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. Agenda
Tax advantages, treatment and issues
IRS Rulings
Potential problem areas
Captive Taxation

3. 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

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) 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.

6. Tax Treatment of “Small” Captives
831(b) Captive
If premiums are less than $1.2 Million per year, no tax on premium income
Tax is paid on investment income at corporate rates
C-Corporations do not have the preferential individual capital gains income tax rate, so real estate is a bad investment
High cash value or private placement life insurance may be an appropriate vehicle to defer corporate taxation
Also need to watch out for corporate AMT on death benefit paid to a C-Corporation
Not a panacea, and should only be used as part of an overall plan
CAVEAT: 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 & Entities
1.2mm premium
Irrevocable Trust for benefit of clients children
Captive Insurance Company
1.2mm deduction
Shareholder(s)
Captive pays NO income tax on 1.2mm of premium income
Wealth Transfer of underwriting profit
Qualified dividend or capital gain to shareholder(s)

8. Federal Income Taxation
Requirements:
Bona-fide Business Purpose
Risk Transfer
Risk Distribution
Operates as an insurance company
Reasonable premiums
Adequate capitalization

9. Federal Income Taxation
What is insurance?
Helvering v. Le Gierse, 312 U.S. 531 (1941)
Risk Shifting
Risk Distribution
Uninsurable 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

10. Federal Income Taxation Risk Distribution and Shifting
Case law developed two theories.
Theory 1 (Third Party Theory):
Sufficient third party premium with related premiums
Courts say 30% third-party insurance is adequate
Theory 2 (Balance Sheet Theory):
Sufficient related party entities insured to create risk distribution and shifting

11. Federal Income Taxation Risk 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 for employees benefits seems to recognize
employees benefits as third party insurance.

12. The Harper Group, Inc. v. Commissioner (1992)
Third Party Case
The Harper Group, Inc. v. Commissioner (1992)
The
Harper Group
Sister Co.
Brother Co.
Captive
Insurance Co.
Sister Co.
Brother Co.
Sister Co.
29% of Premiums
3rd Parties
Insurance Premiums
Insurance Premiums

13. Federal Income Taxation Risk Shifting
Some History
Revenue Ruling , C.B. 53
Service creates the “economic family doctrine”
Risk must be transferred outside of the economic family to be true insurance
Key focus was on a lack of risk shifting, therefore not insurance and premiums not deductible

14. Federal Income Taxation Risk Shifting
More History
Revenue Ruling , C.B. 107
Adequate risk shifting with 31 unrelated companies
This was a group captive, not a pure captive, so this was not terribly helpful to closely held business owners
Service noted that no single member had a controlling interest

15. Federal Income Taxation Risk Shifting
More 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 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 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.”

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 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

18. Federal Income Taxation Risk Shifting
The 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).

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 Premiums
Insurance Premiums
Captive
Insurance Co.
Insurance Premiums
Insurance Premiums
Premiums allocated to Parent would not be deductible

20. Federal Income Taxation Risk Shifting/Distribution
Important 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 or
number of risks?

21. Federal Income Taxation as an Insurance Company
Revenue Ruling , C.B. 1348
Service determines it will no longer raise the economic family theory
Explicitly acknowledged that no court had fully adopted the economic family theory set forth in Rev. Rul
Analysis is now a case-by-case analysis
Service promised more challenges based on facts and circumstances
Focus is on risk shifting, risk distribution, inadequate capitalization, and parental guarantees

22. Other Significant IRS Rulings
Rev. Rul – Third Party Risk
Rev. Rul – Balance Sheet Theory
Rev. Rul – Disregarded Entities and More
Rev. Rul – Cell Captive
Rev. Rul – Reinsurance and Risk Distribution

23. Safe Harbor Rulings Rev Rul. 2002-89 – Third Party Risk
Rev Rul – Balance Sheet Theory
Rev 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 basis
Postulates 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. Rul
says they are disregarded, risk of a single member LLC is risk
of the parent
Inconsistent 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 services
What 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 distribution
Related parties that are separate taxpayers are considered separate premium payers
50% third party risk is adequate

