moderator: frederick e. turner, j.d. speaker: jay d. adkisson, j.d. speaker: david j. slenn, j.d

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DOES YOUR 831 (b) CAPTIVE QUACK? Breakout Session 1 (Thursday September 29, 2011). Moderator: Frederick E. Turner, J.D. Speaker: Jay D. Adkisson, J.D. Speaker: David J. Slenn, J.D. Agenda. Tax advantages, treatment and issues IRS Rulings - PowerPoint PPT Presentation


  • DOES YOUR 831 (b) CAPTIVE QUACK? Breakout Session 1 (Thursday September 29, 2011) Moderator: Frederick E. Turner, J.D.Speaker: Jay D. Adkisson, J.D.Speaker: David J. Slenn, J.D.

  • Tax advantages, treatment and issuesIRS RulingsPotential problem areasCaptive Taxation


  • Tax Advantages

    Deduction of premiums by Insureds

    Generally, the loss reserves are deductible by a captive which shelters Premium Income to the captive

    831(b) election allows Captive with 1.2 million or less Premium Income to elect to be tax exempt from Premium Income

  • 831(b) Captive Insurance Companies

    An insurance company, including a captive, may elect under 28 U.S.C. sec. 831(b) to be taxed on its investment income only, so long as the company receives less than $1.2 million in premium each year. The 831(b) election is filed along with the company's first tax return, and cannot be revoked without the consent of the Secretary of the Treasury. This election is an incentive provided by Congress to encourage the formation of new insurance companies. What 831(b) effectively allows a small insurance company to receive up to $1.2 million per year in premiums, without paying any income taxes on those premiums. The 831(b) election does not affect -- at all -- the deductibility of the premiums paid by the operating business to the captive. So long as those premiums are otherwise deductible, they may be deducted by the operating business just like any premium payments to a captive. This has the effect of creating an up to $1.2 million deduction in the operating business, with the premium moneys transferred to the captive, and with the captive not paying any income taxes on the receipt of those premiums.

  • 831(b) Election

    Alternative Tax Election Statement

    The named taxpayer herby elects to be subject to tax only on its taxable investment income as computed under IRC Section 834.This taxable income calculation does not include any net operating loss carried from a tax year in which the taxpayer was not taxed as a property and casualty insurance company. The election is made pursuant to IRC Section 831 (b) (2). It applies to the tax year of this return and to all subsequent tax years for which the election requirements are met.

  • Tax Treatment of Small Captives831(b) CaptiveIf premiums are less than $1.2 Million per year, no tax on premium incomeTax is paid on investment income at corporate ratesC-Corporations do not have the preferential individual capital gains income tax rate, so real estate is a bad investmentHigh cash value or private placement life insurance may be an appropriate vehicle to defer corporate taxationAlso need to watch out for corporate AMT on death benefit paid to a C-CorporationNot a panacea, and should only be used as part of an overall planCAVEAT: Beware of promoters selling captives as a way to buy tax deductible life insurance

  • Shareholder(s)1.2mm premium1.2mm deductionCaptive pays NO income tax on 1.2mm of premium incomeWealth Transfer of underwriting profitQualified dividend or capital gain to shareholder(s)831(b) - Simple Example

  • Federal Income Taxation

    Requirements: Bona-fide Business Purpose Risk Transfer Risk Distribution Operates as an insurance company Reasonable premiums Adequate capitalization

  • Federal Income Taxation

    What is insurance?Helvering v. Le Gierse, 312 U.S. 531 (1941)Risk ShiftingRisk DistributionUninsurable 80-year-old woman purchased a life policy and an annuity policy from the same insurance company one month before death

    Executor did not report death benefit on estate tax return

    Supreme Court found no risk shifted because of offsetting positions; this was just an attempted tax dodge

    First case to set forth the standard for true insurance as required to have both risk shifting and risk distribution

  • Federal Income TaxationRisk Distribution and ShiftingCase law developed two theories.

    Theory 1 (Third Party Theory):Sufficient third party premium with related premiumsCourts say 30% third-party insurance is adequate

    Theory 2 (Balance Sheet Theory): Sufficient related party entities insured to create risk distribution and shifting

  • Federal Income TaxationRisk Distribution

    Third Party Theory

    Courts have ruled that, if the captive writes sufficient unrelated premiums, related business is also deductible.

    Courts allowed 30% unrelated premiums (Sears, AMERCO, Harper Group, Ocean Drilling).

    Courts never established a floor (Gulf Oil 2% insufficient).

    Rev. Rul. 93-92 for employees benefits seems to recognize employees benefits as third party insurance.

