Presentation on theme: "DOES YOUR 831 (b) CAPTIVE QUACK"— Presentation transcript:
1 DOES YOUR 831 (b) CAPTIVE QUACK 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.
2 AgendaTax advantages, treatment and issuesIRS RulingsPotential problem areasCaptive Taxation
3 Tax AdvantagesDeduction of premiums by InsuredsGenerally, the loss reserves are deductible by acaptive which shelters Premium Income to thecaptive831(b) election allows Captive with 1.2 million orless Premium Income to elect to be tax exemptfrom Premium Income
4 831(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.
5 Alternative Tax Election Statement 831(b) ElectionAlternative Tax Election StatementThe 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.
6 Tax Treatment of “Small” Captives 831(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”
7 831(b) - Simple Example 1.2mm premium Captive Insurance Company Client (s) Operating Business & Entities1.2mm premiumIrrevocable Trust for benefit of clients childrenCaptive Insurance Company1.2mm deductionShareholder(s)Captive pays NO income tax on 1.2mm of premium incomeWealth Transfer of underwriting profitQualified dividend or capital gain to shareholder(s)
8 Federal Income Taxation Requirements:Bona-fide Business PurposeRisk TransferRisk DistributionOperates as an insurance companyReasonable premiumsAdequate capitalization
9 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 deathExecutor did not report death benefit on estate tax returnSupreme Court found no risk shifted because of offsetting positions; this was just an attempted tax dodgeFirst case to set forth the standard for true insurance as required to have both risk shifting and risk distribution
10 Federal Income Taxation Risk Distribution and Shifting Case law developed two theories.Theory 1 (Third Party Theory):Sufficient third party premium with related premiumsCourts say 30% third-party insurance is adequateTheory 2 (Balance Sheet Theory):Sufficient related party entities insured to create risk distribution and shifting
11 Federal Income Taxation Risk Distribution Third Party TheoryCourts have ruled that, if the captive writes sufficient unrelatedpremiums, 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 for employees benefits seems to recognizeemployees benefits as third party insurance.
12 The Harper Group, Inc. v. Commissioner (1992) Third Party CaseThe Harper Group, Inc. v. Commissioner (1992)TheHarper GroupSister Co.Brother Co.CaptiveInsurance Co.Sister Co.Brother Co.Sister Co.29% of Premiums3rd PartiesInsurance PremiumsInsurance Premiums
13 Federal Income Taxation Risk Shifting Some HistoryRevenue Ruling , C.B. 53Service creates the “economic family doctrine”Risk 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
14 Federal Income Taxation Risk Shifting More HistoryRevenue Ruling , 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
15 Federal Income Taxation Risk Shifting More HistoryCourt Rejection of Economic Family DoctrineCarnation 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 Service’s theory, the court concluded that “under no circumstances do we adopt the economic family argument advanced by the government.”
16 Federal Income Taxation Risk Shifting Explicit Rejection of Economic Family DoctrineHarper 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.”
17 Federal Income Taxation Risk 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 parentThe 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
18 Federal Income Taxation Risk Shifting The Balance Sheet TheoryAllows deduction of premiums paid to a brother-sister captivewithout unrelated business.Originally had favorable decisions only in the Sixth Circuit(Humana, Hospital Corporation of America); subsequentlyexpanded to all taxpayers (Kiddie).
19 Balance Sheet Case Humana, Inc. v. Commissioner (1998) Sister Co.Holding Co.Brother Co.Sister Co.Brother Co.Brother Co.Sister Co.Brother Co.Sister Co.Brother Co.Sister Co.Brother Co.Sister Co.Insurance PremiumsInsurance PremiumsCaptiveInsurance Co.Insurance PremiumsInsurance PremiumsPremiums allocated to Parent would not be deductible
20 Federal Income Taxation Risk Shifting/Distribution Important Issues in Brother-Sister StructuresBrother-sister risk is not unrelated risk for purposes ofinsulating parent risk. Will not provide a deduction for parent'spremiums.How many brother-sister insureds do you need?Is the correct measure the number of insureds ornumber of risks?
