The Insurance Branch of IRS Chief Counsel-FIP publicly released a legal memorandum concluding that 10-year excess loss policies issued by a captive insurance company to affiliated (brother-sister) companies did not qualify as insurance for federal income tax purposes ILM 201533011 (publicly released August 14, 2015; dated May 6, 2015).
The IRS memo concludes that: (1) the taxpayer accrues income from premiums the earlier of when premiums are due or when they are paid; and (2) because the policies are not insurance for federal income tax purposes, the claims must be treated as “other liabilities” subject to Reg. section 1.461-4(g)(7)—meaning the all-events test is not satisfied until those claims are paid.
The taxpayer, a captive insurer, has seven brother-sister companies (the “Group Entities”). Six of these companies are healthcare service providers and the other is a healthcare administrator.
The taxpayer serves as the insurer for the Group Entities’ workers’ compensation and professional liability coverages (not addressed in the IRS memo). The taxpayer also entered into 10-year excess loss policies (“Policies”) with the Group Entities that covered their costs of providing healthcare services to HMO members over an undefined attachment point over a 10-year period. The IRS legal memo states that claims were payable at the end of the 10-year policy term; as of the end of the fourth policy year, no claims had been made. The memo states also that the premiums for the Policies were priced and executed before the attachment point for coverage was established.
The taxpayer’s liability to each Group Entity was capped under each policy, with the first cap set at 150% of a Group Entity’s premiums. The memorandum indicates that the cap was raised to 170% with no change in premium at some point during the period of coverage. The Group Entities claimed deductions for each tax year that premiums were paid to the taxpayer.
The IRS concluded that the only risk that the taxpayer assumed under the policy was an “investment risk”—that is, the risk that its investment yield on the premiums that it received from the Group Entities would be lower than expected, and thus would not be sufficient to fund the amount that it had promised to pay the Group Entities.
The Insurance Branch stated that the policies were “…effectively designed as guaranteed investment contracts, payable in 10 years, with 1/10 of the principal deposited each year, and with a fixed annual interest rate of 7.25 percent (which is the rate necessary to grow 100 units, deposited in equal installments over 10 years, into 150 units at the end of those 10 years).”
The memo also concludes that the arrangement between each Group Entity and the taxpayer was “no more than the prefunding of future expenses,” citing Rev. Rul. 89-96 (no insurance when casualty event occurred before insurance contract was entered into), and Rev. Rul. 2007-47 (contract for remediation expenses treated as a pre-funding arrangement).
One of the more interesting items in the ruling is the inconsistency between the Insurance Branch’s assertion that the transaction does not qualify as insurance because it is essentially just a financing transaction, and the characterization of the amount received by the taxpayer as taxable income when received.
The IRS has been reticent to issue guidance describing how to recast purported insurance transactions that do not qualify as insurance for tax purposes, suggesting that a facts-and-circumstances test is to be applied.
It seems inconsistent to suggest that the arrangement isn’t insurance because it is economically just a deposit, but then conclude the recipient has taxable income. Merely holding money for the benefit of others generally does not give rise to taxable income. In addition, one would think that the characterization of the arrangement ought to be consistent between the payor and recipient of the funds, and that the Group Entities are entitled to a deduction for the amount paid—although the memorandum doesn’t address the treatment of the transaction to the Group Entities.
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