Presenting a live 90-minute webinar with interactive Q&A IRS Targets Captive Companies: Structuring Section 831(b)-Compliant Operating Documents Avoiding Tax Penalties, Navigating IRS Safe Harbors, and Ensuring Premium Deductibility

TUESDAY, MAY 5, 2015 1pm Eastern | 12pm Central | 11am Mountain | 10am Pacific

Today’s faculty features:

Beckett G. Cantley, Professor of Tax Law, John Marshall Law School, Atlanta John Colvin, Partner, Colvin & Hallett, Seattle F. Hale Stewart, Owner, The Law Office of Hale Stewart, Houston Robert J. Walling, III, Principal and Consulting Actuary, Pinnacle Actuarial Resources, Bloomington, Ind.

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F. Hale Stewart, JD, LL.M. . Masters in Domestic and International taxation, TJSL School of Law . Magna Cum Laude . Co-Author of US Captive Insurance Law, 2nd Edition . Tax Analysts’ Author . Domestic and International Tax Structuring at The Law Office of Hale Stewart and US Global Tax

5 • Insurance Factors What is – Definite Insurance? – Fortuity – Insurable Interest – Risk Shifting – Risk distribution – Harper Test • (1) whether the arrangement involves the existence of “insurance risk”; • (2) whether there was both risk shifting and risk distribution; and • (3) whether the arrangement was for “insurance” in its commonly accepted sense.

6 • Starting in the 1950s, certain businesses either couldn’t find Captive insurance, or could only find very expensive insurance. – Flood Cases Insurance – Oil and Gas – Large Contractors (Stearns Rogers) and Market – Hospitals (Humana) • In the 1970s, the US insurance industry was sued under four Failure causes of action – Asbestos – Professional Liability (Med Mal) – Environmental Claims – Products Liability • These cases were very expensive leading to some bankruptcies and major payouts. • Starting in the late 1970s, the insurance industry started to greatly limit their actual exposure, slowly eliminating expensive insurance coverage.

7 • CGL All – Employment Claims Common – Employee Fidelity (employee theft) – Cyber-Risk Insurance – Products Liability Policies – Products Recall – Loss of key contract/loss of key person Have Large • Property – Pollution Exemptions – Mold Remediation – Flooding – Windstorm Deductible

8 • From the late 1970s to the late 1980s, the IRS won The Captive most of their cases. Insurance • Why? – Better Prepared Story Arc – Taxpayers put on terrible cases – Courts were unsophisticated – Lack of solid insurance definition

9 • From the latest 1980s to 2002, taxpayers won most of The Captive the cases. Insurance • Why? – Better prepared Story Arc – IRS’ argument starts to unravel – Courts are more sophisticated

10 • 1.) Ocean Drilling and Exploration Co. v. United States, 24 Pre-UPS Cl. Ct. 714, 715 (1991) (‘‘Because of the limited experience in insuring the new rigs and a number of substantial losses on these rigs, insurance rates increased sharply’’); Risk • 2.) Kidde Industries Inc. v. United States, 40 Fed. Cl. 42 Subjective (1977) (‘‘In 1976, in the midst of a products liability insurance crisis in which many insurance companies either Intent ceased or significantly restricted their coverage of products liability. . . . Travelers informed Kidde that it would not renew Kidde’s products liability insurance policy for 1977’’);

• 3.) Malone and Hyde Inc. v. Commissioner, T.C. Memo. 1989-604 (‘‘By the mid-1970s, the Hyde Insurance Agency found that insurance premiums were increasing each year and certain insurance was not obtainable for some clients’’);

11 1. Going naked: not an option when several successful Pre-UPS wrongful death claims could bankrupt the company 2. Forming a reserve: rejected because there were no Subjective tax benefits Intent: 3. Forming a group captive: this was rejected out of concern the other participants had financial problems The 4. Forming a captive: accepted and approved Humana Decision Tree

12 Objective . After Humana, taxpayers opted for one of two strategies to create sufficient Substance substance: of . The Presence of 3rd Party Risk Early . For example, Harper Group had 30% Captive . Sears had 90%+ . Sufficient Distribution Within the Structures Corporate Group . Humana 12+ entities

13 Safe Harbor . Under Harper, a captive must comply with a three prong test: Guidance, . (1) whether the arrangement involves Part I the existence of “insurance risk”; . (2) whether there was both risk shifting and risk distribution; and . (3) whether the arrangement was for “insurance” in its commonly accepted sense. . The duck test – does the company “walk and talk” like an insurance company?

