Asset Protection Shysters

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December 18, 2015
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This web page directly addresses the seedy side of the asset protection industry, including those people who run scams in the guise of providing asset protection structures, or who mislead people about their organization or qualifications, or who themselves are unqualified and/or misguided to assist clients with asset protection issues.

The Crooked

Pure Trust Scam
a/k/a Constitutional Trusts,
Common Law Trust Organizations

The most widespread asset protection scam is the Pure Trust scam, which involves a non-existing form of trust and – in attempt to keep one step ahead of law enforcement – goes by a variety of aliases, including Constitutional Trust, Patriot Trust, Common Law Trust, Business Trust, Common Law Trust Organization (COLATO), Foreign Common Law Trust Organization (FOCOLATO), and a bunch of other names

While the scam artists who push these have a lot of neat-sounding reasons why they should defeat creditors, the truth is that Pure Trusts are easily blown up by creditors under a bunch of theories, including that they are “self-settled spendthrift trusts” (expressly disallowed by all but a couple of states), that they have an illegal purpose (tax evasion), that they are a sham, that transfers to the trusts are fraudulent conveyances, and a bunch of other reasons.

Pure Trusts are often part of a three-tier trust structure, which purport to hide the existence of the trust (and also make the structure tax free). In reality, it doesn’t do anything except make it seem like the structure is worth the cost (it isn’t).

On top of everything else, the IRS goes after Pure Trusts like the proverbial heat-seeking missle, because the IRS has never lost a case against the Pure Trust and knows that it can easily grab the assets to satisfy the taxes, interests, and usually heavy penalties which are awarded by the court (using a Pure Trust really is like waiving a red blanket at a mad bull – while your feet are stuck in concrete; something very bad is bound to happen and usually does).

We could talk all day about this scam, but this gives you a flavor of how they work: http://www.quatloos.com/taxscams/contrusts.htm

Asset Protection Consultants Scam

A new scam being marketed is the “Asset Protection Consultant”. Basically, you pay thousands of dollars for some rudimentary information worth maybe $12 which talks about the benefits of Nevada corporations. You then launch yourself as the “Advisor to the Stars”, never mind that your lack of a law license will both subject you to criminal penalties for the Unlicensed Practice of Law (UPL) as well blow the attorney-client privilege for whatever your client says to you or whatever information they give you.

Then, you charge your clients thousands of dollars to set up Nevada corporations that could be set up for a couple of hundred bucks, tops. You tell your clients that these are “foolproof” structures, and that creditors will be thwarted by the “Bearer Shares”, even though ownership can be imputed even when the bearer shares can’t be found, and Nevada law probably doesn’t even apply when the person and their assets are in another state.

Then, you have to hire your own lawyer when: (1) the tax bill for the entity comes due, and you didn’t know how to advise your client about how to correctly structure and fund these entities; or (2)  your client actually gets sued by a creditor, who adds you as a co-defendant on a civil conspiracy claim, or, worse, your client gets sued by the U.S. government who then files money laundering charges against you.

And you get all this for just a few thousand bucks? Shrewd, shrewd. But, hey, even when you blow up you can be comforted in the knowledge that you paid for all of this stuff in advance, and whoever sold you this stuff is gone, long gone.

Asset Protection Seminars & Materials

Lot’s of good planners give “asset protection” seminars – we hold “The Summit” once per year, and various other respected asset protection planners give seminars.

Unfortunately, we are in the minority. You see, the planners doing the best work are actually working for their clients, and don’t have time to be out on the seminar circuit. I’ve pretty much limited my appearances to a half-dozen or less times per year (frankly, I’d rather be out on the boat or up in the mountains), and most of the best planners try to limit themselves to a dozen or so appearances per year.

So mostly who you see giving the asset protection seminars are the dregs of the sector, being people who make their money either giving expensive seminars ($1,500 or more per person – real value $300), or giving ultra-cheap seminars ($15 per person) where they sell nearly worthless books and other materials, partnership forms and trust forms, etc., for many thousands of dollars (like $2,500 for a “do it yourself asset protection kit”).

