United States: Is the IRS Cracking Down on "Stuffed" Captives?

Two recent rulings reflect increased Internal Revenue Service (IRS) scrutiny of offshore insurance companies. These rulings do not bode well for offshore captives sometimes referred to as "stuffed" captives.

According to the two IRS rulings,¹ some offshore companies are not doing enough insurance business to be considered "insurance companies" for federal income tax purposes. As a result, the IRS has revoked the tax-exempt status previously granted to a pair of offshore corporations under § 501(c)(15) of the tax code. That provision allows taxexempt status for property and casualty insurers that are very small (based upon annual premiums or, under recent legislation, a formula that takes account of both total gross receipts and annual premiums).

In recent years, a number of U.S. businesses have formed captive insurers in offshore tax havens, paying relatively modest annual premiums to the captive (directly, or indirectly for reinsurance), while also "stuffing" the captive full of income-producing investment assets far in excess of the capital and surplus required to support the insurance or reinsurance operation. The offshore captive elects to be taxed as if it were a domestic corporation, under the socalled "953(d) election" available to foreign "insurance companies."² The purpose of making the 953(d) election is to avoid the federal excise tax on insurance or reinsurance of U.S. risks with a foreign person.³ Being taxed as a U.S. domestic entity has no adverse consequences for the captive because — as a small property and casualty insurer — it is tax-exempt under § 501(c)(15). The investment income of the "stuffed" captive accumulates free of U.S. tax.

But not so fast, says the IRS. For some time, the IRS has threatened to revoke the 501(c)(15) tax exemptions of companies whose investment activities and investment income dwarf their insurance operations. While the two new rulings do not state explicitly that the companies involved were "overstuffed," or even that they were captives, it is almost certain that these rulings represent the IRS’ first volley in a campaign against stuffed captives. The rulings revoke 501(c)(15) status on the ground that the company does not qualify as an "insurance company" for tax purposes; this is a direct consequence of having too little insurance business relative to the corporation’s other activities and other income.

Some aspects of these rulings are potentially confusing. First, the rulings state that "the revocation of exempt status under section 501(c)(15) of the Code results in the loss of the IRC 953(d) election that was previously accepted by the Internal Revenue Service." That is not precisely correct. Exempt status could be lost for a number of reasons, including too much premium. This would not affect "insurance company" status or invalidate a 953(d) election. In this case, however, the specific reason for loss of 501(c)(15) exemption was the IRS’ denial of "insurance company" status that, by definition, causes the loss of the 953(d) election. Loss of the 953(d) election in turn causes these offshore companies to be treated as foreign entities for tax purposes, bringing into play the federal excise tax on insurance or reinsurance by a foreign person.

Does the loss of "insurance company" status preclude any federal excise tax on the insurance or reinsurance the offshore company provides? Unfortunately, the answer is no. The federal excise tax may be imposed on a specific transaction even though the foreign insurer or reinsurer is not considered an "insurance company" for federal tax purposes. In other words, for federal excise tax purposes, the IRS looks at whether a particular transaction is "insurance" and not whether most of the insuring entity’s activity consists of "insurance" activity. So the excise tax may apply even though the offshore entity does not qualify as an "insurance company" for tax purposes. Moreover, while the IRS rulings state that the offshore company may be liable for the federal excise tax, the person paying premiums to the foreign insurer or reinsurer may be liable as well, whether that payor is an insured, a ceding company, a broker, and so forth.

Finally, the rulings note that the loss of "insurance company" and tax-exempt status makes the offshore companies liable for taxes on their U.S. source investment income and other income if they have conducted business in the United States. In addition, the rulings note that the U.S. shareholders of these offshore companies are liable for current U.S. tax on the "subpart F" income of the offshore companies even if that income has not yet been repatriated to the U.S. shareholders.

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