21 Federal Income Taxation as an Insurance Company Revenue Ruling , C.B. 1348Service 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. RulAnalysis is now a case-by-case analysisService promised more challenges based on facts and circumstancesFocus is on risk shifting, risk distribution, inadequate capitalization, and parental guarantees
22 Other Significant IRS Rulings Rev. Rul – Third Party RiskRev. Rul – Balance Sheet TheoryRev. Rul – Disregarded Entities and MoreRev. Rul – Cell CaptiveRev. Rul – Reinsurance and Risk Distribution
23 Safe Harbor Rulings Rev Rul. 2002-89 – Third Party Risk Rev Rul – Balance Sheet TheoryRev Rul – Disregarded Entities and More
24 Third Party Revenue Ruling Rev. Rul ruled on deductibility of parent's premiums where captive had 10% unrelated business (unfavorable ruling) and 50% unrelated business (favorable ruling).Note Harper’s 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 be spread.
25 Balance Sheet Revenue Ruling Rev. Rul ruled on premiums paid by sister companies to a captive owned by their parent, with 12 subsidiaries, none with more than 15% or less than 5% of The Total Risk insured on a net and gross basisPostulates 12 fairly equal-sized subsidiaries.Note none less than 5% requirement.Requires that risks be homogeneous.Requires that risks be from different States.Requires that captive be licensed in all 12 States
26 Disregarded Entities Ruling Treatment of disregarded entities (i.e., LLC’s) – Rev. Rulsays they are disregarded, risk of a single member LLC is riskof the parentInconsistent with the Balance Sheet theory.Inconsistent with treatment IRS wants for partnerships.Single member LLC’s are respected by the IRS in other contexts.Section 965 repatriation of profits; separate entities for liability for taxes.Most importantly, disregarded entities are respected for liability and legal purposes, and that is what is being transferred in insurance transactions. They have separate balance sheets
27 Relationship between Insured and Captive Owner Ruling Rev.Rul says that, even if the insurer is adequately capitalized and completely unrelated, if there are an insufficient number of insureds, you may not have risk distribution, and thus no insurance.If not insurance, what is it? - Insured has paid an adequately capitalized, unrelated entity for goods or servicesWhat is the rationale? - If an insurer insures 10,000 buildings in 500 cities against fire, does the law of large numbers work differently, from the insurer's perspective, if one entity owns them all?12 or more insured can ensure risk distributionRelated parties that are separate taxpayers are considered separate premium payers50% third party risk is adequate
28 Other IRS GuidanceTAM Service will not count limited partnerships with a common general partner as separate entitiesNo logic to the Service’s argument that the common general partner bears all risk of lossRev Rul Protected Cell Captives - Service requires risk distribution within each cell, not just within the overall organization, as cells are segregated from each other for liability purposesRev. Rul To Determine risk distribution regarding a reinsurance contract one must look through to the risks of the ultimate insured – The Primary (underlying) Insurance Contract
29 Potential Problem Areas Thinly capitalizedRelated party loan-backsInvestment in life insuranceCan be a signal to the Service that this was a sham transaction/lacking in economic substanceLet the captive mature before buying life insurance, and be sure there is a substantial, nontax purpose (estate planning/buy-sell purpose may be helpful)Service has issued summonses for Aviva Life, AmerUs (now Aviva), and Indianapolis Life (now Aviva) related to ongoing scrutiny of captive promoters maintaining alliances with life insurance companiesInadequate third party riskLess than 12 insuredsRisk pools that pay no claimsProtected cell companies (Rev. Rul )Heavy investment in the activities of affiliate companies (Service could use this as evidence in a sham transaction)Heavy investment in illiquid assets (not “acting like” an insurance company)
30 Potential Problem Areas Accessing captives through any sort of “alliance”, “institute” or other title used to notate a consortium of individuals banded together to sell tons of life insurance through the aggressive marketing and inappropriate use of tax-advantaged structuresThis is a sure way to get a target painted on your back or your client’s backNo attorney-client privilegeThe Service can and does get customer lists from these groupsThese groups tend to be more reckless in their marketing materials since they need the “sizzle” to attract the attention of life insurance producersThe Service can and does use reckless marketing materials to hang taxpayersSuch as materials marketing captives as a way to deduct life insurance premiums and never pay tax on the proceedsLike any advanced planning tool, captives should be accessed through an attorney as part of a comprehensive approach in arranging a client’s affairsAttorney-client privilege will apply
