Rev. Rul 2005-40 - Risk Shifting and Risk Sharing Essential for Favorable Tax Treatment of Insurance
For most LISI members, this
Revenue Ruling may not have a direct impact. So you may want to skip down to
It IS an important reaffirmation and deepening of the Helvering v. Le Gierse principles which help define what Insurance IS and IS NOT.
Revenue Ruling 2005-40 pertains to so-called "Single Insurers" and serves as a reminder that there are two essential requirements which must be met for a contract to qualify as life insurance and thus obtain for both the issuing company and the insured favorable tax treatment. There must be BOTH risk shifting and risk sharing.
Here, the IRS addressed three questions:
(1) Do the arrangements in the examples described below constitute insurance for federal income tax purposes?
(2) If so, are amounts paid to the issuer deductible as insurance premiums?
(3) Does the issuer qualify as an insurance company?
X, a domestic corporation, operates a
courier transport business covering a large portion of the
X owns and operates a large fleet of automotive vehicles representing a significant volume of independent, homogeneous risks.
For valid, non-tax business purposes, X entered into an arrangement with Y, an unrelated domestic corporation. Under that agreement, in exchange for an agreed amount of "premiums," Y "insures" X against the risk of loss arising out of the operation of its fleet in the conduct of its courier business. The amount of "premiums" under the arrangement is determined at arm's length according to customary insurance industry rating formulas.
Y possesses adequate capital to fulfill its obligations to X under the agreement, and in all respects operates in accordance with the applicable requirements of state law.
There are no guarantees of any kind in favor of Y with respect to the agreement, nor are any of the "premiums" paid by X to Y in turn loaned back to X.
X has no obligation to pay Y additional premiums if X's actual losses during any period of coverage exceed the "premiums" paid by X. X will not be entitled to any refund of "premiums" paid if X's actual losses are lower than the "premiums" paid during any period.
In all respects, the parties conduct themselves consistent with the standards applicable to an insurance arrangement between unrelated parties, except that Y does not "insure" any entity other than X.
In Situation 1, the arrangement with X represents Y's only insurance agreement. Although the arrangement may shift the risks of X to Y, those risks are not, in turn, distributed among other insureds or policyholders. Therefore, the arrangement between X and Y does not constitute insurance for federal income tax purposes.
Assume the same facts as in Situation 1 except that, in addition to its arrangement with X, Y enters into an arrangement with Z, a domestic corporation unrelated to X or Y, whereby in exchange for an agreed amount of "premiums," Y also "insures" Z against the risk of loss arising out of the operation of its own fleet in connection with the conduct of a courier business substantially similar to that of X.
The amounts Y earns from its arrangements with Z constitute 10% of Y's total amounts earned during the taxable year on both a gross and net basis. The arrangement with Z accounts for 10% of the total risks borne by Y.
The fact that Y now also enters into an arrangement with Z does not change the conclusion that the arrangement between X and Y lacks the requisite risk distribution to constitute insurance.
Y's contract with Z represents only 10% of the total amounts earned by Y, and 10% of total risks assumed, under all its arrangements. This creates an insufficient pool of other premiums to distribute X's risk. See Rev. Rul. 2002-89 which concluded that risks from unrelated parties representing 10% of total risks borne by subsidiary are insufficient to qualify arrangement between parent and subsidiary as insurance.
X, a domestic corporation, operates a
courier transport business covering a large portion of the
The LLCs own and operate a large fleet of automotive vehicles, collectively representing a significant volume of independent, homogeneous risks. For valid, non-tax business purposes, the LLCs entered into arrangements with Y, an unrelated domestic corporation under which, y in exchange for an agreed amount of "premiums," Y "insures" the LLCs against the risk of loss arising out of the operation of the fleet in the conduct of their courier business. None of the LLCs account for less than 5%, or more than 15%, of the total risk assumed by Y under the agreements.
The amount of "premiums" under the arrangement is determined at arm's length according to customary insurance industry rating formulas. Y possesses adequate capital to fulfill its obligations to the LLCs under the agreement, and in all respects operates in accordance with the licensing and other requirements of state law.
There are no guarantees of any kind in favor of Y with respect to the agreements, nor are any of the "premiums" paid by the LLCs to Y in turn loaned back to X or to the LLCs.
No LLC has any obligation to pay Y additional premiums if that LLC's actual losses during the arrangement exceed the "premiums" paid by that LLC. No LLC will be entitled to a refund of "premiums" paid if that LLC's actual losses are lower than the "premiums" paid during any period.
Y retains the risks that it assumes under the agreement. In all respects, the parties conduct themselves consistent with the standards applicable to an insurance arrangement between unrelated parties, except that Y does not "insure" any entity other than the LLCs.
Here, Y contracts only with 12 single member LLCs through which X conducts a courier transport business. The LLCs are disregarded as entities separate from X. If an entity is disregarded, its activities are treated in the same manner as a sole proprietorship, branch or division of the owner.
Because the separate LLCs have been disregarded, in essence, Y has entered into an "insurance" arrangement only with X. Therefore, for the reasons stated in Situation 1 , the arrangement between X and Y does not constitute insurance for federal income tax purposes.
