For years the Internal Revenue Service has essentially been saying that if it “walks like a duck and talks like a duck, for all intents and purposes, it is a duck”–or in the case of captives, an insurance company. But captive insurers beware: the definition of a “duck” can get murky, as with multimember LLCs (limited liability corporations) and limited partnerships.

As has been the case for some time, the IRS is examining gray areas and has revoked tax exemptions for two section 501(c)(15) captive insurance companies– this time in Chief Counsel Advice (CCA) 200952060 and CCA 200952061.

The benefit of this type of captive is that it is completely exempt from all federal income tax–this complete tax exemption is granted to very small insurance companies that meet the qualifications.

These revocations demonstrate that the IRS continues to scrutinize captive insurers. The IRS justified its decision that the captive was not engaged in selling insurance by focusing on:

o The number of insureds.

o Concentration of risks with a few insureds.

o Lack of independent risks.

The CCAs involved A, an individual owning all the stock of captive insurer D, which insured six-to-10 related entities, two of which were limited liability corporations, with the rest limited partnerships with the same general partner, C.

Apparently, D also insured A and his relatives for relatively minor amounts. D sold two policies–one covered one entity in one location. The other covered the remaining entities, each of which was in the same geographic area. Included in the coverage was flood and windstorm from “named” storms (for example, Hurricane Katrina) and earthquake coverage.

The IRS first determined how many insureds there were. Even though there were six-to-10 entities, the IRS counted only three insureds for tax purposes.

The IRS determined that each multimember LLC was a separate insured because an LLC owner has no more at risk than its equity in the LLC, just as a shareholder has no more at risk than its equity in the corporation.

The IRS determined, however, that the general partner of a limited partnership is the insured. Since each of the limited partnerships had the same general partner, the general partner (C) was the insured, rather than each of the numerous limited partnerships. Accordingly, rather than six-to-10 insureds, the IRS viewed there to be only three insureds for tax purposes.

The reason the IRS determined that a general partner is the insured, rather than the limited partnership itself, is that in the case of a severe loss the general partner would be liable for the entire loss without limitation. The general partner's loss was not limited to its equity in the limited partnership.

Accordingly, the IRS viewed the general partner as the one attempting to shift its risk through insurance. This is the same position the IRS took in TAM 200816029.

Neither TAM 200816029, CCA 200952060 nor CCA 200952061 can be cited as precedent, but they represent the only times the IRS has decided who is the insured in a multimember LLC and a limited partnership situation. Some in the industry believe that the limited partnership (rather than the general partner) is the insured, at least under some circumstances.

An example is a limited partnership that buys property insurance on a building subject to a nonrecourse note. In that instance, many view the general partner as having no more at risk than its equity in the limited partnership, just as a shareholder's loss is limited to equity in its stock.

Once the IRS determined that there were three primary insureds (the two LLCs and the general partner), it focused on the concentration of risk with those insureds.

To have insurance for tax purposes, there must be enough distribution (sharing) of risk. This means several things, including that there be enough exposure units (opportunities for loss) so that the law of averages can statistically predict the likely amount of losses.

The IRS believes there must be multiple insureds (not just sufficient exposure units) and that no insured can so dominate the premium payments that it is effectively paying its own losses with its own premiums. The IRS “safe harbor” is that there should be at least 12 insureds–none representing more than 15 percent, nor less than 5 percent, of the risks.

The precise numbers with CCAs were redacted, but it was clear that each of the primary insureds had concentrations greater than 15 percent (and the implication was the three insureds bought the bulk of the insurance). One example would be 40 percent for the general partner, 35 percent for one LLC, 20 percent for the other LLC, and 5 percent for the individual insureds.

The IRS determined that the risks were too concentrated in too few entities to find that there was insurance. Because the CCAs are heavily redacted, it is impossible to know the exact facts, but based on the above assumptions, the industry would likely disagree with the IRS conclusion.

One principle of insurance is that risks should be independent of each other. This means that the same conditions that caused one insured to have a loss will not simultaneously cause another insured to have a loss. For instance, the hurricane risks of two adjacent houses are not independent.

For 50 years, the IRS has held that flood insurance issued only to those in the same flood plain is not insurance. That is because a flood would result in a loss to everyone, so that in essence, one's premiums were being used to pay one's own loss.

In the CCAs, the IRS concluded that because all but one of the properties were in the same geographic area, the same “named storm” or the same earthquake would affect all the insureds–thus the risks were not independent of each other. Accordingly, the policies were not insurance for tax purposes.

These CCA are reminders that the IRS continues to scrutinize captive insurance arrangements. While properly structured arrangements should pass muster for tax purposes, those that are not properly structured and implemented will not.

Charles J. “Chaz” Lavelle is an attorney in the Louisville, Ky., office of Greenebaum Doll & McDonald PLLC. He was outside tax counsel for both Humana and Ocean Drilling & Exploration Company in their U.S. Court of Appeals captive insurance victories.