If you go to one of the cheapie seminars, when they announce that they are selling materials at the back of the room, you’ll see about 20 people jump up out of their seats and rush back there, checkbook in hand. Don’t be fooled; most of these people are “shills” who are paid by the seminar promoters to run to the back to make it look like there is a great interest in the worthless materials being sold (your invitation to “join the herd” – Las Vegas casinos are notorious for using shills to encourage people to bet and to make bigger bets than they should be making). Just remember that if 20 people run to the back of the room to purchase a set of materials for $1,800 yours might be the only check actually cashed.

The Misleading

“Institutes” Concerning Asset Protection

There are no “Institutes” where learned scholars sit around daily discussing asset protection issues. What you have instead are a bunch of marketers who put together the “Institute” to give this impression, but is really just the marketer trying to create a herd mentality for you to send them clients.

Is this practice illegal? No. Is it misleading? Can be, and often is.

Various Books on Offshore Trusts

Wanna know about offshore trusts and so-called “Foreign Asset Protection Trusts”? You’re in luck, as there are a lot of books readily available for your casual perusal. Yessir, books (and even do-it-yourself kits) on offshore trusts are all the rage. Seems like everybody and their dog has written one book or another extolling the virtues of offshore trusts.

Unfortunately, as I chronicle elsewhere, offshore trusts are a bottom-tier asset protection solution, falling into the Dissociation Methodology (“It’s Not Mine Because I Gave It Away”). And they have been blown up in a major sort of way in several federal court opinions. Unless you are interested in the (nominal) federal gift and estate tax benefits of offshore trusts, there’s a good chance that forming one of these entities could put you into a worse situation than if you hadn’t done anything at all.

The problem is that books sales mean dinero, and even though the law has changed, nobody is rushing to pull their books from the shelves to talk about how the main focus of their books is now walking the legal plank into the Abyss of Failed Strategies.

You might be interested to know that many of these books are “ghostwritten” by somebody else — I know because I have had other planners ask me to ghostwrite their books for them, and though I refused, I didn’t fail to notice that their books were still later published (and basically were a re-hash of somebody else’s book; you’ll find that there is a real shortage of original ideas out there, especially amongst the offshore trust crowd).

The Unqualified and/or Misguided

Accountants

A recent phenomenon is the entry of accountants into the asset protection planning sector. They are not only totally unqualified to engage in this sort of planning, but for reasons I will discuss their planning will often put you into much worse shape than if you had done nothing at all.

Fundamentally, if you really think about it, asset protection is “Pre-Litigation Planning,” i.e., doing things in anticipation of going to court and standing in front of a hostile judge with determined creditor’s counsel making arguments about how to get at assets. This requires knowledge and experience in the areas of debtor-creditor law, commercial law, civil procedure, conflicts of law, judgments & remedies, bankruptcy, etc.

Note that “tax” isn’t included in the foregoing. The only time that tax law is implicated in asset protection planning is in figuring out the tax treatment of certain transactions – but basically tax has nothing to do with asset protection planning, except that you don’t want to make a tax error while you are doing the planning.

Another way to say this is that you don’t let the anesthesiologist do the cutting.

What happens is that accountants have this terrible tendency to assume that because something is X for purposes of the Internal Revenue Code, that it must be X for purposes of civil law also – but this simply isn’t the case. With regard to asset protection issues, there is often inconsistent treatment of situations between civil law and tax law, and this is where accountants most often get into trouble.

Unfortunately, accountants are also unaware of criminal laws, and assume that if something is permissible in the Internal Revenue Code, that it must be legal. Thus, in two of the landmark asset protection disasters, Lawrence and Brennan, the plans in each case were put together by the client’s accountant, who got the clients indicted for bankruptcy fraud and money laundering, and the accountants themselves were also indicted on a variety of theories. Ugly.