14 Safe Harbor . The IRS has issued several Revenue Rulings that provide further safe harbor Guidance, guidance Part II . A captive must derive at least 50% of its insurance revenue from a non- parent. . Or, a captive must have at least 12 subsidiaries in order to have sufficient risk distribution.

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IRS TARGETS CAPTIVE INSURANCE COMPANIES: STRUCTURING SECTION 831(B)-COMPLIANT OPERATING DOCUMENTS

MAY 5, 2015

BECKETT G. CANTLEY Atlanta’s John Marshall Law School & Atlanta Law Group [email protected] IRS Judicial Weapons: Anti-Avoidance Rules

• Substance over form • Business Purpose • The Sham Transaction • Economic Substance • The Step Transaction

18 Substance Over Form

• The facts that make up the transaction is its “form”. • The “substance” of the transaction is what is actually below the surface of the facts, sometimes where such facts are created solely for such substance. • This doctrine disregards the form in favor of the true substance to disallow the tax benefits generated by the artificial nature of the transaction.

19 IRC 831(b) Example

• IRC 162 deduction for ordinary & necessary expenses, potentially including insurance. • Assume a risk pool is used to create the insurance, & risk is being kidnapped. • An oil and gas executive who spends 6 mos in Nigeria needs a kidnapping & ransom policy. A dentist in Boulder, Colorado does not. • The form is the risk pool, the substance is an unnecessary expense creating a deduction.

20 The Economic Substance Doctrine Now Codified • Prong 1: The transaction is rationally related to a plausible non-tax business purpose • Prong 2: The transaction results in a meaningful and appreciable enhancement in the net economic position of the taxpayer other than to reduce tax. • Code: penalties as high as 75% and there is no way to use a tax opinion to use “reasonable cause” as a defense.

21 IRC 831(b) Example Loan Backs

• Insured deducts premium paid to CIC. The insured (or its owner) immediately borrows significant funds back out without paying taxes on the money. • Rev. Rul. 2002-89, the IRS Manual, and case law indicate such CIC loan backs are at least subject to strict scrutiny, and may be prohibited under certain circumstances. • The IRS has asked for comments on the facts & circumstances that would give rise to loan back determinations. • This issue has come up as a focus in audits. • IRS may challenge as an improper tax-free distribution.

22 IRC 831(b) Example Loan Backs

• Prong One: Hard to argue that the transaction is rationally related to a useful non-tax business purpose. If you needed the money enough to have it loaned out shortly after paying it, why did you make the premium payment to start with other than to get the tax deduction?

23 IRC 831(b) Example Loan Backs (4 of 4)

• Prong Two: Transaction appears that there is no meaningful enhancement in the net economic position of the taxpayer other than to reduce tax. Your position is identical before and after the transaction with respect to the loaned funds. The only difference is that you have deducted the premium.

24 IRS Statutory Weapons

• Listed Transaction Designation • Transaction of Interest Designation • Promoter Investigations • List Maintenance Requests • Criminal Investigations

25 Listed Transaction Designation

• IRS can designate a transaction as “listed” and trigger reporting requirements and potentially severe penalties for taxpayers and advisors. • IRS rarely does this, so it is usually reserved for transactions that are done across the US among numerous taxpayers. • IRS states its position in the listing notice, and judiciary has taken this designation seriously.

26 IRC 831(b) Example

• In early 2000’s IRS designated a captive variant structure as a listed transaction. • The IRS eventually withdrew the listing on a go forward basis, apparently in part because the deal was not widespread enough. • Given the popularity of 831(b) captives, and the promoter exams that are ongoing, it seems like only a matter of time until something becomes a listed transaction.

27 Transaction of Interest Designation

• IRS can put a transaction with certain attributes on a sort of “watch list” where the IRS thinks the transaction is abusive, but is not ready to “list” the transaction permanently. • Transactions of interest have similar reporting and penalty attributes to listed transactions. • It is up to taxpayers and advisors to keep up with what the IRS posts to this list. There is no ignorance defense.

28 IRC 831(b) Example

• It would not be surprising to find a captive transaction that involves a captive being used as a tax deductible vehicle to fund some sort of investment, and either (a) severely overstates coverage costs, or (b) improperly distributes risk, as a transaction of interest.

29 Promoter Investigations

• If IRS finds several taxpayers who have a common advisor or pool that appear to be taking the same abusive activity, IRS may open a promoter examination of the advisor. • If IRS determines the advisor is a promoter, IRS may penalize them as such at the close of the investigation.

