Safe Harbor Trilogy


Insurance companies (of all sizes) operate under different tax rules than other companies.
The U.S. Tax Code (“Code”) recognizes that insurance companies receive premium dollars up front, but may not pay out claims (associated with those premiums) for many years.
Therefore, the Code allows insurance companies more generous current deductions.
Taxation should not be the primary reason for the establishment of a captive or alternative risk transfer vehicle.  General business objectives must form the basis for establishing a captive.
Insurance taxation is an extremely complex area and professional advice should be sought to protect the interests of shareholders, insured’s and the insurance company.

The Captive

This discussion is solely for U.S. captives, and foreign captives that have elected (under Section 953(d) of the Code) to be taxed as U.S. captives.  True “foreign” captives operate under different rules entirely.
Captives are taxed on an accrual basis, not a cash basis.  The captive files a Form 1120-PC tax return.
Captives are considered “C” corporations.  Even though some jurisdictions may allow a captive to be formed as a partnership or LLC, the captive will still be taxed as a “C” corporation for federal tax purposes.

The Insured

The “insured” is the business or organization paying insurance premiums to the captive.  Multiple insureds can pay premiums to the same captive.  These insureds can be related or unrelated companies.
In order for the insured to deduct the insurance premium as a necessary business expense the captive insurer must conform to the law.  Because the Code does not define “insurance,” much guidance can be found in precedent-setting court cases and IRS rulings.
In very simplistic terms, the IRS expects that the insurance company is established in a recognized jurisdiction, has professionals managing the company and is not established primarily for tax purposes and is adequately capitalized.
The court cases and IRS rulings hold that to be considered an insurance company, three tests must be met:

  1. Involve “insurance” risk
  2. Meet the standards for risk shifting and risk distribution
  3. Follow the commonly accepted notions of insurance (and insurance companies)

The Shareholder / Dividends

A captive can be owned by most any person or entity, including estate planning vehicles.
A captive shareholder is treated much like the shareholder of a “C” corporation.  A captive is organized to have shareholders, and multiple classes of stock can be provided, including preferred and common stock.
The Jobs and Growth Tax Relief Reconciliation Act of 2003 contained provisions that may affect owners of offshore captive insurance companies including provisions that reduced the rate on qualified dividend income from 38.6% to 15%.

Safe Harbor Trilogy
In 2002, the IRS issued three revenue rulings on captive transactions.  These three rulings (discussed in subsequent sections) provide IRS “safe harbors” for captive transactions.  For businesses desiring a captive arrangement that is fully tax compliant with IRS guidelines and recommendations, these safe harbor rulings provide a roadmap.
Revenue Ruling 2002-89
Revenue Ruling 2002-90 Revenue Ruling 2002-91
While individual circuit courts have approved captive arrangements that are more aggressive than the revenue rulings above, by structuring the captive according to a “safe harbor,” clients can know in advance that the captive is approved by the IRS.
Third Party Risk to Provide Risk Distributions and Risk Shifting
In Revenue Ruling 2002-89 the IRS discussed two scenarios where a parent made premium payments to its two wholly owned captive subsidiaries.
Scenario 1
The premiums paid by the parent to its wholly owned captive accounted for 90% of the captive’s income for the year (i.e., only 10% of the premiums were from unrelated parties).
Scenario 2
The premiums paid by the parent accounted for less than 50% of the captive’s income for the year (i.e., more than 50% of the premiums were from unrelated parties).
In its determination whether either or both of these scenarios represented valid insurance transactions the IRS further noted that:

  • Both captives were adequately capitalized
  • Both captives were properly regulated
  • The companies transacted business in a manner consistent with the standards applicable to an insurance arrangement between unrelated parties

