What Is Insurance, and Does a Captive Qualify?

January 2010

When a captive is established, most owners are interested in any potential tax consequences. Payment of premiums to a captive for insurance coverage may well be deductible as an ordinary business expense. But they may not be so deductible. If the tax consequences are important, then a great deal of care must be taken along with engaging trusted, qualified advisers. Elsewhere the reader can find qualified and expert tax advice. My mission is to illuminate a few other points of consideration to support the opinions of the tax experts.

by Michael R. Mead
M.R. Mead & Company, LLC

When an insurance premium is paid to a traditional insurer, the premium is usually deductible as an ordinary business expense of the company. One reason supporting this deduction is that the risk of loss has been transferred to another entity which is deemed to be an insurance company. For many decades, there was no definition of an insurance company in the Internal Revenue Service (IRS) code. The definition rested on a 1943 court case, LeGierse v. Helverington, in which risk shifting and risk distribution were given as reasons for denying the action, but no definitions were offered then or later.

In the following 5 decades or so, captive owners were compelled to fight for tax deductions at great expense, with little reliance on previous rulings. The overwhelming factor to always bear in mind is that the judgment of whether or not a deduction is to be allowed is dependent on the specific facts and circumstances of the particular case at hand. It is tempting, in order to gain confidence and reduce expenses, to look to successful cases and extrapolate their facts onto your circumstances. This may not be successful however. A subtle difference in facts can make all the difference to the tax adjudicators.

Hunting Ducks

With the growth of captives and the concomitant growth of tax cases, there have been some revenue rulings and court cases that have provided safe harbors, and indeed the IRS has given some clearer guidance on occasion. From the viewpoint of a captive consultant, there are some helpful points to consider. The duck issue is one: if it quacks like a duck, then it is a duck. What does an insurance company do? It pays claims. If your captive pays claims, that is likely very helpful to your case.

Having a qualified actuary determine and charge the premiums is another feather for the duck. If the coverage is not available in the marketplace, and can be so demonstrated, the duck wins again. Unfortunately, this point can be debated in so far as if the coverage is not offered in the traditional market, then perhaps it is not commercially needed, or put another way, not insurance at all.

Risk Distribution

As to risk distribution, there are many more puzzling arguments. Some rulings have suggested that writing only one line of coverage in the insurer does not equate to risk distribution. This argument would seem to harm many traditional insurers who write only workers compensation or disability or boiler and machinery. This is an area for further refinement, i.e., more legal fees.

There have been some vague safe harbors, such as insuring more than 13 but less than 50 insureds. This has also been successfully overcome with skilled arguments and specific circumstances.

An approach that has had success is to have an outside insurance party conduct a review of the captive owner's exposures and current coverage to determine if there are exposures peculiar to that business which are not addressed by the traditional market. This approach can be viewed as reasonable for businesses whose line of work isn't well defined by the traditional insurers, such as some construction exposures and supply line issues.

Some success has been gained by reinsuring out of the captive more than 50 percent of the risk as measured by premiums. The choice of the reinsurer becomes critical as that can be viewed as not constituting "rea" insurance.

Domicile

As always, the choice of domicile is important. While that is not strictly within the tax regime, it is a factor that can be egregiously flaunted in a negative way by some owners. Having solid regulation always helps the case for insurance. Also using developed and standardized policy forms can buttress the insurance argument.

Conclusion

Not to overcomplicate the subject, but if you are contemplating owning a captive, then care must be used to be certain that it is indeed an insurance company. The consequences for failing that test are severe.

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