28. Other IRS Guidance
TAM Service will not count limited partnerships with a common general partner as separate entities
No logic to the Service’s argument that the common general partner bears all risk of loss
Rev 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 purposes
Rev. 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 capitalized
Related party loan-backs
Investment in life insurance
Can be a signal to the Service that this was a sham transaction/lacking in economic substance
Let 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 companies
Inadequate third party risk
Less than 12 insureds
Risk pools that pay no claims
Protected 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 structures
This is a sure way to get a target painted on your back or your client’s back
No attorney-client privilege
The Service can and does get customer lists from these groups
These groups tend to be more reckless in their marketing materials since they need the “sizzle” to attract the attention of life insurance producers
The Service can and does use reckless marketing materials to hang taxpayers
Such as materials marketing captives as a way to deduct life insurance premiums and never pay tax on the proceeds
Like any advanced planning tool, captives should be accessed through an attorney as part of a comprehensive approach in arranging a client’s affairs
Attorney-client privilege will apply

31. Do It Right
Like any advanced planning tool, captives should be accessed through
an attorney as part of a comprehensive approach in arranging a
client’s affairs

32. Phantom Capitalization of the Phantom Capitalization of a Captive
$ 1,000,000 Property & Casualty Premiums paid to Captive
Captive
Operating Companies
$30,000 initial Capital Contribution
Family / Irrevocable Trust
Domicile 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 study
No Audits
No Actuarial studies
Business risks

34. Captive Taxation – Getting to Captive Taxation – Getting to Section 831
Insurance Company?
Unrelated Business Theory
Rev. Rul
30% under Harpers;
Balance Sheet Theory
12 companies, with none owning more than 15% - Rev. Rul
Does company’s mean life reserves exceed 50% of total reserves?
YES, Life Insurance Company
Section 801(a)
NO, Property & Casualty Company
Section 831
The 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 Partnerships
Subchapter K
Insurance Companies
Subchapter L
Part I
Life Insurance
§801 imposes a tax on “life insurance company taxable income.”
Part II
Property & 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 & REITs
Subchapter M

36. Tax on insurance companies other than life insurance companies
§831
Tax on insurance companies
other than life insurance companies
General 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
§ 832
Insurance company taxable income
(What we are skipping – non §831(b) taxation)
Definition of taxable income
Definitions 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
§831
Tax on insurance companies
other than life insurance companies
(b) Alternative tax for certain small companies
(1) In general
In 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
§831
Tax on insurance companies
other than life insurance companies
(2) Companies to which this subsection applies
In 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, and
such company elects the application of this subsection for such taxable year.

41. Tax on insurance companies other than life insurance companies
§831
Tax on insurance companies
other than life insurance companies
(2) Companies to which this subsection applies
In general
The 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
§834
Determination 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
§834
Determination 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
§834
Determination 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
§834
Determination of
taxable 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 Reporting
831(b) election
& Treasury Regulation
(a)(1) provides a list of elections.

47. & Treasury Regulation 301.9100-8
Tax Reporting
831(b) election
& Treasury Regulation
Subsection (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 Reporting
831(b) election
& Treasury Regulation
Subsection (a)(3) describes how to file the election.

49. See copy for example (included in hand-outs).

50. Foreign Activities of US Taxpayers “Outbound”
WITHIN THE UNITED STATES
WITHOUT THE UNITED STATES
OFFSHORE CAPTIVE
U.S. Shareholder
The 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); and
Related person insurance rules See 953 (c).

51. U.S. Activities ofU. S. Activities of Foreign Taxpayers
“Inbound”
WITHIN THE UNITED STATES
WITHOUT THE UNITED STATES
On income “effectively connected” with a U.S. trade or business 9see Sec. 882), or, if not effectively connected;
Foreign Shareholder
2. On fixed, determinable and periodical income, or “FDAPI.” See 861(a)(7), 871 and 1441.
OFFSHORE CAPTIVE
The 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 Issues
What 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 Issues
What 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.com
David J. Slenn, J.D.
Akerman Senterfitt
1415 Panther Lane, Suite 250 Naples, FL  /

56. Disclaimer
IRS 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.