Unless an attorney is directly involved and retains the accountant, communications between a client and an accountant are not subject to attorney-client privilege. This means that anything the client and the accountant discuss will be known to creditors, creating evidence of actual intent to defraud creditors.

Finally, by law attorneys are privileged to assist clients with certain types of transactions, but accountants are not – meaning that if the transaction goes south, the accountant and the client may have created the additional liability of civil conspiracy, thus making the client potentially worse off than if he had not engaged in the planning at all.

I have personally found that in collection cases where an accountant did the planning, the first thing to do is to add the accountant as a co-defendant under a civil conspiracy theory. Since the accountants Errors & Omissions insurance doesn’t cover intentional torts like civil conspiracy, it creates a tremendous amount of leverage on them to assist in unraveling the debtor’s asset protection plan, in addition of course to creating another (usually easy) source of funds to collect.

[Some accountants believe that they have something like an attorney-client privilege with their clients. They don’t, but rather have a very weak privilege as to actions brought by the IRS for taxes only, i.e., the privilege does NOT apply in civil lawsuits, bankruptcy hearings, etc. Really, this doesn’t help you as the client at all.]

Estate Planners

Most Estate Planners, to the extent they are attorneys, are usually competent to create some very basic asset protection for the Client, such as maximizing homestead exemptions, structuring limited partnerships, etc.

Unfortunately, too many Estate Planners will go to a couple of “asset protection” seminars, and suddenly decide that ten hours of legal training can substitute for a litigator’s years of actually fighting creditors. They go hog-wild, and start setting up entities and offshore trusts with abandon, and throwing lots of language into documents to “intimidate” a creditor, and thus deter any lawsuits.

The asset protection plans created by Estate Planners seem to almost always have two major defects: First, they involve a lot of “gifting” transactions, which may be good from a federal gift or estate tax perspective, but are usually easy to set aside as Fraudulent Transfers; and, Second, their planning is usually too overt, meaning it is easy for a creditor’s attorney to go to the judge and show that there was actual intent to subvert the interests of creditors.

Some (attorney) Estate Planners are very good asset protection planners, but most aren’t – the key seems to be whether they do much business planning also.

So To Whom Do You Turn?

First, you want to engage a Licensed Attorney — this is the ONLY way that attorney-client privilege can attach to your communications, or that Work Product Immunity has a chance of applying to the documents that you produce to him, and that he drafts for you.

Second, you’ll want to find someone who is a real-world asset protection planner, and not just a member of some Institute (which only means that they part of somebody else’s referral network). Probably the best way to do this is to talk with one of the attorneys on the American Bar Association’s Asset Protection Planning Committee. While membership in the Committee is no guarantee of special competence — since any attorney who pays dues to the ABA can join — generally the “best and brightest” of the asset protection planners are on this Committee. See http://www.abanet.org/rppt/committees/pt/j3/home.html or contact us by e-mail to falc@falc.com and we’ll put you in touch with a member in your area.

IRS Guidance on Insurance Company Taxation

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December 18, 2015
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  • 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?

Correctly Running a Captive

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December 18, 2015
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Have you decided to form a captive? This webpage clarifies certain issues regarding the business plan, purpose, and operation of your insurance company.

It is necessary for your insurance company to be operated as a bona fide insurance company for profit, to be deemed to be primarily in the business of insurance for purposes of the Internal Revenue Code. Your insurance company cannot be a “mere shell” for you to conduct non-insurance company activities, yet claim the favorable tax treatment for insurance companies under the Internal Revenue Code. We cannot, and will not, accept clients whose motivation is to form and hold insurance companies as a “mere shell” to place other businesses into a tax-favored environment.

If your insurance company is not operated as a bona fide insurance company for profit, i.e., if its predominant business activity is not insurance and the purpose and operation of your insurance company does not make good economic sense, you risk the company being deemed not in the business of insurance, in which case you could not take advantage of the certain favorable provisions for insurance companies under the Internal Revenue Code. In such event, your company could possibly be subject to federal income tax on all of its income (with the possibility of “double taxation” as a “C” corporation – or, worse, some type of foreign entity). Therefore, it is critical that your insurance company at all times be operated as a bona fide insurance company for profit, and that insurance activities constitute the primary business of the company.

