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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not necessarily held by the author's employer or IRMI. Expert Commentary articles
and other IRMI Online content do not purport to provide legal, accounting, or other
professional advice or opinion. If such advice is needed, consult with your attorney,
accountant, or other qualified adviser.