31 Do It RightLike any advanced planning tool, captives should be accessed throughan attorney as part of a comprehensive approach in arranging aclient’s affairs
32 Phantom Capitalization of the Phantom Capitalization of a Captive $ 1,000,000 Property & Casualty Premiums paid to CaptiveCaptiveOperating Companies$30,000 initial Capital ContributionFamily / Irrevocable TrustDomicile regulations provide that underwriting profits within 90 days of formation are added to capital.Shareholder
33 Improper Formation AnalIImproper Formation Analysis for a Captive No feasibility studyNo AuditsNo Actuarial studiesBusiness risks
34 Captive Taxation – Getting to Captive Taxation – Getting to Section 831 Insurance Company?Unrelated Business TheoryRev. Rul30% under Harpers;Balance Sheet Theory12 companies, with none owning more than 15% - Rev. RulDoes company’s mean life reserves exceed 50% of total reserves?YES, Life Insurance CompanySection 801(a)NO, Property & Casualty CompanySection 831The term “net premiums” means gross premiums (including deposits and assessments) written or received on insurance contracts during the taxable year less return premiums paid or incurred for reinsurance.
35 Captive Taxation –Captive Taxation – Subchapter L L Partners and PartnershipsSubchapter KInsurance CompaniesSubchapter LPart ILife Insurance§801 imposes a tax on “life insurance company taxable income.”Part IIProperty & Casualty§831(a) imposes a tax on the taxable income of all other insurance companies.§831(b)(1)Alternative tax for small companies: multiply “taxable investment income” by §11(b) rates.§832(b)(1)Investment Income & underwriting Income; plus gain and all other items of income.RICs & REITsSubchapter M
36 Tax on insurance companies other than life insurance companies §831Tax on insurance companiesother than life insurance companiesGeneral rule - Taxes computed as provided in section 11 shall be imposed for each taxable year on the taxable income of every insurance company other than a life insurance company.[---Go to §832 for definition of insurance company taxable income, which includes investment income, underwriting income, gain, etc---].
37 § 832 Insurance company taxable income § 832Insurance company taxable income(What we are skipping – non §831(b) taxation)Definition of taxable incomeDefinitions In the case of an insurance company subject to the tax imposed by section 831—(1) Gross income The term “gross income” means the sum of—(A) The combined gross amount earned during the taxable year, from investment income and from underwriting income
39 Tax on insurance companies other than life insurance companies §831Tax on insurance companiesother than life insurance companies(b) Alternative tax for certain small companies(1) In generalIn lieu of the tax otherwise applicable under subsection (a), there is hereby imposed for each taxable year on the income of every insurance company to which this subsection applies a tax computed by multiplying the **taxable investment income** of such company for such taxable year by the rates provided in section 11 (b).
40 Tax on insurance companies other than life insurance companies §831Tax on insurance companiesother than life insurance companies(2) Companies to which this subsection appliesIn general This subsection shall apply to every insurance company other than life …. if—the net written premiums (or, if greater, direct written premiums) for the taxable year do not exceed $1,200,000, andsuch company elects the application of this subsection for such taxable year.
41 Tax on insurance companies other than life insurance companies §831Tax on insurance companiesother than life insurance companies(2) Companies to which this subsection appliesIn generalThe election under clause (ii) shall apply to the taxable year for which made and for all subsequent taxable years for which the requirements of clause (i) are met. Such an election, once made, may be revoked only with the consent of the Secretary.
42 Determination of taxable investment income §834Determination of taxable investment income(a) General rule For purposes of section 831 (b), the term “taxable investment income” means the gross investment income, minus the deductions provided in subsection (c).