Please note that if your insurance company is attempting to qualify as an IRC § 501(c)(15) company (which we do not suggest, based on anticipated changes to the tax laws), and your insurance company earns more in investment income that in premiums, it risks being deemed an “investment company” as opposed to an “insurance company”, with the loss of any tax benefits given to insurance companies by Congress. For more information on this topic, please see IRS Notice 2003-35.

One aspect of a bona fide insurance company is that your insurance company will charge a commercially reasonable or “arm’s length’s” rates for premiums on all insurance policies. Charging commercially unreasonable rates for premiums, or premiums that have rates well in excess of those available in the insurance marketplace, could endanger the classification of your company as an insurance company for a variety of purposes, including U.S. tax purposes.

The fact that you will arrange for insurance management and related services, such as actuarial and underwriting services, etc., does not negate the fact that the insurance company must be operated as a bona fide insurance company for profit. It is ultimately your responsibility to maintain your company as a legitimate insurance company whose primary business is that of insurance.

  • Evidence that your insurance company is a bona fide insurance company for profit will include the fact that your insurance company has retained certain licensed professionals to assist the company in the conduct of its business. Your insurance company should retain certain licensed professionals to perform inter alia the following services:
  • Insurance management services, including drafting of policies, etc., performed by an insurance manager of your insurance company; and
  • Accounting and audit services, performed by accountants who are approved in the jurisdiction of domicile of your insurance company.

However, the mere retaining of professionals to act on behalf of your insurance company does not ipso facto place it in the business of insurance. Rather, your insurance company enters the business of insurance by a relatively long and detailed process, which is further described below.

Most U.S. states have relatively high license fees, surplus and capital requirements. While these may be necessary to provide for the fiscal needs of the state, and to protect third party insureds, respectively, these requirements can economically strangle a new insurance company which is attempting to feel its way into the insurance business and has not yet established a book of high profit/low risk business. Therefore, it is often necessary for budding insurance companies to avail themselves of jurisdictions outside the U.S., to the so-called “offshore” jurisdictions that are characterized by minimal licensing fees and relatively low capital and surplus requirements.

Please keep in mind, however, that even though the “offshore” jurisdiction where you will initially domicile your insurance company will have relatively low fees, surplus and capital requirements, this does not mean that your insurance company will not be regulated. To the contrary, the Insurance Commission (or equivalent) of the jurisdiction wherein your domicile your insurance company is apt to have a number of technical requirements relating to minimum surplus and capital, types of policies which can be written, etc., that your company will be required to comply with. While a technical misstep in complying with these rules should not necessary invalidate the characterization of your company as an insurance company under current U.S. tax law, a wholesale failure by your insurance company to attempt to comply with these regulations could indicate that it is not seriously interested in being in the business of insurance, which could jeopardize its status as an insurance company for U.S. tax purposes. Although the local insurance regulators might require a relatively low capitalization for their purposes, the company must maintain adequate surplus to satisfy various aspects of U.S. tax law, especially in regard to “risk shifting” analysis, which might in some circumstances be substantially higher than what the local insurance regulators may require.

Primarily important is the creation and execution of a viable business plan. The execution of such plan is intended to result in the company qualifying as an insurance company. The creation of such a business plan will take into account a number of factors too extensive to be discussed here, but will include the following:

