Captive reimbursement arrangement requires facts review and accounting adjustment

Plain-English summary

Chief Counsel considered a captive insurer's deductible reimbursement policy issued to its parent. Whether the captive could report premium income and related deductions depended on the arrangement's facts, including state regulation, capitalization, pricing, guarantees, and documentation. Even if the arrangement was not insurance for federal tax purposes, it might still support business-expense treatment for the parent and income recognition by the captive in limited circumstances. Moving from the captive's existing accounting treatment to the proper method likely would be a change in method of accounting. That change could require a § 481 adjustment bringing the loss reserve balance into income.

Ruling snapshot

• Question: How should the captive treat income, deductions, and its loss reserve for the reimbursement policy?
• Outcome: Advice given to evaluate the arrangement's facts and make any required § 481 method-change adjustment
• Key authorities: IRC §§ 61, 162, 446, and 481; Treas. Reg. § 1.446-1; Rev. Rul. 2005-40; Rev. Rul. 2007-47

Full text (IRS public release)

       Office of Chief Counsel
       Internal Revenue Service
       memorandum
       Number: 201503011
       Release Date: 1/16/2015
       CC:FIP:B04                                             Third Party Communication: None
       POSTF-116454-14                                        Date of Communication: Not Applicable

UILC: 832.00-00, 446.00-00, 481.00-00

date: August 14, 2014

 to:   CATHY A. GOODSON
       (Associate Area Counsel, Area 5)

from: SARAH LASHLEY
Assistant to the Branch Chief
(CC:FIP:B04)

subject: ----------------------------------------------------

       This Chief Counsel Advice responds to your request for assistance. This advice may
       not be used or cited as precedent.


       LEGEND

       TAXPAYER = -----------------------------------------------------
                      -------------------------
                      ------------------------------------------------------
                      -----------------------------------------
       PARTNERSHIP = --------------------------------
       PARENT LLC = -----------------------------------
       SUBORDINATE LLCs = ------------------------------------------------------------------------------------
                                    -------------------
       STATE = ----------


       ISSUES

       Whether TAXPAYER has income and deductions with respect to a “deductible
       reimbursement policy” it issued to PARENT LLC.

POSTF-116454-14 2

Whether TAXPAYER will need to recapture its loss reserve balance into income under
§ 481.

CONCLUSION

Whether TAXPAYER is entitled to income and deductions with respect to the
“deductible reimbursement policy” depends on the characteristics of the arrangement.

Regardless of whether TAXPAYER is entitled to income and deductions or not, it is
likely that moving from TAXPAYER’s current method to the appropriate method of
accounting would be a change in method supporting an adjustment, including the loss
reserve balance, under § 481.

FACTS

Through direct and indirect ownership of disregarded entities, PARTNERSHIP owns
PARENT LLC. PARENT LLC owns, directly and indirectly, several subordinate LLCs
(“SUBORDINATE LLCs”). All the LLCs are single member LLCs disregarded for federal
income tax purposes.

PARENT LLC, provides personnel services to its client companies through
SUBORDINATE LLCs. Because they provide personnel services for the client
companies PARENT LLC and SUBORDINATE LLCs are the “employers of record”
under state law for the client companies’ employees. As one of the personnel services
provided to the client companies, SUBORDINATE LLC s provide worker’s
compensation insurance to the client companies for which it charges the client
companies an additional fee or surcharge. As the employer of record, PARENT LLC
and SUBORDINATE LLCs are also jointly and severably liable to obtain worker’s
compensation insurance for the client companies’ employees.

PARENT LLC obtains worker’s compensation coverage for the SUBORDINATE LLCs
from a third party insurer. Under the terms of that policy, at the end of a fifty-four month
period, the insurer calculated a final premium equal to the total amount it paid to cover
the deductible. PARENT LLC was liable for the excess of the final premium over its
initial premium deposit (“premium deficiency”).

PARENT LLC owns 100% of TAXPAYER, a STATE non-life insurance company that
files an 1120PC. PARENT LLC purchased a “deductible reimbursement policy” from
TAXPAYER that covered the premium deficiency and protected the SUBORDINATE
LLCs against the risk of loss for payments it may owe to the third party insurer.

PARENT LLC’s policy is TAXPAYER’s only business.

PARTNERSHIP deducted the amount PARENT LLC paid TAXPAYER for the deductible
reimbursement policy. The Service proposes to disallow PARTNERSHIP’s deduction.
POSTF-116454-14 3

LAW AND ANALYSIS

In a CCA issued to SB:SE on September 20, 2013, the National Office advised that
TAXPAYER was not an insurance company for federal income tax purposes.

Section 446 and the related regulation provide the general rules for methods of
accounting. The term “method of accounting” includes not only the overall method of
accounting of the taxpayer but also the accounting treatment of any material item. A
material item involves the proper time for the inclusion of the item in income or the
taking of a deduction. (Treas. Reg. §§ 1.446-1(a) and 1.446-1(e)(2)(ii)(a)). A change in
method of accounting does not include adjustments of any item that does not involve
the proper time for the inclusion of the item of income or the taking of a deduction.
(Treas. Reg. § 1.446-1(e)(2)(ii)(b)). Therefore, a practice that permanently changes the
taxpayer's lifetime income, not merely a change in the timing of income, is not a change
in method of accounting. (Rev. Proc. 91- 31, 1991-1 C.B. 566, § 3.02.)

Section 481 and the related regulations provide the adjustments rules to prevent
amounts from being duplicated or omitted due to the change in accounting method.

In limited circumstances, where an arrangement purporting to be insurance is not
insurance for federal income tax purposes, the arrangement may still support a
deduction under § 162 as an ordinary and necessary business expense for the parent’s
payment of the premium and inclusion of the amount of the premium in the captive’s
income under § 61. Any losses paid by the captive, in that case, would be deductible to
the captive when paid, and not before because, as stated in Rev. Rul. 2007-47, 2007-30
I.R.B. 127, “[i]f an arrangement is not an insurance contact, no reserves are permitted
for unearned premiums or for discounted unpaid losses with respect to the
arrangement.”

Whether TAXPAYER is entitled to income and deductions with respect to the
arrangement will depend on the characteristics of the arrangement. As described in
Rev. Rul. 2005-40, 2005-2 C.B. 4, “[i]n order to determine the nature of an arrangement
for federal income tax purposes, it is necessary to consider all the facts and
circumstances in a particular case, including not only the terms of the arrangement, but
also the entire course of conduct of the parties.”

To support income and deductions to TAXPAYER we would consider, among other
things, whether: (1) TAXPAYER is regulated by the state as an insurance company; (2)
the particular arrangement qualifies as insurance under the state law; (3) TAXPAYER is
adequately capitalized; (4) the premium is set under customary insurance industry
rating formulas; (5) the parent has not expressly guaranteed the obligations of the
captive; and (6) that the documentation underlying the arrangement supports
characterization of the arrangement as providing income and deductions for
TAXPAYER.
POSTF-116454-14 4

Whether TAXPAYER is entitled to income and deductions or not, we believe it likely that
moving from TAXPAYER’s current method to the appropriate method of accounting
would be a change in method supporting an adjustment, including the loss reserve
balance, under § 481.

This writing may contain privileged information. Any unauthorized disclosure of this
writing may undermine our ability to protect the privileged information. If disclosure is
determined to be necessary, please contact this office for our views.

Please call Sharon Y. Horn at (202) 617-4426 if you have any further questions.