Who’s Afraid of the IRS Defining Insurance?

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I just got back from the annual CICA conference in Arizona this week and I know what you are thinking: nothing but a scam to get into the nice sunny weather. Well, maybe, but there was a lot of really good stuff as well.

One piece of news that there was much discussion over was the recent public letter ruling (PLR) by the IRS, which held that a captive it was reviewing was not an insurance company and failed to meet the requirements of Section 501(c)(15) to qualify as a tax-exempt entity. Now, as we all know, for many years there has been much consternation on how the IRS defines insurance for tax purposes, and maybe we should be happy that there now seems to be something a little more definitive from the service on this issue, even though the lawyers tell me that a PLR is not considered precedential.

Bruce Wright, partner in the Tax Department at the law firm of Sutherland Asbill & Brennan, as well as the recipient of this year’s CICA Distinguished Service Award, provided the overview. In brief, over a three year period the captive wrote a number of policies, participated in a pooling agreement, and assumed third-party reinsurance. Of particular interest is the ruling’s focus on whether the different types of coverages provided by the captive involve insurance risk. The ruling found only two of the coverages, weather-related business interruption and excess directors and officers liability, involve insurance risk. The IRS concluded that the other coverages involve only business or investment risk, not insurance risk.

The problem is that the IRS’s definition of what constitutes insurance risk versus business risk (whatever that is) and investment risk is all over the place. Some of the coverages the IRS disallowed included Product Recall, Excess Pollution Liability, Loss of Major Customer, Excess Intellectual Property, Excess Employment Practices Liability, Excess Cyber Risk, and Loss of Services of Key Employee.

I can see that some of the coverages might have validity for exclusion, like the Excess Cyber coverage focused on purchasing security upgrades that should have been a part of the company’s regular business operations. However, the majority make sense as insurance and include many coverages we see in captives on a regular basis! Furthermore, Bruce reported that in reaching its conclusion the organization is not an insurance company for federal tax purposes, the ruling does not appear to take into account recent Tax Court cases that address the insurance risk and risk distribution issues.

The fact that the IRS’ lack of consistency in its treatment of captives is no surprise; the lack of gray matter being put to its rulings is puzzling to me, if not to many of you in the world of tax!

Thank you all very much, and I look forward to hearing from you.

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