Captive insurance update.

• Author: Tapajna, Joseph J.
• Position: Expenses

Captive insurance arrangements insure risks within a group of related companies. A captive insurance company functions as an alternative to purchasing an insurance policy from an outside insurer. Having a related insurance company assume the function of an outside insurer can be an efficient way of managing risk within a group. Group members pay premiums to the related insurance company as consideration for assuming their risks.

The IRS has been skeptical of captive insurance arrangements, believing they were designed solely to take advantage of more favorable timing rules or to shift taxable income to companies that paid little or no tax in the U.S. Because of the Service's attitude toward captive insurance, some companies have hesitated to use captive insurance companies. This June, there were two favorable developments that may decrease the associated risk.

First, in Rev. Rul. 2001-31, the IRS formally announced that it would no longer use the "economic family" theory to attack captive insurance arrangements. The Service first articulated this theory almost 25 years ago in Rev. Rul. 77-316. Under this theory, captive insurance arrangements did not qualify as true insurance, because a group of related companies should be treated as a single economic unit. Viewing a group of companies as a single economic unit meant that there was no shifting of risk or distribution of risk--two of the primary requirements for insurance. The IRS asserted this theory in litigating captive insurance cases, but met only with limited success at best.

In Rev. Rul. 2001-31, the Service acknowledged that no court had ever fully accepted the economic-family theory. It stated that it would no longer invoke this theory in attacking captive insurance arrangements. However, it may continue to challenge specific captive insurance arrangements based on their facts and circumstances in a particular case. For example, a captive insurance company that was thinly capitalized or somehow propped up by its parent company could still be vulnerable to attack.

The second development, United Parcel Service America (UPS), 254 F3d 1014 (11th Cir. 2001), rev'g TC Memo 1999-268, involved an insurance arrangement established by UPS. UPS had restructured its business to shift income from its profitable package insurance business to a former subsidiary. Before the restructuring, UPS had self-insured its "excess value" coverage. It sold excess-value coverage to customers who needed...