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Mostly Quiet On Captive Tax Front, But Federal Bill On Off-Shore Entities Cited

Following the tumultuous tax issues that dominated 2007 into 2008—changes that could have altered the captive industry—this year by comparison has been relatively tame.

While there have been several developments on the taxation of captive insurance this year, they generally did not expand the status quo. This is not surprising, as there were not many “hot button” issues scheduled on the IRS agenda. (See NU, “Tax Challenges Remain for Captive Entities,” March 9, 2009.)

An issue potentially relevant to captives is the IRS Business Plan. Each year, the IRS publishes a Business Plan—technically called its “Priority Guidance Plan”—which lists projects on which the IRS hopes to issue a public position (generally referred to as “guidance”).

The July 1, 2008-June 30, 2009 IRS Business Plan listed two topics relevant to captives:

• A “Revenue Ruling providing guidance on reinsurance agreements entered with a single ceding company.”

The IRS has not been more explicit as to what issues the Revenue Ruling will address. The industry assumes it will not “break new ground” and will be consistent with traditional captive insurance concepts.

• Cell taxation.

In 2008, the IRS ruled that whether a premium paid to a cell is “insurance” for federal income tax purposes will be determined on a cell-by-cell basis, rather than by looking at the entire company (including the core and all the cells)—at least where the core capital bears no risk.

This means that to meet the IRS tests of having enough insured entities, or having enough unrelated business, only the activities of a given cell are taken into account.

For example, the cell cannot rely on the unrelated insurance in other cells to meet the IRS risk distribution tests. If there is “insurance” in a cell, in other words, the insured’s premiums are deductible. (See NU, “IRS To Research Cell-Captive Taxation,” Feb. 11, 2008.)

This year, the IRS plans to finalize its proposal as to how to tax the cell (the recipient of the premiums).

In Notice 2008-19, the IRS proposed to treat each cell as its own company—at least where the core capital was not liable for the cell’s debts.

If by looking exclusively at the activities within the cell, there is insurance, then the cell is treated as an insurance company that needs its own Employer Identification Number, files its own tax return, and makes its own tax elections—all independent of the status or actions of the other cells.

While neither of these items were issued by June 30, 2009, unfinished items are generally included in the next year’s plan.

The industry was asked to comment on the IRS proposal. Because none of the comments attacked the IRS’s basic direction, however, the industry assumes the final regulations will follow the Notice’s approach. The Notice stated that the regulations would not be effective until at least 12 months after they are finalized.

The Captive Insurance Companies Association and the Vermont Captive Insurance Association had jointly requested liberal transition rules that would permit taxpayers to conform to the new rules without adverse tax consequences.

At a conference in May, an IRS representative stated that the IRS had drafted guidance addressing both cell captives and “series LLCs.” Series LLCs have nothing to do with captive insurance but present many of the same tax issues.

The IRS prefers to issue a single piece of guidance to address both, but may decide to issue the guidance on cells separately. (See 2009 Tax Notes Today 101-9.)

Meanwhile, captive owners should think about Small Tax-Exempt Insurance Companies—Section 501(c)(15) of the Internal Revenue Code, which provides a complete exemption from taxation for very small insurance companies.

Most captives do not qualify for this section, and it became even more difficult to qualify after a change in the law in 2004.

However, it is often instructive to learn what the IRS says about these companies, because its approach is often applied to larger captives.

Under the current statute, gross receipts of a tax-exempt property and casualty insurance captive (and its corporate affiliates) cannot exceed $600,000, and more than 50 percent of the gross receipts must be premiums.

Prior to 2009, the IRS revoked many tax exemptions because the captives did not have valid insurance arrangements. In 2009, there were also many revocations of exemptions, principally because these numerical tests were not met.

The IRS consistently has held that if a protective section 831(b) election had also been made by an entity whose tax exemption was revoked, then the election would be treated as valid—but that a retroactive election cannot be made.

The IRS also has stated that if captives with revoked elections subsequently meet the tests, then they “may be allowed to file the Form 990 for each year they qualify, as a self-declared entity.”

If the captive subsequently fails again to meet section 501(c)(15), but had previously made a section 831(b) election, then the 831(b) election applies. (See private letter ruling 200903089, as well as PLR 200913069. Although a PLR may not be cited as precedent, it does evidence IRS thinking.)

On the legislative front, President Barack Obama has railed against tax abuses using foreign entities, and Sen. Carl Levin, D-Mich., has often introduced legislation relating to foreign transactions in general.

Rep. Richard Neal, D-Mass., introduced new legislation in July that would bar foreign-owned insurers from moving their excess U.S. earnings into “tax havens” through a reinsurance transaction with an affiliate. At this point nothing has passed, but this highly controversial topic bears watching. (See page 10 for more details about the bill.)

Earlier this year, the U.S. Senate Finance Committee circulated a similar discussion draft, which drew vociferous comments from both proponents and opponents.

In the courts, there have been no 2009 cases that relate to captive insurance issues. One case did involve a tax-exempt insurance company, but the issue addressed whether the captive owned property that was sold and did not address the definition of insurance.

Charles J. (Chaz) Lavelle is an attorney in the Louisville, Ky., office of Greenebaum Doll & McDonald PLLC. He served as outside tax counsel for both Humana and Ocean Drilling & Exploration Company in their U.S. Court of Appeals captive insurance victories.

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