  • Economic Viability – Your insurance company and its plan of operation must be designed so that company is profitable. For budding insurance companies, such as yours, this will include identification of certain “niche” insurance markets, which are characterized by a level of profitability that is favorably high in relation to a low level of risk being assumed. At the same time, it is important that your insurance company not commit itself to a large amount of risk before it has built up its pool of business and reserves so that the risks can be spread and premiums earned in accordance with conservative underwriting considerations.
  • Ratings – One of your goals may be to operate your insurance company in such a fashion that it receives favorable ratings by the ratings triumvirate of Standard & Poor’s, Moody’s and Best’s. Typically, these ratings companies will not rate a new insurance company for a period of at least several years after the company has been formed. When the companies are rated, there are at least three factors that are critically important:
    • The level of competence of the insurance company’s management to-date (i.e., that the insurance company has been managed in a competent fashion, and has an underwriting history which tends towards profitability without putting reserves or surplus at risk of a serious loss);
    • The maintained level of the insurance company’s capital and surplus (the higher the level of capital and surplus, the higher the rating your insurance company will likely receive); and
    • The outstanding risks and liabilities of the insurance company (the lower the level of outstanding risk and liabilities, the higher the rating your insurance company will likely receive).

    Please note that the ratings your insurance company may receive from Standard & Poor’s, Moody’s and Best’s may create substantial additional value in your insurance company, as highly-rated insurance companies command a much higher sale value. This should motivate you to operate your company in a conservative fashion, as described above, so as to obtain these ratings.

  • Underwriting Activities –It is important that your new insurance company does not overextend itself, by accepting risks which are outside the company’s experience level. New insurance companies should usually attempt to limit themselves to underwriting the otherwise uninsured risks of related-party businesses (i.e., providing insurance for other businesses which you own or control, and for which you understand the risks and are currently self-insuring). You may also investigate participating in reinsurance pools as well as underwriting in the securities and financial markets in which you have expertise.
  • Investigation of “Niche” Insurance Opportunities – You should be prepared to locate and analyze certain opportunities to offer insurance in currently untapped or noncompetitive markets. Indeed, your desire to enter the insurance market in such niches should be one of your primary motivations in forming a new insurance company.The creation of the business plan for your insurance company is merely the first step towards qualifying your company as an insurance company. After licensing, your primary business must be that of insurance. Your insurance company must be operated in accordance with the business plan, and as a bona fide insurance company for profit, actuaries, underwriters, insurance managers, and accountants, etc.
  • IRS Guidelines and Requirements — The IRS is continually modifying the definition of what qualifies as an “insurance company”. In order to qualify as an insurance company, at a minimum your company will have to insure at least twelve brother-sister corporations, or underwriter at least 29% third-party risk (at least 50% is preferable). These merely represent two of a multitude of tests that your company must meet to qualify as an insurance company for Internal Revenue Service purposes.

Captives

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December 18, 2015
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Comprehensive information about captive insurance companies (captives) and arrangements, including risk retention groups. While our focus is on the uses of these structures for U.S. companies and business owners, many of these concepts may be useful to others.

This topic is broken into basically three major sections:

Captive Insurance Companies Cases — A selection of Landmark Cases regarding the use of captive insurance arrangements is included.

Risk Retention Groups — Explains these pseudo-insurance company arrangements that are uniquely formed pursuant to federal law, and their use as fronting companies.

Captive Jurisdictions — Overview of the major captive jurisdictions, foreign and domestic, including the insurance company statutes of those jurisdictions.

Additional Information

IRS Guidance on Insurance Company Taxation

Correctly Running A Captive — Overview of what it takes to properly run a captive insurance company and keep it in compliance with the local regulators and the IRS. “Know before you leap!”

Captive Insurance Terms

  • Captive Insurance Company (“Captive”)
    Slang for an insurance company used predominantly to underwrite the business risk of other subsidiaries of the parent company or owner. The term “captive” is not used in any insurance statutes or in the Internal Revenue Code, but is rather a practice term used to describe an insurance company fulfilling the described role.
  • Closely Held Insurance Company (CHIC)
    A privately-held insurance company that is typically owned either by the owner’s children or an irrevocable trust formed for the owner’s children, to provide additional tax and succession benefits in addition to those of the captive arrangement.
  • Insurance Manager
    A person or entity that has obtained a license from the local insurance commissioner to manage insurance companies in that jurisdiction.