Much has been written about the new federal rules governing surplus lines taxation, and the failed opportunity to create a uniform system of taxation across all US jurisdictions. One benefit of the current chaotic system is that it creates an arbitrage opportunity to reduce an insured’s overall tax obligations with respect to certain master policies. Some states have lower surplus lines tax rates than others, so structuring master policies such that the "home State" is a low-tax jurisdiction can result in significant savings -- at least until the states or federal government move to a uniform system of taxation and/or allocation.

Each state establishes its own tax rate for surplus lines premiums. The tax rates vary from 1% in Iowa, to 6% in Alabama, Kansas, and Oklahoma, with Puerto Rico being an outlier at 15%. The majority of states tax surplus lines premiums at a rate from 3% to 5%. Insofar as a single state will now be required to collect tax on an entire master policy, and presumably they must collect the entire tax at the single rate authorized by their legislature regardless of whether the risk falls within multiple states, the determination of the "home State" collecting the tax can make a huge difference in the amount of tax being paid by the insured.

In short, the Nonadmitted Reinsurance and Reform Act that took effect on July 21, 2011, states that only the "home State" may collect the surplus lines tax, and then may either keep it all or enter into an agreement to allocate. (15 USCS § 8201.) Although approximately 15 states have indicated a willingness to enter into some form of tax allocation agreement as of the date of this article, no tax allocation agreements are currently in effect. As such, in some instances it may be worthwhile to alter a policy, or the persons insured under the policy, to impact the determination of which state is in fact the "home State." This could be done, for example, by forming a new entity in a particular state, or excluding certain subsidiaries from coverage under a master policy as described below.

First, the decision-making criteria for establishing the home State can be summarized as follows:

  1. Is the insured an individual or an entity?
  2. a. If an individual, then the home State is the state of the individual’s principal residence.

      2.    b. If not an individual, is there one or more affiliated entities insured under one policy?

      3.    a. If a single entity is insured, the home State is where the insured maintains its "principal place of business." [This phrase is not defined in the statute, but has generally been interpreted as the "nerve center" of the enterprise as described in a 2010 Supreme Court decision regarding diversity jurisdiction.] 

     3.     b. If more than one affiliated entities are insured under one policy, (i) determine which entity has the largest percentage of premium attributed to it under the policy, and (ii) the home State is where that entity maintains its principal place of business.

     4.     a. Is any of the insured risk located in the home State as determined under item 2.a., 3.a, or 3.b. above?

     4.     b. If yes, then that remains the home State.

     4.      c. If no, then the home State is the state to which the greatest percentage of the relevant insured’s taxable premium is allocated.

(15 USCS § 8206(6).) Thus, for a policy covering an individual or a single entity, there is likely to be little opportunity to alter which state is the home State other than (a) having an individual move, or (b) forming an entity in, or redomesticating an entity to, a state with a lower tax rate. Moreover, it remains an open question as to whether trusts or similar entities or associations may be selectively formed and located to impact the home State for a group. However, for master policies covering affiliated entities, it may be worthwhile to drop certain entities from the master policy coverage and insure them under a separate policy.

For example, assume that Holdco, domiciled in and operated from Delaware, wholly owns five companies domiciled and operated, respectively, in Alabama (tax rate 6%), California (3%), Iowa (1%), Ohio (5%), and South Carolina (4%). All five of the affiliates are insured under a single master policy. If the Iowa entity has the largest percentage of premium attributed to it, then the entire premium is taxed at only 1%, whereas if the Alabama entity has the largest percentage of premium attributed to it, then the entire premium is taxed at 6%. Rather than have the entire premium taxed at 6%, it may be worthwhile to drop the Alabama entity from the policy and procure a stand-alone policy for that entity. Then Alabama receives its 6% tax only on the policy insuring its domestic, but all of the premium for the master policy covering the remaining four entities would be taxed at a necessarily lower rate (1%, 3%, 4%, or 5% depending on which remaining entity is the home State). There are potentially endless permutations of the changes that could be made for this group of affiliates, particularly if (a) there is room to argue that the "principal place of business" of one or more of the entities is different than its state of domicile, or (b) some of the domiciliary states enter into tax allocation agreements but others do not.

As you can see from this relatively simple example, there is ample room to make changes under master policies to impact the amount of taxes paid for the exact same coverage. Under the current taxation regime, surplus line insureds should work closely with their counsel, brokers, and other advisors to determine whether there are ways to reduce the insured’s surplus lines tax obligations, i.e. analyze insurance risks to (a) assess the "home State" designation applicable for any policy or insured under both federal law and then-applicable state allocation agreements (if any), and (b) develop the documentation necessary or advisable to substantiate the basis for the designation and tax payment plan ultimately identified.