Assume the same facts as in Situation 3, except that each of the 12 LLCs elects to be classified as an association. RESULTS:
Here, the 12 LLCs are classified as separate associations for federal income tax purposes. The arrangements between Y and each LLC thus shift a risk of loss from each LLC to Y.
The risks of the LLCs are distributed among the various other LLCs that are insured under similar arrangements.
Therefore the arrangements between the 12 LLCs and Y constitute insurance for federal income tax purposes. See Rev. Rul. 2002-90 where similar arrangements between affiliated entities constituted insurance.
Because the arrangements with the 12 LLCs represent Y's only business, and those arrangements are insurance contracts for federal income tax purposes, Y is an insurance company within the meaning of Code Sections 831(c) and 816(a). In Situation 4, the arrangements constitute insurance for federal income tax purposes and the issuer qualifies as an insurance company. The 12 LLCs may be entitled to deduct amounts paid under those arrangements as insurance premiums under Code Section 162 if the requirements for deduction are otherwise satisfied.
INSURANCE COMPANY DEFINED:
An "insurance company" is any company more than half of the business of which during the taxable year is the issuing of insurance or annuity contracts or the reinsuring of risks underwritten by insurance companies.
A business is allowed a deduction for its ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business. Among these deductible expenses are insurance premiums against fire, storms, theft, accident, or other similar losses in the case of a business.
INSURANCE - DEFINED BY CASES RATHER THAN CODE
There is no definition in either the Code or the Regs of either "insurance" or "insurance contract." But in the landmark 1941 Supreme Court case of Helvering v. Le Gierse, two criterion were set: there must be both risk shifting and risk distribution.
Further cases have made it clear that:
1. The risk transferred must be risk of economic loss,
2. The risk must contemplate the fortuitous occurrence of a stated contingency, ,
3. The risk must not be merely an investment or business risk.
Risk shifting occurs if a person facing the possibility of an economic loss transfers some or all of the financial consequences of the potential loss to the insurer, such that a loss by the insured does not affect the insured because the loss is offset by a payment from the insurer.
RISK DISTRIBUTION DEFINED:
Risk distribution incorporates the statistical phenomenon known as the law of large numbers. Distributing risk allows the insurer to reduce the possibility that a single costly claim will exceed the amount taken in as premiums and set aside for the payment of such a claim. By assuming numerous relatively small, independent risks that occur randomly over time, the insurer smooths out losses to match more closely its receipt of premiums.
POOLING OF PREMIUMS AND SPREADING OF RISK ESSENTIAL:
Risk distribution necessarily entails a pooling of premiums, so that a potential insured is not in significant part paying for its own risks. Risk distribution involves spreading the risk of loss among policyholders. It means that the party assuming the risk distributes his potential liability, in part, among others."); "'By diffusing the risks through a mass of separate risk shifting contracts, the insurer casts his lot with the law of averages. The process of risk distribution, therefore, is the very essence of insurance.'"; "The concept of risk-distributing emphasizes the pooling aspect of insurance: that it is the nature of an insurance contract to be part of a larger collection of coverages, combined to distribute risk between insureds.".
IF IT AIN'T INSURANCE, WHAT IS IT?
The Service and the courts will consider all the facts and circumstances in a particular case. This includes not only the terms of the arrangement, but also the entire course of conduct of the parties in order to determine the nature of an arrangement for federal income tax purposes.
So often, the IRS or courts will find that an arrangement that purports to be an insurance contract but lacks the requisite risk distribution may instead be a deposit arrangement, a loan, a contribution to capital (to the extent of net value, if any), an indemnity arrangement that is not an insurance contract, or otherwise, based on the substance of the arrangement between the parties.
The proper characterization of the arrangement may determine whether the issuer qualifies as an insurance company and whether amounts paid under the arrangement may be deductible.
The IRS, in Notice 2005-49, has requested comments on newly released guidance that is intended to clarify the standards for determining whether an arrangement constitutes insurance for federal income tax purposes.
WHAT'S THIS ALL MEAN?
As I noted above, most LISI members will not be dealing with these issues directly. But in a world of financial innovations and creativity, this ruling reminds and reinforces the message that in understanding and analyzing the implications and predicting the tax outcome of sophisticated new ideas and concepts, we continually need to go back to basics.
HOPE THIS HELPS YOU HELP OTHERS!
Rev. Rul. 2005-40;
2005-27 IRB 1 ; JS-2502 , June 17l, 2005; Notice 2005-49; 2005-27 IRB 1; IRC Secs. 162 ; 831 ; Rev. Rul.
2002-89, 2002-2 C.B. 984 ; Rev. Rul. 2002-90,
2002-2 C.B. 985 ; Helvering v. Le Gierse, 312 U.S. 531 (1941). Allied Fidelity Corp. v.
Commissioner, 572 F.2d 1190, 1193 (7th Cir.), cert. denied, 439 U.S. 835
(1978); Commissioner v. Treganowan, 183 F.2d 288,
290-91 (2d Cir.), cert. denied, 340 U.S. 853 (1950); Rev. Rul.
89- 96, 1989-2 C.B. 114. Clougherty Packing Co. v.
Commissioner, 811 F.2d 1297, 1300 (9th Cir. 1987). Humana, Inc. v.
Commissioner, 881 F.2d 247, 257 (6th Cir. 1989). See also Ocean Drilling
& Exploration Co. v.