30 IRC 831(b) Example (1 of 2)

• IRS Personnel Statements Include: – IRS planning on bringing “a great many” CIC cases – IRS planning on “expanding” promoter exams – IRS seems very interested in the “investments” as driver for CIC formation & operation – IRS concerned with promotional material that focuses on tax benefits & investment return – IRS hiring private sector forensic personnel required for ramping up caseload

31 IRC 831(b) Example (2 of 2)

• Forensic audits of taxpayers. – IRS will drill down deep into a case – Determining issues that should concern IRS – Common touch points across other cases – Specific professionals or risk pools in common • Open 6700 promoter examinations of: – Risk Pools – CIC companies

32 List Maintenance Requests

• The IRS can request a list of all clients of an advisor, or pool participants if investigation is of a pool. • Where IRS has found an offending taxpayer, this tool allows IRS to quickly locate a large number of potential taxpayers to audit that may have done the same thing. • IRS will look for similar touch points among taxpayers to map out the web of promoters.

33 IRC 831(b) Example

• IRS finds one captive that has risk distributed improperly in a pool. • IRS will request the pool to provide a list of all participants, and then will audit some or all of the participants, to see if the pool has improperly risk distributed all its participant captives.

34 Criminal Investigations

• CID investigations can now progress simultaneously with civil promoter examinations. • A promoter exam can be referred to CID for potential criminal prosecution. • This is obviously reserved for the worst actors. • To date, these cases appear to involve “pretend we are doing it right” discussions with taxpayers.

35 IRC 831(b) Example

• Criminal warrants issued in cases in several states. – Risk Pools – Captive professionals • Grand jury indictment in one advanced case. – Clients told better not to make claims – Promoters focused on tax savings (not insurance)

36 Dirty Dozen Listing

• Covering Ordinary or Implausible • Structured Maximized Premiums • Poor Actuarial Substantiation • Excessive Fees Charged to Unsophisticated Taxpayers

37 Senate Finance Committee

• Raise premium cap to $2.2m but lose 831(b) qualification if no more than 20% of premium from one insured. • Proposal tabled, while IRS investigates estate planning in captives. • Sen. Grassley is a very serious opponent to abusive tax avoidance transactions. • IRS will take investigation seriously. • Legislation is likely to result to curb abuses.

38 Where is this Going? IRS Investigation Pattern Familiar

• First: targeted forensic audits • Discover common denominators • Begin 6700 promoter investigations • Begin criminal investigations • Broad based warnings to taxpayers • We are here • Issue broad based guidance • Start broad audit program based on guidance

39 THE END

FOR MORE INFO: http://aegiscaptive.com/articles/

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Tax Controversy Issues Pertaining to Captive Insurance Companies

John M. Colvin Colvin + Hallett

T: (206) 223-0800 Email: [email protected] Issues with Risk Distribution: Related Insureds

 Gulf Oil Corp. v. Comm’r, 89 T.C. 1010, 1025-26 (1987) (Dicta: “[U]nrelated risks need not be those of unrelated parties; a single insured can have sufficient unrelated risks to achieve adequate risk distribution.”)  IRS Position: Number of Exposure Units alone not sufficient PLR 200837041  IRS focuses on “number of policyholders” – not clear what this means, especially in group master policies, or situations where there are multiple named insureds (e.g. doctors in a professional practice), all of whom presumably is a “policyholder”  Distribution among related parties: Number of insureds required?  Rev. Rul. 2002-90 - 12 brother-sister insureds each with between 5-15% premium volume  Rev. Rul. 2002-91 - Suggests 7 group captive insureds are sufficient (equal owners - each with less than 15% ownership, vote and premium volume)  PLR 200837041 suggests 5 insureds are sufficient  Rev. Rul. 2005-40 –  One insured is not sufficient  12 disregarded LLCs held by one owner are not sufficient because just “one insured” for tax purposes.  12 LLCs are sufficient if classified as corporations (separate entities) for tax purposes.

43 Risk Distribution: Amount of Unrelated Risks Required

 ODECO (Fed. Cl.): 44% unrelated is sufficient  Rev. Rul. 2002-89:  50% unrelated is sufficient  10% unrelated is not sufficient  PLR 201126038  30 percent of the company's risks was unrelated insurance through reinsurance and a reinsurance pool  IRS suggested that an insurance company must have both sufficient number of insureds (per RevRuls) or sufficient unrelated business. If too concentrated will fail.

