May 22, 2014
Authored by: Brian Berglund and Chris Rylands
An employer will sometimes form a captive insurance subsidiary to provide insurance coverage for workers compensation and a variety of other risks associated with the employer’s business. For premium payments to a captive insurance company to be currently deductible, the underlying policy issued by the captive generally must constitute insurance under the tax laws. To constitute insurance, the arrangement must, among other requirements, shift the risk of loss from the employer to the captive, and the captive must distribute that risk of loss among other insured parties. To satisfy the “risk distribution” requirement, some captive insurance companies have issued policies to employee medical plans insuring the medical benefit risks associated with employees and retirees (and their dependents).
In Revenue Ruling 2014-15, the IRS addressed the application of the risk shifting and risk distribution requirements involving retiree health benefits and a voluntary employee’s beneficiary association (“VEBA”). An employer voluntarily provided health benefits to its retirees by making contributions to a VEBA. The VEBA provided the health benefits, but instead of self-insuring, it entered into a contract with an unrelated insurance company. That insurance company then reinsured the risks with a captive insurance company wholly-owned by the employer. The IRS concluded that it was the risks of the retirees (and not the employer) that were being insured. As a result, sufficient risk shifting and risk distribution existed such that this arrangement qualified as insurance for federal income tax purposes. Click here to view our alert summarizing the ruling.
While the ruling provides favorable tax precedent, it does not address all ERISA implications. In particular, it is a prohibited transaction to use plan assets to purchase insurance from a captive insurance company in the employer’s controlled group and no statutory or class exemption is available. Accordingly, an individual prohibited transaction exemption must be obtained to avoid excise taxes or Department of Labor penalties.