IRS Guidance on Insurance Company Taxation

By Marc Fox
December 18, 2015
Comments Off on IRS Guidance on Insurance Company Taxation
  • Revenue Ruling 2001-31 – IRS Gives Up on “Economic Family Theory”
  • Notice 2002-70 – “Listed Transaction” – Auto Dealer Warranties
  • Revenue Procedure 2002-75 – Private Letter Rulings on Insurance Co. Issues
  • Revenue Ruling 2002-89 – 50% Third Party Insurance Risk
  • Revenue Ruling 2002-90 – 12 Brother / Sister Subsidiary Requirement
  • Revenue Ruling 2002-91 – Spreading of Risk in Captive Group
  • Internal Revenue Bulletin 2002-44 – pdf
  • Notice 2003-34 – Use of Insurance Companies / Hedge Funds
  • Notice 2003-35 – Qualification as an Insurance Company

Revenue Ruling 2001-31, issued June 4, 2001: With this ruling, the Internal Revenue Service has acknowledged that it will no longer invoke and follow the “economic family theory” with respect to captive insurance transactions. The judicially accepted definition of insurance involves the following elements of risk:

  • Risk-shifting-the transferring of the financial consequences of the potential loss to the insurer, and
  • Risk-distribution-allowing the insurer to reduce the possibility that a single costly claim will exceed the amount taken in as premiums and set aside for the payment of such a claim.

The sharing and distribution of the insurance risk by all the parties insured is essential to the concept of true insurance. The “economic family theory” argues that where insurance risk has not been shifted or distributed outside the “economic family” there cannot be valid or bona-fide insurance contracts. Valid and bona-fide insurance contracts are essential in obtaining deductions for premiums paid to a related party insurer.

As an alternative to the “economic family theory,” the courts have historically employed a balance sheet test to determine if bona-fide insurance exists. Thus, where the risk of loss has been removed from the insured’s balance sheet, shift of risk has occurred.

Although the IRS has indicated that it will no longer invoke the “economic family theory” as an argument that risk has not shifted between related parties, the Service has indicated that it will continue to scrutinize each entity involved in an insurance transaction on many levels to determine if bona-fide insurance contracts exist. These areas may include:

  • Amount of capitalization of the insurance company
  • Ability of the insurance company to pay claims
  • Adequacy of corporate governance and formalities of the insurance company
  • Financial performance of the insurance company
  • Separate financial reporting for the insurance company

Notice 2002-70, issued November 4, 2002: This notice deals with a type of entity known as a producer owned reinsurance company or “PORC.” The transaction outlined within the notice has been labeled a “listed transaction” by the IRS. Listed transactions require additional reporting and recordkeeping requirements and may involve significant penalties if the rules are not followed.

The transaction in the notice involves a taxpayer that offers its customers the opportunity to purchase an insurance contract through the taxpayer in connection with the products or services being sold. The insurance provides coverage for repair or replacement costs if the product breaks down or is lost, stolen, or damaged, or coverage for the customer’s payment obligations in case the customer dies, or becomes disabled or unemployed. The taxpayer offers the insurance to its customers by acting as an insurance agent for an unrelated insurance company. Taxpayer typically receives a commission on the sale of the insurance policy. Taxpayer then forms a company in a foreign jurisdiction and reinsures the policies it sold for the unrelated insurance company. The foreign company elects to be treated as a domestic United States taxpayer and claims the tax benefits associated with small closely held insurance companies pursuant to Internal Revenue Code Section 501(c)(15) or 831(b). In this manner the premiums are sheltered from U.S income tax.

The IRS has indicated that it will attack arrangements of this nature or similar arrangements by arguing that the company in question is not in the business of insurance. The Service has indicated that it will not respect warranty type arrangements similar to the transaction outlined in Notice 2002-70 as bona-fide insurance contracts. The IRS has also indicated that it may assert its income allocation powers under the provisions of Section 482 to tax the income in these arrangements (i.e. buy increasing the amount of the taxable commission) or by arguing that the transaction is a sham.

Arrangements such as the type described in Notice 2002-70 must be avoided at all costs to avoid possible civil and potentially criminal penalties associated with the use of closely-held insurance companies to shelter income.

Revenue Ruling 2002-89, issued December 11, 2002: This ruling discusses two scenarios involving the payment of premiums by a parent to its two wholly-owned captive subsidiaries.