44 Rent-A-Center: Facts

 Insurance sub (Legacy) insured brother-sisters (15 subs)  Handled first layer – claims up to $350,000, then reinsured with a commercial reinsurer for the excess – reasonable business arrangement for high frequency, low severity claims  3,000 stores, 20,000 employees, 8,000 vehicles  No third party business  Relatively high risk concentration in one sub (RAC East , over 50%)  Premiums actuarially determined (monthly payroll, vehicles, stores)

45 Rent-A-Center: Potential Problems

 RAC issued guarantee (of Legacy’s deferred tax asset DTA) in order to meet Bermuda solvency requirement  The DTAs were deferred tax assets arising from timing differences in amount of taxes payable for tax versus financial accounting purposes – would take effect if tax laws changed that impaired the tax asset  Failure to qualify as an insurance company for US tax purposes might have impaired these assets?  Guarantee limited to $25M – small in comparison to $264M in premium  Bermuda regulator gave Legacy permission to treat DTAs as general business assets  At the end of 2006, RAC canceled the guarantee because Legacy met the regulator’s solvency margins without it  Payment of premiums and claims largely by journal entry  Legacy did not have much 3P investments, buying RAC treasury stock, non-dividend paying (had approval of regulator for this investment)  High premium to surplus ration (compared to commercial insurers)  Bermuda requires $120,000 or 10% of loss and loss expense provisions, plus reserves or 20% of first $6 million of net premiums up to $6M, 10% of premium over $6M  $9.9M capital under % of premium formula  Tax consequences were considered in structuring arrangement

46 Rent-A-Center: Preliminary Matters

 Netting of premiums/claims was permissible  Premiums actuarially determined and reasonable in amount  Valid business reasons for arrangement  Premium-to-surplus ration was not unreasonable – commercial insurers make money on investment side (surplus). Captives need not do this.  Workers comp, automobile and general liability are true insurance risks  Arrangement similar to those “commonly accepted” as insurance. Legacy issued policies, charged actuarially determined premiums and paid claims.

47 Rent-A-Center: Risk Shifting and Risk Distribution

 Risk Shifting

 Follows 6th Circuit in Humana (reversing Tax Court) in accepting that brother-sister arrangements may shift risks  Need not be risk shifting “comparable to that provided by a commercial insurance company” as suggested by IRS expert  Separate and viable entity capable of meeting obligations  R expert admitted that if respect form, then shifted risk  Guarantees and investment in parent’s stock did not alter this conclusion  Risk shifting from S perspective not altered by P guarantee  Risk Distribution

 Agrees risk distribution was met based on number of risks (employees, locations, automobiles)  Did not analyze risk distribution based on number of entities or “level of concentration of risks”

48 Rent-A-Center: Concurring and Dissenting Opinions

 Concurrence – (Buch)  Agreed with analysis, but thought the discussion of sibling argument (Humana) was unnecessary because IRS had abandoned that position in Rev. Rul. 2001-31 (Rauenhorst – IRS is deemed to have conceded arguments which are contrary to Revenue Rulings)  Dissent (Lauber)  “Not arm’s length”  Inadequately capitalized – effect of parental guarantees  Not operate like a real insurance (COMMERCIAL) company would  No non-RAC employees  Netting of premiums/loss payments – looks more like a bank account/reserve fund from which to pay “self insurance”  Dissent (Halpern)  Should not have overruled prior conclusion in Humana.

49 Securitas Holdings, Inc. & Subs. v. Commissioner, T.C. Memo. 2014-225 – Facts

 Operating subsidiaries employed 2000,000 people in 20 countries in security, alarm and cash handling businesses  P acquired a Vermont captive (Protectors), which had been in runoff  Set up new Irish captive reinsurer (SGRL). Protectors reinsured all risks of operating subs with SGRL  P guaranteed performance of Protectors with respect to policies issued to subs with purpose of prevent losing §501(c)(15) status of other member of controlled group)  3 largest subs each had more than 15% of the risks/premium (20%, 25% and 37%)  Protectors lent all but $1 million of capital to P, with approval of VT regulators

50

Securitas: Risk Shifting

 Holdings guarantee of Protectors’ obligation did not shift risk of loss to P  Purpose of guarantee was to preserve § 501(c)(15) status of other member of controlled group  No amounts were ever paid on guarantee  Protectors was not undercapitalized  Premium to surplus ration was very low considering “net insurance” premium (Protectors reinsured 100% of risks) o SGRL was adequately capitalized • Journal entry payment system did not result in P maintaining risk of loss

51 Securitas: Risk Distribution

 Despite underlying premiums/risks related to dozens of entities, IRS argued that risk assumed by SGRL all came from Protectors (the initial insurer)  Court looks through entities to large number of employees, offices, vehicles and services, finding a large poop of statistically independent risks, which did not vanish because brought together in one entity  Note: The IRS argument in this case was contrary to its previously stated position that risk distribution in the reinsurance setting is determined by looking through to the insureds on the underlying policies. Rev. Rul. 2009-26 (direct), PLRs 200950016 and 200950017 (layers)

52 Consequences of Invalid Section 953(d) Election (AM 2014-002)

 If the captive is foreign and there is a § 953(d) election in place, the election terminates if the company ceases to be “an insurance company.”

