Tax issues arising in an insurance-company conservation or liquidation proceeding can be as complex as regulatory and legal ones—potentially blindsiding stakeholders at a time when they're not focusing on the Internal Revenue Service.

Regulators and creditors, as well as managers and owners of the troubled companies—and of healthy ones included on consolidated tax returns—should be aware of some of the common tax issues, including the potential for consolidated filings and tax-sharing agreements to impede the wind-down process.

AT The OUTset of liquidation

Regulators may not have an opportunity to become familiar with the tax posture of a troubled insurance company before the actual conservation or liquidation order becomes effective. If timing is an issue, they will at least want to quickly assess the ownership structure and the location of critical tax data. Other considerations include:

•  Evaluating tax uncertainties

If an organization is included in a consolidated federal income tax return, potential tax exposures may exist. The IRS can pursue claims for unpaid tax liabilities from any of the members included in a consolidated federal income tax return.

If practicable, a detailed review of prior-year consolidated return filings is desirable in order to identify potential exposures or tax risks that could lead to claims by the IRS or other members of the consolidated-return group, who can also pursue claims under tax-sharing agreements.

While the IRS is not bound to any terms set forth in the tax-sharing agreement, it is important to obtain a copy of this agreement to understand how members of the consolidated return are supposed to share tax liabilities and benefits.

• Understanding tax attributes

During the conservation and liquidation proceedings, the company will continue to have a filing obligation for both federal and state income tax purposes. Therefore, organizations must understand the tax basis of assets and liabilities, the various jurisdictions in which the organization is operating and filing income tax returns, the existence of any tax attributes, and the status of any taxing-authority audits and tax years that remain open to examination.

• Deconsolidation is an option

If the insurance company is a member of a consolidated-return group, then the parent company may be able under tax law to take certain actions or make certain elections unilaterally that could adversely impact the value of the insurance company's tax attributes.

Therefore, it may be advantageous to deconsolidate the company from its parent so that the company no longer will be liable under the joint-and-several provisions of the consolidated return regulations.

During liquidation

Special tax rules apply to insurers with premium volume at or below certain thresholds. Additionally, there are specific elective provisions in the tax code that can provide benefits to insolvent companies.

Currently, a non-life insurance company shall be tax-exempt under IRC 501(a) provided: 1) its gross receipts (including investment income) for the taxable year do not exceed $600,000; and 2) more than 50 percent of such gross receipts consist of premiums. 

An insurance company in conservation or liquidation may, instead, be eligible to make an election under IRC Section 831(b) to be taxed solely on its investment income. To qualify, annual net-written premium (or net-direct premium if greater) must not exceed $1.2 million.

The wind-down

Organizations should explore available administrative procedures with the IRS to resolve potential tax uncertainty that can impede the liquidation process.

Lastly, if the company is a member of a consolidated return, it may be prudent to execute an indemnification agreement with the parent barring any future assertion of liability for unpaid taxes.