Captive Insurance Companies: Beware of New Treasury Proposal
October 2007
On September 27, 2007, the Department of the
Treasury issued proposed regulations to provide guidance in regard to the tax
treatment of transactions between and among members of a group, including members
who are insurance companies, i.e., captives. These proposals are significant
and far-reaching.
by Michael
R. Mead
M.R. Mead &
Company, LLC
I will attempt to address them briefly in non-accounting, non-tax language.
You should look into this if you have a captive or are considering one.
Background
Some background may be in order. First, as a disclaimer, I am neither a tax
professional nor an attorney. I am merely a captive consultant who frequently
sits in meetings with such folks and listens to their views. Without question,
you should seek your own counsel for advice on this new proposal.
Over time, the Internal Revenue Service (IRS) has sought to disallow tax
deductions for premiums paid by a member of a group to another member of the
group on grounds that have been referred to as the "economic family theory."
In other words, the view of the IRS was that such transactions had no risk transfer
and inadequate risk distribution; therefore, they should not be deductible for
tax purposes.
The probable landmark case on this issue is known as the Humana decision.
The court found that premiums paid in a related party group to a brother/sister,
as opposed to a parent/child, were indeed deductible. With no prodding, in June
2000, the IRS announced that it would abandon the economic family theory of
disallowing deductions. The formation of new captives exploded.
Proposed Change
When regulations are to be changed, the process is that the Department of
Treasury announces the proposed changes, seeks public comment, holds hearings,
and then puts them into effect, sometimes with changes and modifications derived
from the public feedback. At the end of this article, I will tell you how to
comment if you so desire.
The main point of the new proposal in regard to captives is to once again
return to disallowing deductions for members of the same group in which one
member is an insurance entity insuring the other members, i.e., a captive. The
exact proposal involves the treatment of the accounting as to whether or not
the premium payment will be considered a single entity for the combined group
or on a separate entity basis for individual members. The code sections are
to switch from § 1.1502-13(e)(2)(ii)(A) and (B) to the matching and acceleration
rules of § 1.1502-13, if that helps you at all. If premiums paid by the combined
group are in excess of 5 percent of the captive's revenues, it is deemed self-insurance,
and no deduction for reserves is allowed.
In effect, the IRS is saying that such transactions are in fact self-insurance.
With self-insurance, you cannot deduct funds set aside for reserves for future
losses through the use of a premium. This challenges the entire foundation of
captives; however, it may only affect certain types of captives.
Over the years since the Humana decision and the voluntary abandonment of
the economic family doctrine, the world of captives has moved far beyond single-parent
captives. This new proposal would seem to me to essentially affect large companies
with domestic captives or offshore captives which have elected to be taxed as
a U.S. entity under Section 953 D. It would also seem to affect certain specific
captives in which the insuring member of the group is a related party, such
as is the case with warranty coverage. While this encompasses a very large number
of captives used by the Fortune 1000 and similar firms, it should not affect
group captives, association captives, nonprofits, Non-Controlled Foreign Corporations,
or risk retention groups.
The world of captives today has grown beyond the typical structure being
addressed by Treasury. While these proposals, if put in place as written, will
certainly negatively impact many, many captives, it will not impact all captives.
Industry and Association Response
Again, I urge you to seek professional guidance on this matter as it could
have very serious consequences for you and your business. Several industry groups
are discussing responses, including the Captive Insurance Companies Association,
Vermont Captive Insurance Association, Nevada Captive Insurance Association,
and Arizona Captive Insurance Association. And there will be others. I have
learned that the Director of Insurance in South Carolina has written to every
member of his state's Congressional delegation to mount resistance.
If you wish to read the proposal, it was published in the Federal Register
on Friday, September 28, Volume 72, Number 188, page 55139.
If you wish to get involved directly, write to: CC:PA:LPD:PR (REG-107592-00),
Room 5203, Internal Revenue Service, P.O. Box 7604, Ben Franklin Station, Washington,
D.C., 20044. You may e-mail through the Federal eRulemaking Portal at http://www.regulations.gov (IRS REG-107952-00).
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