 Being an “insurance company” means more than half of the business during the taxable year is issuing insurance or annuity contracts. § 816(a) via § 831(c). PLR 201019001  Exception for companies in runoff? Must insurer continue to take in premium to qualify?

 Consequences of termination include:  § 367 tax event – deemed transfer of the company’s assets to a foreign corporation and an exchange that is taxable to the domestic corporation (Chapman Glen, Ltd. v. CIR, 140 T.C. No. 15 (2013) in Tax Court and Rev.Rul. 2003-47) on first day of subsequent taxable year  Subpart F inclusions in later years (or PFIC treatment if more widely owned)  Foreign Insurance Excise Tax under 4371  Essentially any deferral benefits end when stops taking in significant premium, but perhaps before all of the insured risks have been resolved.

 Filing of Form 1120 does not protect shareholders because no Form 5471 was filed by shareholders (statute extended pursuant to § 6501(c)(8)). AM 2014-002.

53 Risks of Failure to Maintain 831(b) Status

 Generally to maintain § 831(b) status, more than half of TP business is the issuance of insurance contracts  The legislative history of 2004 revisions to insurance provisions provides, "[i]t is not intended that a company whose sole activity is the run-off of risks under the company's insurance contracts be treated as a company other than an insurance company, even if the company has little or no premium income." H.R. Conf. Rep. No. 108-457, 2d Sess. 50-51 (2004).  PLR 201031001 – Exception for taxpayer in runoff status  Insurance company was in receivership under control of state insurance commissioner and not taking in any new premium;  “[A]t no time during the period Taxpayer has been in liquidation could Taxpayer's investment activity be considered in excess of its requirements to pay claims.”  TP remains eligible for §831(b) status  What if investment activity is significantly in excess of amounts needed to pay claims and/or risk exposure terminates? Inclusion of prior premium in income to extent not required to reserve?

54 Failure to Qualify as § 501(c)(15) - TAM 201517018

 Facts  Captive for group of companies in real estate development and petroleum business, providing “non- traditional coverages,” covering risks that are not covered by commercial insurers.  “Administrative actions” “employment practices” “excess general liability” and “special risks/medical” coverages, primarily issued to two entities  Insurance amounted to 1% to 2% of total revenue in two years and 24% in a third year  Held real estate as investment assets (and paid management fees to related parties)  Paid a claim, but may have been outside policy coverage  Ruling  Insurance was not primary and predominant activity – majority of business was related to businesses other than insurance. Treasury Reg. § 1.831-3(a)  Analyze type of risks separately (homogeneity) – insufficient distribution because only one policy holder in each type of coverage for two of the coverages  Claim payment appears to have been a business cost for real estate development ventures. (Business risk not insurance risk)

55 Homogeneity

 Risks in the same line of coverage  Is risk distribution tested in the aggregate or line-by-line?  No court has required homogeneity  FSA 1998-578 (April 1, 2002), Rev. Rul. 2002-89 and Rev. Rul. 2005-40 all suggest that the IRS requires homogeneity  Notice 2005-49 sought comments on the relevance of homogeneity  ILM 200849013 (July 24, 2008) instructed Exam to determine whether homogeneity is a relevant factor

56 Amount of Premium

 Premiums based on arm's length commercial rates (always good fact in cases) or high quality actuarial work  IRS gets suspicious if premiums appear to be based on the $1.2 million section 831(b) amount. NSAR 20020160 (April 17, 2002)  Premiums should not be based on deduction sought and/or the owner's available cash flow. Salty Brine I, Ltd. v. U.S., Docket No. 10-cv-108 (N.D. Tex. May 16, 2013)

57 Adequate Capitalization

 Guarantees from owner(s)  Indemnification or hold-harmless agreements  Letters of credit from owner(s)  Circular cash flows/loan-backs  Recent cases suggest that courts will be receptive to captives that depart from commercial premium/capital ratios (4:1 to 2:1)  Often captives have low capital in early years (funded primarily with deductible premium), then capital increases as profits accumulate  Accumulated Earnings Tax Issues

58 Risk Pooling

 ILM 200844011 (Oct. 31, 2008)  Contractual pooling arrangement  “Pool” constitutes a foreign entity such that premiums paid are subject to Federal Excise Tax  PLR 200907006  Company that participated in a reinsurance pool with several unrelated insurers qualified as an insurance company  PLRs 201224018, and 201030014  Each taxpayer's risks for each line of business were those of at least 12 underlying insureds with no single underlying insured representing more than 15 percent of taxpayer's total risk  PLRs 201219009, 201219010 and 201219011  Originally TPs received favorable rulings  IRS examined later and found language in contacts that appeared to preclude an individual captive entity from making a claim without having to repay the pool with interest (negated risk shifting).

