New IRS Ruling Reveals that Not All Captives are Bad

On August 21, 2017, the Tax Court handed the IRS a critical victory in the first ever case deciding an IRS challenge to an IRC section 831(b) microcaptive insurance arrangement. This decision follows an over three year enforcement push by the IRS against the small captive insurance industry, an initiative that ensnarled captive managers and taxpayers alike as well as landed microcaptives on the IRS’ dirty dozen lists. For a detailed discussion of the Tax Court’s decision, click here. But a ruling issued just days before that decision reveals that the IRS is not seeking to disavow all captive insurance arrangements – perhaps just cull out some of the bad apples.

The facts of the ruling involve a consolidated corporate group that manufactured, imported, and distributed motor vehicles. One subsidiary, which provided vehicle financing (Subsidiary), historically offered third party maintenance contracts in connection with the sale of new and used cars by affiliated dealers. Under the proposed arrangement, Subsidiary would form a new company (Issuer) that would issue vehicle service contracts providing customers of affiliated dealers with financial protection, i.e., indemnity, against economic loss for covered repairs. Issuer, in turn, would form a wholly-owned corporation that would operate as a regulated insurance company (Reinsurer). Either directly or indirectly, Issuer would cede, and Reinsurer assume, most, if not all, of the risks under the vehicle service contracts.

On these facts, the IRS ruled that the vehicle service contracts would qualify as insurance contracts. They would not be treated as prepaid service contracts for, among other reasons, Issuer would not actually provide the repair services. Also, the IRS ruled there would be risk distribution. Through dealer sales, Issuer would sell to a substantial number of individual customers covering a variety of new and used motor vehicles. Finding that the arrangement would also result in the shifting of risk of loss, the IRS further ruled that the arrangement would constitute insurance in its commonly accepted sense. These rulings prompted the IRS to conclude that Issuer would qualify as an insurance company for purposes of IRC section 831. For a complete copy of the IRS’ ruling, Private Letter Ruling 201732021, click here.

Although the IRS’ ruling involved a traditional section 831(a) captive and not a section 831(b) microcaptive, the ruling reveals the IRS’ willingness to respect captive insurance companies of all types that are properly formed and operated and which insure risks logically connected to the insuring businesses. Therefore planning opportunities continue to exist for well-intentioned clients in both the large, and small, captive insurance markets.

If you have any questions about the IRS ruling or captive insurance, or any other tax-related topic, please do not hesitate to contact me at (214) 749-2464 or email me at adaddino@meadowscollier.com.