Tax Considerations in Forming a Captive Insurance Company: The Deductibility of Premiums

SUMMARY: The deductibility of premiums is a potential tax benefit in a corporation forming a captive insurer. The courts have limited the deductibility of premiums to those situations in which the insurance issued by the captive is actual insurance, not just reinsurance. A key factor is whether the economic substance of the transaction resembles actual insurance. This commentary explores how this issue has been resolved in various instances.

Authors Gary Wilcox and Adam Budesheim write: Although captive insurance companies are often touted as a tax benefit to the parent corporation, a number of court rulings relating to the deductibility of premiums paid to a captive have undermined dramatically the potential tax benefits of the captive for the parent. The rules governing deductibility of premiums paid to a captive defy broad categorization because the inquiry is fact-intensive. The Internal Revenue Service ("IRS") and courts focus on whether the parent has purchased "real" insurance from its captive; premiums for "real" insurance are deductible, but premiums that resemble setting reserves for self-insurance are not.

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The federal tax code considers premiums for the purchase of insurance to be tax deductible as "ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business . . . ." 26 U.S.C. § 162(a); 26 C.F.R. § 1:162-1(a). Conversely, it is well-established that money put aside by a business for funding self-insurance is not tax deductible. See Clougherty Packing Co. v. Comm'r, 811 F.2d 1297, 1300 (9th Cir. 1987).

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When determining whether premiums are tax deductible, courts focus on the "economic substance" of the insurance transaction between the parent and the captive. See Mobil Oil Corp. v. United States, 8 Cl. Ct. 555, 556 (1985). Courts employ a three-part analysis, derived from Helvering v. LeGierse, 312 U.S. 531 (1941), to determine whether the economic substance of the transaction resembles actual insurance or self insurance. The courts look for the presence of: (1) an "insurance risk"; (2) risk shifting and risk distributing; and (3) "commonly accepted notions of insurance." See Ocean Drilling & Exploration Co. v. United States, 988 F.2d 1135, 1148 (Fed. Cir. 1993).

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The first step in determining whether premiums paid to a captive are tax deductible is to determine whether the captive was created "for a legitimate business purpose or whether the captive was in fact a sham corporation." Malone & Hyde, Inc. v. Comm'r, 62 F.3d 835, 840 (6th Cir. 1995). The classic example of a captive as a sham corporation is one which is an undercapitalized foreign corporation that is "propped-up by guarantees of the parent corporation."

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A pure captive insures the risks of only its parent and its parent's subsidiaries or affiliates. Premiums paid by the parent to its pure captive are not tax deductible for the parent because there is no shifting of the risk from the parent. When viewed from the perspective of the insured (i.e., the parent), any risks shifted to the subsidiary are, in actuality, retained by the parent.

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Two separate Revenue Rulings by the IRS advise that when a captive is owned by multiple unrelated corporations, none of which has a controlling interest in the captive, premiums paid for insurance provided by that captive are tax deductible, even though the captive provides insurance only to its several owners. See Rev. Rul. 78-338, 1978-2 C.B. 107; Rev. Rul. 2002-91, 2002-2 C.B. 991. Because the taxpayer and the other insureds-shareholders are not related companies (even if they are involved in the same industry), the risk of loss is shifted from an individual company and distributed among the multiple shareholders that comprise the insured group. Rev. Rul. 78-338 at 4.

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Several cases have addressed the situation in which a pure captive issues insurance policies to both the parent and the parent's other subsidiaries. The separate corporate existence of the subsidiaries and the parent are not ignored for tax purposes. See Malone & Hyde, 62 F.3d at 839 (citing Moline Props. v. Comm'r, 319 U.S. 436 (1943)). Therefore, the insurance transaction, with respect to the deductibility of premiums paid by the subsidiaries, is examined from the perspective of the subsidiaries as the insureds, not from the perspective of the parent.

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Reinsurance and captive insurers intersect in two possible ways: either the captive reinsures policies issued to the parent by an insurer unaffiliated with the parent, or the captive purchases reinsurance for the policies to the parent from an unaffiliated reinsurer. The former has been addressed in a number of cases, all of which hold premiums paid to an unaffiliated insurer that substantially reinsures its policies with the parent's captive are not tax deductible. While the latter situation has never been addressed directly by the courts, dicta in one case, as well as the three-part test for determining whether a transaction is insurance or self-insurance, strongly suggest that premiums paid to a captive insurer that substantially reinsures the policy the captive issued to its parent are tax deductible.

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Several courts have allowed a parent to deduct premiums paid to a captive when the captive writes a substantial amount of insurance covering unrelated entities. The courts have determined that the substantial unrelated business of the captive creates a pooling of risk with entities unaffiliated with the parent, thereby shifting the risk of the parent onto the general pool.

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The caveat to this discussion of captives with unrelated business is that under the definition of a captive insurer in some states, the captive cannot have any unrelated business -- captives are limited, by definition, to issuing insurance to their parents and other affiliated companies. See N.J. Stat. Ann. § 17:22D-1.

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