59

Insurance Risk vs. Business/Investment Risk

 IRS Position: Not all contracts that transfer risk are insurance policies. Contracts that protect against the failure to achieve a desired investment return protect against investment risk, not insurance risk. Insurance risk requires a fortuitous event or and not a mere timing or investment risk. A fortuitous event (such as a fire or accident) is at the heart of any contract of insurance. CIR v. Treganowan, 183 F.2d 288, 290-91 (2d Cir. 1950)  LeGierse, 312 U.S. at 542 (the risk must not be merely an investment risk)  SEC v. United Benefit Life Insurance Co., 387 U.S. 202, 211 (1967) (the transfer of an investment risk cannot by itself create insurance)  Rev. Rul. 89-96, 1989-2 C.B. 114 (risks transferred were in the nature of investment risk, not insurance risk);  Rev. Rul. 68-27, 1968-1 C.B. 315 (although an element of risk existed, it was predominantly a normal business risk of an organization engaged in furnishing medical services on a fixed price basis rather than an insurance risk)  Rev. Rul. 2007-47, 2007-30 I.R.B. 127 (the arrangement lacked the requisite insurance risk to constitute insurance because the arrangement lacked fortuity and the risk at issue was akin to the timing and investment risks of Rev. Rul. 89-96).

60 Insurance Risk vs. Business/Investment Risk: Foreign Exchange Insurance

not insurance risk. ILM 201511021  Statement of Statutory Accounting No. 60, “Financial Guaranty Insurance,” describes such insurance as providing “protection against financial loss as a result of . . . fluctuations in exchange rates between currencies.”  Subs entered into contracts with the captive insurance company to mitigate risk in foreign currency exchange rate fluctuations through indemnification of loss of earnings caused by the fluctuations.  The contracts had many features found in insurance policies, and an outside actuary performed an actuarial review.  IRS rules not insurance risk: currency fluctuation risk is part of general business risk

61 Insurance Risk vs. Business/Investment Risk: Residual Value Insurance

 RVI Guaranty Co., Ltd. & Subs. v. CIR, Tax Court Docket No. 27319-12, TAM 201149021  Case has been tried and briefed  Coverage at issue provides payments if assets (real estate, commercial vehicles, equipment) have a residual value less than expected at the end of a lease term  Stay tuned!

62 IRS Warning IR 2015-19 (February 3, 2015) Some Captives Are Abusive

 “In the abusive structure, unscrupulous promoters persuade closely held entities to participate in this scheme by assisting entities to create captive insurance companies onshore or offshore, drafting organizational documents and preparing initial filings to state insurance authorities and the IRS. The promoters assist with creating and ‘selling’ to the entities often times poorly drafted ‘insurance’ binders and policies to cover ordinary business risks or esoteric, implausible risks for exorbitant ‘premiums,’ while maintaining their economical commercial coverage with traditional insurers.”

 “Total amounts of annual premiums often equal the amount of deductions business entities need to reduce income for the year; or, for a wealthy entity, total premiums amount to $1.2 million annually to take full advantage of the Code provision [§ 831(b)]. Underwriting and actuarial substantiation for the insurance premiums paid are either missing or insufficient. The promoters manage the entities’ captive insurance companies year after year for hefty fees, assisting taxpayers unsophisticated in insurance to continue the charade.”

63 IRS Disclosure of Similar Captive Arrangements in Audit/Litigation ILM 201250020

 The IRS suggests that third party pattern evidence demonstrating that the arrangements did not take into account each participant’s individual risk profile could be used to show that the arrangements were not insurance. For example, if the documents demonstrated that the arrangement entered into by the other taxpayers was not tailored to those taxpayers' individual situation and risk because the other taxpayers' insurance documents were identical to B-1's and C-1's documents, this pattern evidence would demonstrate the arrangement was not “insurance” in the other taxpayers' case and would satisfy the “item test [of Section 6103(h)(4)(B)].”  With respect to the argument that specific captive insurance arrangements lack economic substance, “pattern evidence” from other participants showing that all the arrangements were designed, implemented, and operated identically can be used to demonstrate that the arrangement was not designed with a specific taxpayer's business needs in mind and therefore lacked a bona fide business purpose other than tax benefits.