43 Determination of taxable investment income §834Determination of taxable investment income(b) Gross investment income For purposes of subsection (a), the term “gross investment income” means the sum of the following:(1) The gross amount of income during the taxable year from—(A) interest, dividends, rents, and royalties, …….(D) gains from sales or exchanges of capital assets to the extent provided in subchapter P.
44 Determination of taxable investment income §834Determination of taxable investment income(c) Deductions In computing taxable investment income, the following deductions shall be allowed:(1) Tax-free interest(5) Interest paid or accrued(2) Investment expenses(6) Capital losses(3) Real estate expenses(7) Special deductions(4) Depreciation(8) Trade or business deductions(9) Depletion
45 taxable investment income §834Determination oftaxable investment income(e) Definitions For purposes of this part—Net premiums The term “net premiums” means gross premiums (including deposits and assessments) written or received on insurance contracts during the taxable year less return premiums and premiums paid or incurred for reinsurance.
46 & Treasury Regulation 301.9100-8 Tax Reporting831(b) election& Treasury Regulation(a)(1) provides a list of elections.
47 & Treasury Regulation 301.9100-8 Tax Reporting831(b) election& Treasury RegulationSubsection (a)(2) provides the timing for making the list of elections in (a)(1):…the elections described in paragraph (a)(1) of this section must be made by … [t]he due date (taking into account any extensions of time to file obtained by the taxpayer) of the tax return for the first taxable year for which the election is effective.
48 & Treasury Regulation 301.9100-8 Tax Reporting831(b) election& Treasury RegulationSubsection (a)(3) describes how to file the election.
50 Foreign Activities of US Taxpayers “Outbound” WITHIN THE UNITED STATESWITHOUT THE UNITED STATESOFFSHORE CAPTIVEU.S. ShareholderThe term “net premiums” means gross premiums (including deposits and assessments) written or received on insurance contracts during the taxable year less return premiums paid or incurred for reinsurance.On share of income under Subpart F See 951 (a); andRelated person insurance rules See 953 (c).
51 U.S. Activities ofU. S. Activities of Foreign Taxpayers “Inbound”WITHIN THE UNITED STATESWITHOUT THE UNITED STATESOn income “effectively connected” with a U.S. trade or business 9see Sec. 882), or, if not effectively connected;Foreign Shareholder2. On fixed, determinable and periodical income, or “FDAPI.” See 861(a)(7), 871 and 1441.OFFSHORE CAPTIVEThe term “net premiums” means gross premiums (including deposits and assessments) written or received on insurance contracts during the taxable year less return premiums paid or incurred for reinsurance.
52 §831(b)Miscellaneous IssuesWhat if the captive fails to meet the $1.2M premium limit?Taxed as a normal captive, so must include underwriting income. “The election can not be made retroactive.” See PLR
53 §831(b)Miscellaneous IssuesWhat if you fail to make a timely 831(b) election?See PLR – “Any election filed now or in the future would only be effective for the year the election was filed and all subsequent years. The election cannot be made retroactive.”
54 §831(b) Miscellaneous Issues Need an extension of time? See PLR– “Taxpayer requests that it be granted an extension of time under section to make the election under section 831(b) of the Code to be taxable only on its investment income.” (60 days was granted to make 831(b) election “on a return for the first open taxable year.”)
55 Presenters Frederick E. Turner. J.D. Active Captive Management LLC 16485 Laguna Canyon Road, Suite 200 Irvine, CA 92618/ /Jay D. Adkisson, J.D.P.O. Box 7088, Laguna Niguel, CA 92677/ gmail.com / www. Jayadkisson.comDavid J. Slenn, J.D.Akerman Senterfitt1415 Panther Lane, Suite 250 Naples, FL /
56 DisclaimerIRS Circular 230 Notice: Any information pertaining to tax related matters contained in this presentation is not intended or written to be used, and it cannot be used, by any person or entity for the purpose of (i) avoiding tax penalties imposed by any governmental taxing authority or agency, or (ii) promoting, marketing or recommending to another party any tax-related matters addressed herein. Information provided in these materials are for informational purposes only and are not to be reprinted or distributed without written consent. All rights apply.
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