  • Third Party Case

    The Harper Group, Inc. v. Commissioner (1992)

    TheHarper GroupCaptiveInsurance Co.Sister Co.Sister Co.Sister Co.Brother Co.Brother Co.3rd PartiesInsurance PremiumsInsurance Premiums29% of Premiums

  • Federal Income TaxationRisk Shifting

    Some History

    Revenue Ruling 77-316, 1977-2 C.B. 53Service creates the economic family doctrineRisk must be transferred outside of the economic family to be true insuranceKey focus was on a lack of risk shifting, therefore not insurance and premiums not deductible

  • Federal Income TaxationRisk Shifting

    More History

    Revenue Ruling 78-338, 1978-2 C.B. 107Adequate risk shifting with 31 unrelated companiesThis was a group captive, not a pure captive, so this was not terribly helpful to closely held business ownersService noted that no single member had a controlling interest

  • Federal Income TaxationRisk ShiftingMore History

    Court Rejection of Economic Family Doctrine

    Carnation Company v. Commissioner, 640 F.2d 1010 (9th Cir. 1981) (taxpayer loss largely on other grounds)Clougherty Packing Co. v. Commissioner, 84 T.C. 948 (T.C. 1985) (taxpayer loss largely on other grounds)Humana, Inc. v. Commissioner, 881 F.2d 247 (6th Cir. 1989) (taxpayer victory - mostly)

    Particularly explicit rejection of economic family doctrine. After a detailed discussion of prior courts rejecting the Services theory, the court concluded that under no circumstances do we adopt the economic family argument advanced by the government.

  • Federal Income TaxationRisk Shifting

    Explicit Rejection of Economic Family Doctrine

    Harper Group v. Commissioner, 979 F.2d 1341 (9th Cir. 1992) (taxpayer victory)

    Affirmed tax court opinion, which stated, in part: We have repeatedly rejected respondent's economic family theory.

  • Federal Income TaxationRisk Shifting

    The Service won in most cases where the captive insured the parent (still problematic today), but lost in cases where the captive insured affiliates owned by a common parent

    The taxpayer losses were never on the basis of the economic family doctrine, as the courts consistently refused to apply this bright-line test as too overly inclusive and instead applied a facts & circumstances test

  • Federal Income TaxationRisk ShiftingThe Balance Sheet Theory

    Allows deduction of premiums paid to a brother-sister captive without unrelated business. Originally had favorable decisions only in the Sixth Circuit (Humana, Hospital Corporation of America); subsequently expanded to all taxpayers (Kiddie).

  • Balance Sheet Case

    Humana, Inc. Holding Co.Brother Co.Sister Co.Insurance PremiumsInsurance PremiumsInsurance PremiumsBrother Co.Brother Co.Brother Co.Brother Co. Brother Co.Sister Co.Sister Co.Sister Co.Sister Co. Sister Co.Insurance PremiumsPremiums allocated to Parent would not be deductibleHumana, Inc. v. Commissioner (1998)

  • Federal Income TaxationRisk Shifting/DistributionImportant Issues in Brother-Sister Structures

    Brother-sister risk is not unrelated risk for purposes of insulating parent risk. Will not provide a deduction for parent's premiums.

    How many brother-sister insureds do you need?

    Is the correct measure the number of insureds ornumber of risks?

  • Federal Income Taxation as an Insurance CompanyRevenue Ruling 2001-31, 2001-1 C.B. 1348

    Service determines it will no longer raise the economic family theoryExplicitly acknowledged that no court had fully adopted the economic family theory set forth in Rev. Rul. 77-31

    Analysis is now a case-by-case analysis

    Service promised more challenges based on facts and circumstancesFocus is on risk shifting, risk distribution, inadequate capitalization, and parental guarantees

  • Other Significant IRS Rulings

    Rev. Rul. 2002-89 Third Party Risk

    Rev. Rul. 2002-90 Balance Sheet Theory

    Rev. Rul. 2005-40 Disregarded Entities and More

    Rev. Rul. 2008-8 Cell Captive

    Rev. Rul. 2009-26 Reinsurance and Risk Distribution

  • Safe Harbor RulingsRev Rul. 2002-89 Third Party Risk

    Rev Rul. 2002-90 Balance Sheet Theory

    Rev Rul. 2005-40 Disregarded Entities and More

  • Third Party Revenue Ruling

    Rev. Rul. 2002-89 - ruled on deductibility of parent's premiums where captive had 10% unrelated business (unfavorable ruling) and 50% unrelated business (favorable ruling).

    Note Harpers 30% decision is in the middle.Gulf Case 2% third party business was insufficient.Unrelated premium percentage was determined on both gross and net basis; gross should not be relevant. Requirement for homogeneous risks does not make sense from an actuarial approach or from case law. Captive was licensed in multiple U.S. States; captives are traditionally not licensed in multiple U.S. States. The risks were from different States. Risk must


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