64 FATCA/IGAs

 For captives domiciled outside the U.S., even if a § 953(d) election is in place, the entity will be either  An FFI, if provides cash value life insurance/annuity products; or  An NFFE, if only provides casualty insurance  February 2014 revisions to FATCA regulations now permit foreign captive insurance companies with 953(d) election in place to avoid foreign treatment, provided licensed to do business in at least one state  The entity will likely have to fill out the painful new Form W-8(BEN-E) for FATCA purposes, even though W-9 required for all other purposes (§§ 6041-6049).  Financial Institutions who have to report to the IRS will do due diligence (based on account size) on the captive and its owners. NFEEs - “substantial ownership” (Regs 10%) vs. ”controlling persons” (IGA follows FATF – ordinarily 25% but falls to 10% for high risk customers)

65 Captive Insurance: IRS Guidance Plan

 The IRS apparently plans to issue additional guidance on captive insurance issues. On August 26, 2014, the IRS placed “captive insurance issues” in its priority guidance plan for the 2014/2015 fiscal year. (Topic No. 7 in Insurance issues)  http://www.irs.gov/file_source/pub/irs-utl/2014-2015_pgp_initial.pdf  http://www.irs.gov/file_source/pub/irs-utl/2014- 2015_pgp_2nd_quarter_update.pdf (January 29, 2015)  Stay tuned!

66 Slide Intentionally Left Blank

Avoiding IRS Scrutiny in Captive Insurance Companies – An Actuarial Perspective

Robert J. Walling III, FCAS, MAAA, CERA 309.807.2320 [email protected]

May 5, 2015 Outline

. The Captive Trend . Why Form a Captive? . What Makes it a Captive INSURANCE COMPANY? . Funding Approaches

69 Continued Growth of Captives

Source: Business Insurance – March 17, 2014

70 Changes by Domicile

Rank Domicile 2013 2012 Change (#) Change (%) 1 Bermuda 831 856 -25 -3% 2 Cayman 759 740 19 3% 3 Vermont 588 586 2 0% 4 Guernsey 344 333 11 3% 5 Utah 342 287 55 19% 6 Delaware 298 212 86 41% 7 Anguilla 295 291 4 1% 8 Nevis 276 203 73 36% 9 Barbados 264 261 3 1% 10 Luxembourg 225 238 -13 -5%

Source: Business Insurance – March 17, 2014

71 Key Drivers and Trends

. More Risk Sophistication In Middle Market

 Drives Growth of Cell, Series and Group Captives . U.S. Healthcare Changes

 Increased Benefits Coverage in Captives . Maturation of Captives

 Increased Expansion of Captive Programs (e.g. Small Captives and Group Captives) . Softening of U.S. Property/Casualty Market

 Increased Interest in Captives (e.g. CA Workers Compensation)

 Increased Use of Captives by Insurers (e.g. Agency Captives, RRG purchases) . Increased Taxation

 Increased Use of Series Captives by Smaller Companies

 Increased IRS Scrutiny of Risk Transfer and Risk Distribution

72 Why Form a Captive?

. Control...of Claims Costs (Risk Management/Loss Prevention) . Control...of Underwriting Expenses . Control...of Underwriting Profits . Control...of Insurance Costs (and Access to Reinsurance) . Control...of Coverage (Customizable) . Control...of Collateral and Cash Flow . Control...of Investment of Assets/Investment Income . Control...of Insured vs. Uninsured Losses . Control...of Tax Position

73 What makes it a Captive INSURANCE COMPANY?

. Primary business activity must be insurance

 (a.k.a. Legitimate Business Purpose) . Needs to be operated like an insurance company

 Have Sufficient Capitalization

 Underwrite Coverage

 Issue Policies

 Provide Loss Prevention/Loss Control

 Collect Premiums

 Pay Claims

 Maintain Appropriate Loss Reserves for Unpaid Claims

 Invest Assets

 Produce Financial Statements

 Many of the Professional Services are Typically Out-Sourced

74 What makes it a Captive INSURANCE COMPANY?

. Premiums and policies must be

 Market-comparable

 Risk-based

 Established at arms length . Actuarial support is strongly encouraged . Initial capitalization must be adequate

 4:1 (premiums to capital)

 Often Minimum Capital Requirements ($100K, $250K, or $1M) . Insurance transaction

 Risk Transfer

 Risk Distribution

75 Risk Transfer and Distribution

. Risk Transfer

 Must involve shifting of risk

 Must involve significant chance of a significant economic loss . Risk Distribution

 Brother-Sister Model

 “Unrelated Related” Model

76 Approaches to Funding Studies

. Experience Rating

 Rely on insured(s) experience to the greatest extent possible. . Exposure Rating

 Market Comparable Pricing

 Industry Benchmarks (ISO, NCCI, etc.)