In the first scenario, the premiums paid by the parent to its wholly owned subsidiary accounted for 90% of the subsidiary’s income for the year. In the second scenario, the premiums paid accounted for 50% of the second subsidiary’s income for the year. In determining whether these scenarios represented valid insurance arrangements, the IRS noted that:

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

The IRS again focused on the concepts of adequate risk shift and risk distribution and concluded that the arrangement in scenario 1 did not provide sufficient risk shift or distribution while the facts in scenario 2 did. Thus, where 50% of the subsidiaries risk is with unrelated third parties, the IRS has concluded that sufficient shift and distribution of risk has passed to the subsidiary to constitute a valid and bona-fide insurance arrangement for the parent.

Although Revenue Ruling 2002-89 appears to definitively state that 50% of an insurance company’s business must be with unrelated parties in order for the related party insurance arrangement to constitute bona-fide insurance, judicial precedent exists in the 9th Circuit’s Harper Group decision that this third party element may be as little as 29% to constitute a valid and bona-fide arrangement between related parties.

Revenue Ruling 2002-90, issued December 11, 2002: The IRS concluded that the premiums paid by 12 operating subsidiaries to a captive insurance subsidiary owned by a common parent are deductible. The facts in Revenue Ruling 2002-90 are similar to the brother-sister subsidiary arrangement as outlined in the 5th Circuit’s ruling in Humana. The IRS concluded that the transaction contained adequate risk shift and risk distribution and that the amounts paid for insurance by domestic operating subsidiaries to an insurance subsidiary of a common parent are deductible as “insurance premiums.” The IRS also based their position on several facts as follows:

  • The premiums of the operating subsidiaries were determined at arms-length.
  • The premiums were pooled such that a loss by one operating subsidiary is borne, in substantial part, by the premiums paid by others.

It is important to note that the IRS analyzed each of the subsidiaries to ascertain:

  • If they conducted themselves in all respects as would unrelated parties to a traditional relationship;
  • Whether the insurance company is regulated as an insurance company in the jurisdiction(s) where it does business;
  • Whether an adequate amount of capital was present within the insurance company;
  • If the insurance company was able to pay claims;
  • The adequacy of the insurance company’s financial performance; and
  • If separate financial reporting was maintained on behalf of the insurance company.

Revenue Ruling 2002-91, issued December 11, 2002: The IRS concluded that a group captive arrangement, which was formed by fewer than 31 unrelated insured’s, with each insured having no more than 15% of the total risk, was a bona-fide insurance arrangement. The ruling also outlines other factors that the IRS will consider in determining whether a transaction constitutes a bona-fide insurance arrangement.. These factors include:

  • Whether the insured parties truly face hazards;
  • Whether premiums charged by the captive are based on commercial rates;
  • Whether the risks are shifted and distributed to the insurance company, since the entities are commercially and economically related;
  • 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 before payments are made;
  • Whether the captive’s business operations and assets are kept separate from the business operations and assets of its shareholders.
  • The IRS again focuses on risk shifting and risk distribution in determining whether the transactions are considered deductible “insurance premiums.”

Revenue Procedure 2002-75, issued December 11, 2002: This revenue procedure discusses certain insurance transactions whereby the IRS will now contemplate issuing private letter rulings regarding whether a valid and bona-fide insurance arrangement exists between related parties. The IRS has indicated that taxpayer’s seeking a ruling should contact the appropriate department at the IRS to determine whether the facts in each case will be considered by the IRS for a ruling before preparing the ruling request.

Internal Revenue Bulletin 2002-44, issued October 15, 2002: This bulletin addresses a specific transaction involving a taxpayer (typically a service provider, automobile dealer, lender or retailer) that offers its customers the opportunity to purchase an insurance contract through the taxpayer in connection with the products or services being sold. The taxpayer offers insurance to its customers by acting as an insurance agent for an unrelated insurance company. The taxpayer then reinsures the policies sold by the taxpayer on behalf of the third party insurer utilizing its wholly owned insurance corporation. The IRS has indicated that this type of transaction qualifies as a “listed transaction.” Listed transactions must be disclosed within the body of the income tax return containing the transaction and with a special department of the IRS. Significant civil penalties exist for taxpayers that do not comply with the listed transaction rules.

Notice 2003-34, issued June 9, 2003: Notice 2003-34 involves the use of offshore insurance companies organized for the purpose of sheltering passive investment income over the life of the company. The shareholder of the offshore insurance company then disposes of the stock in a transaction that qualifies for capital gain treatment. The insurance written by these companies frequently contains unrealistic policy limitations and the investment income generally far exceeds the amount of premiums received from insurance contracts. The IRS in this notice has indicated that it intends to attack these types of transactions in one of three ways.

