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The owners of captive insurers have scored major victories in cases against the IRS, but they still face uncertainties on several fronts.
U.S. Tax Court judges ruled in favor of Plano, Texas-based Rent-a-Center Inc. and Parsippany, New Jersey-based Securitas Holdings Inc., finding last year that captives can meet the captive risk distribution requirements by insuring a large number of risks rather than, as the IRS contended, a large number of related policyholders.
The rulings provide “a lot more flexibility in putting together a captive structure,” said Leslie C. Boughner, deputy CEO of Willis North America Inc.'s global captive and consulting practice in Burlington, Vermont.
The IRS has not appealed either ruling, though how it will respond to similar future cases is uncertain, experts say.
Meanwhile, microcaptives formed under section 831(b) of the U.S. Tax Code may become more attractive under a Senate Finance Committee proposal unveiled in February, even as the IRS added 831(b)s to its Dirty Dozen list of potential tax abuses.
And the Tax Court is expected to rule this year on whether policies covering the residual value of leased property can be defined as insurance for tax purposes.
Last year's Rent-a-Center and Securitas rulings were big wins for captive owners, experts agree. Both upended IRS decisions on what constitutes risk distribution, one of the hallmarks, along with risk transfer, of determining premium deductibility.
Pure captives that only insure the risks of their parent companies typically cannot deduct premiums for tax purposes, however, in cases where risk is distributed among several companies covered by a captive, even if the companies are related, companies can argue that the premiums are deductible.
IRS revenue rulings in 2002 and 2009 suggested that risk distribution requires that a captive insure at least 12 independent brother/ sister entities and that no one entity account for less than 5% or more than 15% of the captive's risk.
In Rent-a-Center and Securitas, though, the Tax Court ignored IRS rulings and focused on the number and variety of insured risks rather than the number of insured entities. For example, Securitas employed more than 100,000 people and operated more than 2,250 vehicles in the U.S. in 2002-2004, enough “statistically independent risk exposures” to create risk distribution, the court found.
The rulings “look at the substance of the program vs. the form,” said Michael Serricchio, senior vice president of the captive solutions group at Marsh L.L.C. in Norwalk, Connecticut.
While the rulings give captive owners more flexibility in structuring their arrangements, they also create uncertainty about where the line on “statistically independent risk exposure” will be drawn in the future.
“What happens if you have not 20,000 employees but 2,000 employees?” asked P. Bruce Wright, a partner at Sutherland Asbill & Brennan L.L.P. in New York. “What happens if you have not 16 subsidiaries but two? Not thousands of vehicles but 20?”
It is unclear how the IRS will answer these questions or what its future legal position will be, said Charles J. Lavelle, a senior partner with Bingham Greene-baum Doll L.L.P. in Louisville, Kentucky.
Owners of 831(b) captives, meanwhile, have political and tax issues to ponder.
The Senate Finance Committee in February considered capping premiums from any one 831(b) policyholder at 20% of the captive's total, a move that could have been fatal to many microcaptives, which often insure a single policyholder. The provision was replaced, though, with one that could expand microcaptive growth by upping the deductible limit on premium contributions to $2.2 million from $1.2 million.
Neither the full Senate nor the House of Representatives has considered the plan.
At the same time, the IRS added 831(b) companies to its list of abusive tax schemes: Microcaptives may write policies covering ordinary business risks or “implausible” risks for exorbitant premiums simply to get the tax deduction, the IRS warned.
An official of Artex Risk Solutions Inc., Arthur J. Gallagher & Co.'s Hamilton, Bermuda, captive management unit, said last fall that Artex and other captive managers were engaged with the IRS in a probe of 831(b) clients.
Gallagher and others, though, said that 831(b) captives formed for legitimate insurance purposes are viable options.
“If you only were doing it for tax purposes, you shouldn't have been doing it at all, but especially not in today's environment,” Mr. Lavelle said.
If anything, the IRS attention “just promotes properly structured captives, regardless of size,” Mr. Boughner said.
A current U.S. Tax Court dispute involving a little-discussed line of coverage — residual value insurance — could have broader insurance market implications.