 Frequency & Severity

 Reinsurance Techniques (Rate on Line)

77 Experience Rating

Loss Initial Reported Incurred Losses Expected Estimated Ultimate Losses Selected Line of Evaluation Loss Total Excess of % of Ult. Loss Dev B - F Ultimate Coverage Policy Period Date Cost Limits $250,000 Reported Method Method Losses (1) (2) (3) (4) (5a) (5b) (6) (7) (8) (9)

WC 12/31/12 - 12/31/13 03/29/13 1.09 213,192 0 13.92% 1,531,463 1,070,043 1,070,043 12/31/11 - 12/31/12 03/29/13 1.08 942,757 0 77.98% 1,208,900 1,149,397 1,149,397 12/31/10 - 12/31/11 03/29/13 1.07 950,826 0 88.57% 1,073,504 1,053,698 1,063,601 12/31/09 - 12/31/10 03/29/13 1.06 724,760 0 91.39% 793,009 805,458 799,233 12/31/08 - 12/31/09 03/29/13 1.05 411,026 0 92.99% 442,001 465,307 465,307 12/31/07 - 12/31/08 03/29/13 1.04 791,333 67,190 94.49% 766,399 763,952 765,175

Total 1.06 4,033,894 67,190 5,815,276 5,307,856 5,312,758 Selected Benefit Line of Ultimate Level Loss Trend Trended Coverage Policy Period Losses Factor Exposure Cost Factor Loss Cost Weights (1) (2) (9) (10) (11) (12) (13) (14) (15)

WC 12/31/12 - 12/31/13 1,070,043 1.0000 946,226 1.13 1.010 1.14 0.240 12/31/11 - 12/31/12 1,149,397 1.0000 901,168 1.28 1.020 1.30 1.000 12/31/10 - 12/31/11 1,063,601 1.0015 872,932 1.22 1.030 1.26 1.000 12/31/09 - 12/31/10 799,233 1.0020 918,359 0.87 1.041 0.91 1.000 12/31/08 - 12/31/09 465,307 1.0045 766,211 0.61 1.051 0.64 0.500 * 12/31/07 - 12/31/08 765,175 1.0110 721,371 1.07 1.062 1.14 1.000

Total 5,312,758 5,126,267 1.04 1.10

78 Experience Rating

Anticipated Indicated Credit for Indicated Indicated Line of SIR Projected $250,000 Claims Management $250,000 Indicated Excess Total Coverage Level Exposure Loss Cost Savings Loss Fund Loss Layer Ratio Funding Funding (1a) (1b) (2) (3) (4) (5) (6a) (6b) (6c) (7)

WC 250,000 993,538 1.10 0.900 984,297 984,297 350,000 100 x 250 3.5% 34,450 1,018,747 500,000 250 x 250 6.0% 59,058 1,043,354

Column (2) Exposure base: WC is Payroll (00's) (3) Exhibit B, Total Col (14) (4) Reflects credit for claims management savings (5) Col (2) x Col (3) x Col (4) (6a) Provided by MO School District (6b) Exhibit C, Total Col (13) (6c) Col (5) x Col (6b) (7) Col (5) + Col (6c)

79 Market Pricing

. Customer is interested in placing product recall coverage in a small captive. . Their agent/broker received a quote of $20,000 for ISO-based coverage. Market Price $20,000 Expected Loss Ratio 75% Expected Loss $15,000 Risk Margin 25% Expense Load 15% Indicated Premium $21,000

80 Benchmark Pricing

. Customer is interested in placing product recall coverage in a small captive. Company Revenues $45M Benchmark Products Loss Cost per (000) 1.40 Deductible/Increased Limits 1.50 Product Recall as a % of Products Liability 25% Expected Loss $23,625 Risk Margin 25% Expense Load 15% Indicated Premium $33,075

81 Frequency & Severity

. Customer is interested in placing product recall coverage in a small captive with a $500,000 per occurrence and aggregate limit. Expected Claims per Year 0.125 Expected Average Severity $250,000 Expected Loss $31,250 Risk Margin 25% Expense Load 15% Indicated Premium $43,750

82 Rate on Line

. Customer is interested in placing product recall coverage in a small captive. Coverage Limit $500,000 Rate on Line 6.25% Expected Loss $31,250 Risk Margin 25% Expense Load 15% Indicated Premium $43,750

6.25% rate on line is equivalent to a 16 year return period.

83