Case Law (Revenue Rulings): "Safe Harbor" Rulings and Field Service Advice

In 2002, the IRS issued three revenue rulings providing safe harbors for captive insuranc arrangements.  If the client safisfies the requirements of any of these rulings, the IRS genearlly will not cahllenge the deductibility of premiums paid to the captive.  Rev. Rul. 2002-89 [2002-52 C.B. 984] deals with parent-subsidiary captive insurance arrangements; Rev. Rul. 2002-90 [2002-52 C.B. 985] deals with brother-sister captive insurance arrangements and Rev. Rul 2002-91 [2002-52 C.B. 991] deals with a group captive arrangement.  As group captives typically fall outside the parameters of IRC 831(b) small captive insurance companies, it will not be detailed herein.

Taken together, the Revenue Rulings address, and provide guidance to, the following scenarios:

• Risks of a parent can not be insured by a captive insurance subsidiary unless the captive has at least 50% of its risk insured by third parties;
• Risks of 12 brother-sister operating companies can be insured by a captive, to the extent the insured each pay no mnore than 15% of the total premiums to the captive; and,
• Risks of unrelated parties in a group captive can be insured by a captive so long as no one insured pays more than 15% of the total premiums to the captive.

The IRS further clarified its parent-subsidiary position in Rev. Rul. 2005-40 [2005-2 C.B. 4], ruling that risks of 12 single member limited liability companies that are disregarded entities by their parent can not be insured by the captive since all of the risk would be considered parent risk.

1. Revenue Ruling 2002-89 (Third Party Risk)

In Rev. Rul. 2002-89, the IRS covered two situations.  The first involved a wholly-owned subsidiary captive that insured the risks of its parent.  The premiums earned by the captive from the parent company constituted 90 percent of the gross and net premiums earned by the captive annually, and the liability coverage provided by the captive to the parent accounted for 90 percent of the total risks borne by the captive.  The IRS stated that no court has held that an arrangement constitutes insurance when a wholly-owned subsidiary insures only the risks of the parent.  Since there was only nominal true risk shifting from a balance sheet perspective, the arrangement did not constitute insurance for federal income tax purposes.

Situation two involved the same facts as situation one, except that the premiums earned by the captive from the parent company constituted less than 50 percent of the gross and net premiums earned by the captive annually, with the balance coming from insurance for unrelated third parties.  In addition, the liability coverage provided by the captive to the parent accounted for less than 50 percent of the total risks borne by the captive.  The IRS rules that this was insurance for federal income tax purposes because the premium and risks of the parent company and subsidiary captive were pooled with unrelated insureds so that the elements of risk shifting and risk distribution were present.

Therefore, in a parent-subsidiary arrangement, a captive can fit within the first "safe harbor" introduced by the IRS if at least 50 percent of the premium received by the captive relates to unrelated third party risk.  This revenue ruling should be compared to the Harper Group case, [Harper Group and Includible Subsidiaries v. Commissioner, supra. 96 T.C. 45], where the Tax court of the United States held that because the captive had approximately 30 percent unrelated third party risk, the arrangement constituted insurance for federal income tax purposes.

2. Revenue Ruling 2002-90 (12 Entity Rule)

In Rev. Rul 2002-90, a parent owned all stock of 12 operating subsidiaries that provided professional services, which were similar for each subsidiary (homogeneous risk).  The parent formed a wholly-owned domestic captive with adequate capitalization.  Each of the operating subsidiaries purchased professional liability insurance from the captive for premiums determined by industry standards.  No parental guarantees were issued to any of the insured entities.  No insured has less than 5 percent, nor more than 15 percent, of the total risks of the captive.  None of the funds of the captive were loaned back to the parent or to the operating subsidiaries.  The arrangements were consistent with the standards applicable to an insurance arrangement between unrelated parties.

The arrangements between the captive and the 12 operating subsidiaries were held to constitute insurance for federal income tax purposes.  Risk distribution was found to exist because a loss by one insured was substantially borne by the premiums paid by the others.  This revenue ruling should be compared to the Humana case, where the Sixth Circuit held that insuring the risks of seven brother-sister companies was sufficient risk distribution to constitute insurance.

In Rev. Rul 2005-40, however, the IRS stated that for purposes of the 12 Entity Rule, single member LLCs would not qualify as an entity toward the 12 entities required.

In its most recent relevant revenue ruling [Rev. Rul 2008-8. I.R.B. 2008-5], the IRS addressed what is commonly known as a protected cell company ("PCC").  A PCC is a property and casualty company formed by a sponsor with various separate and protected cells.  Each cell is treated as a separate captive insurance company, and each sell issues insurance policies only to its participant(s).  In Rev. Rul. 2008-8, the IRS held that the policies issued to the participant were not insurance for federal tax purposes because this was similar to a parent-subsidiary arrangement which lacks risk shifting and risk distribution.  However, if the participant had 12 subsidiaries that generally meet the same fact pattern in Rev. Rul 2002-90, then the policies issues from the cell company to the subsidiaries of the participant would constitute insurance for federal tax purposes.  Prior to Rev. Rul 2008-8, PCCs were often used as a less costly alternative to the pure captive and to avoid the 12 entity requirement of Rev. Rul. 2002-90.

Field Service Advice 200125009

In Field Service Advice 200125009, the Chief Counsel advised that a taxpayer is entitled to deduct as "insurance" premium amounts paid to a captive in a brother-sister arrangement.  While the Service did not explain why such amounts constituted deductible insurance premiums, the FSA was viewed as a significant win for taxpayers in two respects: (1) the FSA was an initial indication that the Service was abandoning the economic family theory; (2) FSA200125009 seems to indicate that the Service found risk distribution with one insured.