The IRS proposal, which has caught the captive industry off guard, would reverse a longstanding tax benefit for captives and put them on the same footing as self-insureds [NU Online News Service, Oct. 8, 2007].

With no advance notice, the IRS published its proposals in the Federal Register, Sept. 28.

It stated that “subsequent to the issuance of the current regulations, the IRS determined that it would no longer invoke the 'economic family theory' in addressing whether captive insurance transactions constituted insurance for federal income tax purposes.”

The associations said in the e-mail that the proposed regulation would affect domestic captives–including foreign captives which have elected to be treated as domestic for U.S. tax purposes–that are a part of the same consolidated tax return group as the premium payer.

In order for a captive to be included in a consolidated tax return, the domestic parent must own 80 percent or more (vote and value) of the domestic (or electing foreign) captive.

According to the notice, the proposed regulation would defer the tax deduction for any incurred loss from related-party business until it is actually paid. This would mean there would be no deduction for discounted loss reserves as is currently available–the change would essentially treat the transaction as noninsurance for tax purposes.

The proposed regulation, the notice said, would affect new and existing captives equally. As currently written, the regulation “would apply to all transactions entered into in tax years beginning on or after the regulation is published in final form. Existing related-party discounted reserves at the effective date of this regulation will remain deductible as reserves until the corresponding claims are paid.”