In a recently released revenue ruling, the IRS has established procedures for determining if insurance written through protected cell companies constitutes insurance for federal income tax purposes. This is a result of the previously issued Notice 2005-49, in which the IRS requested comments from the public on this issue. Concurrently, the IRS issued Notice 2008-19, in which it is requesting comments from the public on guidance regarding the issues that arise if such arrangements actually do constitute insurance.
As way of background, a protected cell captive insurance company (also known as a cell captive) is an entity formed under state or foreign law. A protected cell company may consist of several individual cells. Each cell will act as an insurer or reinsurer for its own account, but it is not a separate legal entity. The cells are funded by capital contributions of cell owners or participants. Premium ceded or paid to the cell, if structured properly, will be considered as a tax deductible premium payment for federal income tax purposes. Under state or foreign law, an individual cell’s assets are protected from the creditors of other cells as well as the creditors of the protected cell company.
Revenue Ruling 2008-8
The new ruling is an extension of previous revenue rulings where the IRS analyzed payments to captive insurance companies to determine whether such payments qualified as insurance premiums. According to these rulings, to determine whether such payments qualified as insurance premiums, the elements of risk shifting and distribution needed to be present. If they were not, then the risk remained with the parent and the transaction was considered a capital transfer or a loan rather than a deductible insurance premium payment.
Accordingly, under the following scenarios, the rulings concluded that: (1) payments to a captive where the only risks assumed by the captive are those placed by the parent do not constitute insurance premiums as the transaction lacks the requisite risk shifting elements; (2) payments to an affiliate captive where no less than five but no more than 15 percent of the captive's risk is from any one affiliate, do constitute insurance premiums; and (3) payments in group captive arrangements where a small group of unaffiliated companies form a captive, also are considered insurance premiums.
The focus of Revenue Ruling 2008-8 is on transaction by transaction basis and depends on whether the cell arrangement fits in the parent-subsidiary mold (does not count as insurance premiums) or the affiliate mold (counts as insurance premiums). For that reason, whether a transaction with one cell is treated as insurance premium has no bearing on the transactions of other cells or the protected cell company.
The new notice requests comments on whether a cell of a protected cell company would qualify as an insurance company separate and apart from any other company (including the protected cell company) if its assets and liabilities are segregated from those of other cells and of the protected cell company, so that creditors of other cells or the protected cell company may not look to the assets of the cell for satisfaction.
Notice 2008-19 also requests comments on the following: (1) transition rules for a protected cell companies and the cells of such companies in which they qualify as an insurance company in one year but not in an another; (2) any reporting requirements for individual cells; (3) whether there should be special rules for foreign entities; and (4) the proper treatment of protected cell companies and their cells with regards to consolidated returns. Comments are due by May 4, 2008.