In their determination as to whether either or both of the scenarios represented valid insurance transactions, the IRS concentrated on factors of risk shifting and risk distribution. The IRS concluded that scenario 1 did not provide sufficient risk shifting or risk distributions; however, scenario 2 did. Where more than 50% of the captive’s risk is with unrelated third parties, the IRS concluded that sufficient risk shifting and risk distribution had occurred.
This “more than 50%” rule is now considered an IRS safe harbor.
Previous case law relating to unrelated risk placed into a captive held that as little as 29% third party business constitutes a valid and bona fide arrangement (Harper Group, 9th Circuit).  However, in recent years the IRS has sought to distinguish case law that was below the 50% standard.
Group Captives
In Revenue Ruling 2002–91, the IRS addressed group captives and concluded that such a captive that was formed by a “significant number” of unrelated insured’s, with each having no more than 15% of the total risk, was held to be a valid insurance arrangement. The ruling also went on to set out other factors that the IRS expects to see in a bona fide transaction:

  • Whether the insured parties truly face hazards
  • Whether premiums charged are based on commercial rates
  • Whether risks are shifted and distributed to the captive
  • Whether the policies contain provisions such that the covered risks may exceed the amount of premiums charged and paid
  • Whether the validity of claims were established prior to payment
  • Whether the assets and operations of the captive are kept separate from the business operation and assets of its shareholders

This ruling paves the way for franchisees, industry groups, and other associations to form a captive with the benefit of an IRS safe harbor ruling.

Cell Captives
The IRS issued Revenue Ruling 2008-8 (January 2008) to give some clarity to structures known as “cell captives,” “rent-a-captives” and “protected cell captives.”  A cell captive is basically a captive with several “cells” within it.  The income, expense, assets, liabilities and capital of each cell are accounted for separately from any other cell and of the captive generally.  Usually the laws of the jurisdiction provide legal separation between cells.
Each cell is generally owned by unrelated owners, such that within the captive there is a wide distribution of risks.
Under the ruling, if company X owns Cell X and pays premiums to Cell X, this arrangement would not be considered insurance because there is no risk distribution within Cell X – all of the risks are from a related party, company X.
However, where company Y owns the stock of 12 domestic subsidiaries, and company Y owns Cell Y, then premiums paid from Y to Cell Y do constitute insurance premiums (if meeting the other insurance tests), because there is risk distribution within the 12 domestic subsidiaries.
This ruling closely tracks Revenue Ruling 2002-90, in terms of its facts and holdings.
Notice 2008-19, which accompanied this ruling, indicates that it may be possible for a cell within a captive to be treated as an insurance company separate from any other entity.  More discussion and guidance is expected on this in the future.
US Owned Foreign Insurance Companies
If the insurance company does not elect to be a US tax payer there are still tax implications. The company would be considered a controlled foreign corporation (“CFC”) and under the IRS subpart F rules, U.S. shareholders with a 10-percent or greater interest in a CFC are subject to U.S. federal income tax currently on certain income earned by the CFC, whether or not such income is distributed to the shareholders. The income subject to subpart F includes, among other things, insurance income including that relating to risks located in a country other than the CFC’s country of organization.

Important Legal Information

Captive insurance and alternative risk transfer planning involves sophisticated insurance and risk management issues, regulatory and corporate legal issues, federal, state and usually international tax issues, and a wide range of accounting and financial issues. This planning is specific to each set of circumstances.  It is not appropriate to apply general information described herein to any particular situation. The formation of a captive is a part of a client’s implementation of alternative risk transfer planning, and is dwarfed by its ongoing operations. As a result, this planning should not be undertaken without a competent team of professionals who have extensive experience in captive insurance and alternative risk transfer planning.
The information herein is general in nature, and may not be relied on for any specific use. The content herein (including graphics) does not purport to show all details and complexity in establishing a compliant captive or alternative risk transfer program. Tribeca is not engaged in rendering legal services or advice.
Disclosure under IRS Circular 230: The information and services offered are not intended to and do not comply with the U.S. Treasury Department’s technical requirements for a formal legal opinion, and cannot be used by a taxpayer to avoid any penalty that might be imposed on a taxpayer. Nothing herein may be used in promoting, marketing or recommending an investment plan or arrangement.

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