  • Option1 – Definition of Insurance: In this method of challenging these transactions, the Service will argue that the insurance written by the insurance company does not meet the judicial established definition of insurance. This is the traditional attack based on the premise that bona-fide insurance contracts must shift and distribute risk from the insured to the insurer and that the insurer must distribute the risk amongst potential claimants.
  • Option 2 – Status as Insurance Company: This method of challenge relies upon the premise that a taxpayer taxed as an insurance company must use its capital and efforts primarily in earning income from the issuance of insurance contracts. The income tax regulations provide that a company will qualify as an insurance company only if more than half of its business is the issuing of insurance or annuity contracts or the reinsuring of risks underwritten by insurance companies. Thus, the IRS in asserting this challenge will look to all of the relevant facts and circumstances for making the determination of whether an entity qualifies as an insurance company. Items taken into consideration in this assessment may include the size and activities of the insurance company’s staff, whether it engages in other trades or businesses, and its sources of income.
  • Option 3 – Possible Tax Treatment of Stakeholder’s Interest in Foreign Corporation: In this method of challenge the Service will look for ways to categorize the income earned by the foreign corporation as passive investment income subject to U.S. income tax. This method depends upon the Service’s ability to show that the foreign corporation is not involved in the active conduct of an insurance business.

Notice 2003-35, issued June 9, 2003: Notice 2003-35 deals specifically with insurance companies that are availing themselves of the tax-exempt provisions contained in IRC Section 501(c)(15). The notice serves to remind taxpayers that in order to qualify for tax-exempt treatment, the corporation must first qualify as an insurance company. Notice 2003-34 is cited as containing guidelines regarding what constitutes an insurance company.

In summary, the multitude of rulings, procedures, notices, bulletins and notices makes it very clear that the IRS is concerned about the potential abuse of insurance entities to shelter income from U.S. tax. Clearly, the IRS is attempting to establish conservative parameters regarding what does and does not constitute the business of insurance. Although the publications do provide some cause for concern with respect to ongoing IRS scrutiny of taxpayers conducting legitimate insurance businesses, the rulings and notices also provide taxpayers and their tax advisors with a better idea of what the Service considers “the business of insurance.” Although the IRS publications provide some guidance regarding the IRS’s opinion as to what constitutes bona-fide insurance, it is important to note that revenue rulings, procedures, bulletins and notices are not tax law, but merely the IRS’s opinion and interpretation of tax law. Thus, they should be given high priority when considering a closely-held insurance business, however their content should not necessarily govern the treatment of insurance transactions.


Organizations exempt under § 501(c)(15)

Notice 2003-35

The purpose of this notice is to remind taxpayers that an entity must be an insurance company for federal income tax purposes in order to qualify as exempt from federal income tax as an organization described in § 501(c)(15) of the Internal Revenue Code.

Section 501(a) provides that an organization described in § 501(c) shall be exempt from federal income tax. Section 501(c)(15) provides that an insurance company (other than a life insurance company) is tax-exempt if its net written premiums (or, if greater, direct written premiums) for the taxable year do not exceed $350,000. For purposes of this annual test, the company is treated as receiving during the taxable year premiums received during the same year by all other companies within the same controlled group, as defined in § 831(b)(2)(B)(ii).

For an entity to qualify as an insurance company, it must issue insurance contracts or reinsure risks underwritten by insurance companies as its primary and predominant business activity during the taxable year. For a discussion of the analysis applicable to evaluating whether an entity qualifies as an insurance company, see Notice 2003-34, 2003-23 I.R.B. ___ (June 9, 2003) and Notice 2002-70, 2002-44 I.R.B. 765 (November 4, 2002).

The Service is scrutinizing the tax-exempt status of entities claiming to be described in § 501(c)(15) and will challenge the exemption of any entity that does not qualify as an insurance company. The Service will challenge the exemption of the entity, regardless of whether the exemption is claimed pursuant to an existing determination letter or on a return filed with the Service.

Taxpayers claiming exemption pursuant to § 501(c)(15) should also consider whether they are engaged in arrangements described in Notice 2002-70 or substantially similar thereto.

DRAFTING INFORMATION

The principal author of this notice is Lee T. Phaup. TE/GE Division, Exempt Organizations. For further information concerning this notice contact Ms. Phaup at (202) 283-8935 (not a toll-free call).

See Also: Notice 2003-34
Additional Information

Why take our word for it when you can read what the Internal Revenue Service’s Exempt Organizations Technical Division says about these types of companies?

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