk Management Ass, Inc. (DC Fl 3/22/2012) An insurance risk pool comprised of IRC Section 501(c)(3) tax-exempt organizations was not entitled to tax-exempt status. Organization self-insured a baseline risk and arranged for group policies to cover the excess Arrangement was too similar to commercial insurance companies. Exception: The Company could be tax-exempt if they fell under 501(n). Needed required a minimum of $1 million of charitable startup capital from nonmember organizations. The Tax Court stated that legislative history made it clear that commercial-type insurance encompassed every type of insurance that can be bought in commercial market.

PLR 201219011 Specializes in X surgical procedures, with sophisticated medical lasers and equipment A 100% 100% INSURED Company CEDES% on each line it insures ( substantial amount ) Captive 953(d) Reinsurance Pool ( RP ) ASSUMESquota share (equal in $ terms to amount ceded) Captive insures various risks of Company Captive cedes a % of each line of risk it insures to Reinsurance Pool ( RP ) RP has 14 unrelated policy holders No insured s risk accounts for >15% of total risks assumed by Captive Commercial terms/rates, adequate capital, no guarantees Holding IRS concluded that contracts issued by Captive to Company are Insurance contracts (sufficient unrelated risks covered achieving adequate risk distribution and risk shifting)

PLR 201219009 C A B 33% 33% 33% INSURED Partnership Specialized in X surgical procedures, with sophisticated medical lasers and equipment 50% 50% CEDES % on each line it insures Captive 953(d) Reinsurance Pool RP ASSUMESquota share (equal to $ amounts ceded) Captive insures various risks of operating Partnership Captive cedes a % of each line it insures to Reinsurance Pool ( RP ) RP has 14 other unrelated insureds No insured s risk accounts for >15% of total risks assumed by Captive Commercial terms/rates, adequate captial, no guarantees Holding IRS concluded that contracts issued by Captive to Partnership are Insurance contracts (sufficient unrelated risks covered achieving adequate risk distribution and risk shifting)

PLR 201219010 * Individual A owns its GP & LP interests via a Grantor Trust GP INSURED Partnership C Residential Real Estate Business INSURED Company D General Contractor A* 100% LP GP CEDES % of each line it insures IRREVOCABLE TRUST Partnership A Captive 953 (d) Reinsurance Pool ( RP ) Family B LP ASSUMESquota share (equal to $ amounts ceded) Captive insures various risks of Insured Partnership C and Company D Captive cedes a % of each line of risk it insures to Reinsurance Pool ( RP ) RP has > 12 unrelated policyholders No insured s risk accounts for >15% of total risks assumed by Captive Commercial terms/rates, adequate capital, no guarantees Holding IRS concluded that contracts issued by Captive to INSUREDS C and D are Insurance contracts

CCA 2011116019 (4/22/11) LLCs Issue Should single member LLCs count as sisters? IRS says in Rev. Rul. 2005-40 they don t count because they are disregarded entities for tax purposes But this ruling says IRS can t levy on a single member LLC s property for tax obligations of the single member because the sole member has no ownership interest in the LLC s property under local law for collection purposes If this approach were applied to captive tax situations, then single member LLCs would count as separate sister entities

TAM 200816029 Released 4/18/08 Where a partnership is the named insured in a captive insurance arrangement, is the partnership or are the partners the insureds for determining risk distribution? The IRS determined that the: partners are the insureds if it is a general partnership partnership is the insured if there are no general partners and no liability could attach to anyone other than the partnership (i.e., a multi-member LLC choosing partnership taxation)

A Few Problems with TAM 200816029 Fails to discuss the aggregate vs. entity theory surrounding proper tax treatment of partnership items Disregards the partnership as the named insured Does not consider the existence of multiple, independent risks in determining risk distribution Fails to comport with business realities e.g., most limited partnerships have a single general corporate partner with nominal capital, yet all risks are attributed to it Principles of this TAM were applied in PLR 200952060 and PLR 200952061, both released 12/24/09

TAM 201149021 Released 12/9/11 Concluded policy providing residual lease value coverage to a protected party (i.e., policyholder) is not an insurance contract for federal tax purposes 3-pronged IRS rationale: Absence of insurance risk - loss is measured by market forces (i.e., law of supply & demand) rather than by consequences of an accident or casualty event so no fortuity; therefore must be an investment risk Not insurance in the commonly accepted sense - coverage excluded physical damage to the leased property; IRS ignored fact that residual value insurance is readily available commercially

TAM 201149021 (cont d) IRS quote: The tax treatment of a product at issue should be decided by legal relationships and not by the number of product sellers or the amount of product sales Lack of Risk Distribution - IRS alleged contracts in issue were interdependent in that a general economic recession, increase in unemployment, jump in fuel prices, etc. would adversely impact the residual value of all leased property (motor vehicles, etc.) IRS invoked the flood plain no uncorrelated risk ruling Hard to accept with potentially thousands of leased items scattered across the globe

PLR 201030014 Released 7/30/10 Foreign captive with 953(d) election found to qualify as an insurance company Participates in risk pool licensed offshore with sufficient unrelated members and risk spread to support insurance treatment determined on a line by line of coverage basis As a result of pool participation over half premiums are attributable to unrelated risks Assumes no loan backs, adequate capital and no guarantees PLR validates the risk mixer concept

PLR 201225013 (3/16/2012) Start-up Captive insurer Year one only had interest income and start-up expenses. Captive inadvertently made 831(b) election in year 1. Year 2 company requested revocation IRS ruled that without premium the Company did not qualify as an insurance company and therefore the election was invalid Need to write premium to be insurance

