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Premium deductibility status solidified.

SEVERAL RECENT APPEALS cases and a ruling by the Internal Revenue Service (IRS) have solidified a parent corporation's ability to deduct, under certain circumstances, premium paid to its insurance subsidiary. On November 9, 1992, the IRS published Revenue Ruling 92-93 in which the IRS considered an arrangement whereby a parent corporation purchased group-term life insurance on the parent's employees from its wholly owned insurance subsidiary. The IRS concluded that premiums paid by the parent to its insurance subsidiary were deductible as compensation as long as the aggregate amount of compensation for services performed by each employee was reasonable.

The ruling deals with a widely held domestic manufacturing corporation that obtained, for each of its employees, $100,000 of life insurance coverage under a non-participating group-term life insurance contract from its subsidiary. The employees were not required to pay for the coverage and the proceeds of the contract would go to an employee's beneficiaries (rather than the employer). The subsidiary engaged in the life insurance and annuity business and was regulated as an insurance company. The contract issued to its parent qualified as a life insurance contract under state law, and the contractual terms (including premium rates) were customary in the industry. Furthermore, the subsidiary did not guarantee renewal of the contract.

The IRS ruled that premiums paid by the parent to its subsidiary for the group-term life insurance coverage constituted compensation for the employees' services. Moreover, the payment of such premiums was deductible by the parent provided: the aggregate amount of compensation does not exceed reasonable compensation for an employee's services; and the employer is not the direct or indirect beneficiary under the policy.

Under IRS Revenue Ruling 77-316, a parent corporation cannot deduct for insurance premiums paid to its wholly owned captive because nsk shifting, a necessary element of insurance, does not exist if a parent purports to shift its risk to its captive. But the IRS has determined that the ruling did not predude a parent from deducting the cost of insurance coverage provided employees as additional compensation for services because the arrangement did not constitute self-insurance.

The IRS viewed the risk of loss shifted to the subsidiary as a risk of the unrelated employees and their beneficiaries rather than a risk of the parent. Consequently, the parent was entitled to a deduction for the premium paid to its subsidiary provided the aggregate amount of compensation for an employee's services was reasonable. The IRS also ruled that the employees could exclude from gross income under Section 79 of the Internal Revenue Code an amount equal to the cost of $50,000 of the life insurance coverage.

Although the ruling deals with a licensed carrier, the rationale is applicable to captive insurers that may be interested in writing this business. It should be noted, however, that depending on structure, regulatory constraints may dictate that a licensed carrier issue the policy and the captive act as a reinsurer.

Also, as such a program constitutes a welfare benefit plan under the Employee Retirement Income Security Act, such a program would likely require an exemption letter from the Department of Labor in order to ensure that prohibited transaction rules are not applicable. Based on letters issued with regard to similar programs in the past, such letters would appear to be available.

Finally, it should be noted that based on the statement in the ruling that the "economic risk of loss being shifted to the subsidiary is not a risk of its parent," it might well be argued that the premium received by a captive is for unrelated risk and may help facilitate the deduction of other premium by its parent based on recent cases described below.

AMERCO and Harper

IN JANUARY 1991, the U.S. Tax Court decided three cases involving the issue of the deductibility of premium paid by a parent to a wholly owned insurance affiliate. Deductibility was allowed provided that the insurance subsidiary also wrote a substantial amount of "unrelated business" (i.e., insurance written for parties unrelated by ownership to the insurer's parent).

One of those decisions previously reported in this column was that of Sears, Roebuck & Co. vs. Commissioner, a case which was affirmed by the Seventh Circuit Court of Appeals. Now both AMERCO Inc. vs. Commissioner and The Harper Group vs. Commissioner have been affirmed by the Ninth Circuit Court of Appeals. Accordingly, there is now uniform agreement among two U.S. Circuit Courts of Appeals and the U.S. Claims Court (which decided ODECO vs. United States) that significant unrelated business will favorably affect the ability of a taxpayer to deduct premium paid to a wholly owned insurance affiliate for federal income tax purposes. To date; the smallest amount of unrelated business to be considered "significant" was roughly 30 percent.

Model Fronting Bill Revised

THE NATIONAL Association of Insurance Commissioners (NAIC) continues its deliberations regarding a model fronting law. As currently drafted, the law applies only where there is a delegation of underwriting and claims handling authority to a reinsurer who is not "licensed, authorized or accredited" in the acting state.

The regulators continue to debate the appropriate reporting requirements and/or mandatory contract terms applicable to fronting transactions. In addition, there is a sharp division among the regulators regarding the extent to which captive insurers should be exempt from the law. Some regulators, led by the New York Insurance Department, reportedly believe that, in its current form, there should be no captive exemption. Other regulators support a captive exemption but question how much, if any, unrelated business is proper with a "captive insurer." Final action may be taken by the regulators during this month's NAIC spring meeting.

P. Bruce Wright is a partner with the law firm of LeBoeuf, Lamb, Leiby & MacRae in New York and a member of Risk Management's Editorial Board.
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Title Annotation:premiums paid by a parent corporation to an insurance subsidiary
Author:Wright, P. Bruce
Publication:Risk Management
Date:Mar 1, 1993
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