PLR 201031001 - Runoff Domestic insurer placed into liquidation so only activities related to its wind up (previously filed as 501(c)(15)) Taxpayer requested IRC 831(b) status for its final year in which it will distribute its remaining assets Pension Funding Equity Act (2004) It is not intended that a company whose sole activity is the run-off of risks under its insurance contracts be treated as a company other than an insurance company, even if the company has little or no premium income Thus concluded taxpayer is eligible to elect 831(b) tax treatment

Pending Guidance

Agencies Seek Comments on Use of Stop Loss Insurance IRS, US Dept. of Labor, and Dept. of Health and Human Services: Requested information about use of stop loss insurance by group health plans and their sponsors. In 2011, DOL reported 6 of 10 private and public sector workers covered by employer-provided health care were under a self-insured plan. Information such as:

Coca-Cola Designs Innovative Captive Plan New IRS ruling expected this year: allow employers to fund health care benefits through captives and tax exempt trusts 2006 voluntary employees beneficiary association (VEBA) $216 m assets Stop-loss coverage to pay claims between attachment($100) and upper limit($3,500/5,800) Coca-Cola VEBA Prudential Red Re Inc. (SC Captive)

Indiana Department of Revenue v. UPS (June 21, 2012) (IN Supreme Court) Tax Court ruled that foreign insurer was subject to IN statutes and properly netted foreign affiliate reinsurance payments in calculation of premium taxes due Supreme Court focused on definitional terms in order to be subject to, taxpayer must be doing business in the State doing business requires licensure, etc. not proven by facts Case was reversed and remanded to Tax Court In order to be exempt from income tax statutes, taxpayer must be subject to premium tax statutes. Being subject to requires taxpayer to be doing business in the State. Doing business at least means having a Certificate of Authority.

Common IRS Audit Issues

Common IRS Audit Issues Business purpose for the captive Treatment of revenue rulings as imposing statutory rules rather than as the safe harbors much of the IRS concedes they are Whether the risks written by the insurer are "insurance" for federal income tax purposes Alleged lack of risk distribution (i.e., over concentration of risk in one entity) Application of risk distribution requirements to pass-thru entities (LLCs, partnerships, Q-subs, etc.)

Common IRS Audit Issues Tax recognition of risk mixers as legitimate generators of unrelated risk Attempts to bifurcate premiums such that amounts not sent to risk mixer are non-deductible Nature and scope of permissible loans from captive to its parent or affiliates Attempts to apply risk distribution on a line of business basis ( homogeneity issue)

Common IRS Audit Issues Other common notions of insurance Reasonable capitalization w/o parental guarantee Allegations that capitalization of captive using a bank letter of credit constitutes a parent guaranty Reasonable premiums and reserves Consistent treatment i.e. if deduct, also pay FET Existence of standard policy forms Licensed in all jurisdictions where risks located No commingling of assets Maintain corporate formalities, independent operation

Common IRS Audit Issues In determining unrelated risk, application of look thru approach (e.g. thru employer to employees as generators of the underlying employee benefits exposures) any difference between health insurance and medical stop loss?

Common IRS Audit Issues Bad Debt Directive issued July 30, 2012 A taxpayer win! Examiners shall not challenge credit-related OTTI deductions on structured securities from 2009 through 2012 No more book/tax difference Ordinary deduction rather than capital loss

Non Admitted and Reinsurance Reform Act

Dodd-Frank Act Enacted on July 21, 2010 Items affecting captive insurers: Financial Stability Oversight Council Home State Regulation of Nonadmitted Insurance Credit for Reinsurance Captives 35

Home State Regulation Streamlines the reporting, payment and allocation of premium taxes by providing that the home state may require payment of premium tax for surplus lines insurance Encourages states to develop and interstate compact to provide for allocation and remittance for premium taxes 36

Credit for Reinsurance Prohibits a state in which a U.S. ceding insurer is licensed, but not domiciled, from denying credit for reinsurance if the ceding insurer s domestic state recognizes credit for reinsurance for the insurer s ceded risk and the state is NAIC accredited. State of domicile is the sole regulator of the reinsurer s financial solvency if the state of domicile is NAIC accredited. 37

NRRA What has people confused? 38

NRRA, cont Sec. 521. Reporting, Payment, and Allocation of Premium Taxes Home State s Exclusive Authority No State other than the Home State of an insured may require any premium tax payment for nonadmitted insurance Sec. 522. Regulation of Nonadmitted Insurance by Insured s Home State Home State Authority Except as otherwise provided in this section, the placement of nonadmitted insurance shall be subject to the statutory and regulatory requirements solely of the insured s home state The term nonadmitted insurance means any property and casualty insurance permitted to be placed directly or through a surplus lines broker with a nonadmitted insurer eligible to accept such insurance 39

NRRA, cont Home State means: the State in which an insured maintains its principal place of business or, in the case of an individual, the individual s principal residence; or if 100 percent of insured risk is located out of the State referred to in clause (i), the State to which the greatest percentage of the insured s taxable premium for that insurance contract is allocated. Affiliated Group rule: If more than 1 insured from an affiliated group are named insureds on a single nonadmitted insurance contract, the term home State means the home State... of the member of the affiliated group that has the largest percentage of premium attributed to it under such insurance contract. 40

Reactions States Reactions: Amended statute to tax 100% of premium, no compact authorized, or Amended statute to authorize a compact, or Amended statute and adopted a compact SLIMPACT NIMA No action taken 41