Categories
Risk Management

Bad Facts Make Bad Law

One of the first things that a first-year law student learns in law school is that bad facts make bad law.  Well, the most recent example of the truth of that adage was delivered by the United States Tax Court in an opinion filed on March 10, 2021, in Caylor Land & Development, Inc., et al v. Commissioner T.C Memo. 2021-30, another victory for the IRS in a captive insurance case.  However, the facts in this case were so bad and so untethered from the typical captive insurance arrangement that it is difficult to see how this case will have any negative impact on the captive insurance industry.

Findings of Fact

The lead petitioner in the case, Caylor Land & Development, Inc. (Caylor Land), was an Arizona corporation engaged in commercial and residential real estate development.  Its owner, Rob, was the son of the founder of another general building contractor, Robert Caylor Construction Company (Caylor Construction).  Over time, Rob bought Caylor Construction from his father and also formed a number of different entities representing different construction projects.  The Tax Court found that this was not uncommon in the real estate business, where every project carries a separate risk.  The Tax Court also found that Rob ran the “empire” through Caylor Construction.

It is important to note the relationship between Caylor Construction and Caylor Land and between Caylor Land and the other members of Rob’s “empire”.  It appears that most of the revenue generated by Rob’s business ventures was concentrated in Caylor Construction.  Those funds were then distributed to the other entities through “consulting fees” paid to Caylor Land.  For example, the Tax Court found that, in 2009, Caylor Land had $1.4 million in gross revenue, of which $1.2 million were consulting fees paid by Caylor Construction.  Caylor Land then paid much of what it received from Caylor Construction to the other entities, also as “consulting fees”.  The “consulting fees” paid by Caylor Land to the other entities in Rob’s “empire” constituted a significant part of the revenue of those entities.

Why does this matter?  First, the Tax Court questioned whether the payments called “consulting fees” were really consulting fees.  There were no written agreements between any of the parties and no records of what consulting actually took place.  In addition, the entities used almost all of the “consulting fees” to pay insurance premiums.

The Captive

In 2007, Rob engaged Tribeca to form and manage a captive insurance company called Consolidated, Inc. (Consolidated).  Consolidated was incorporated under the laws of Anguilla in December, 2007.  Here is where the facts get a bit sketchy.  The Tax Court found that Caylor Construction paid insurance premiums of $1.2 million in December, 2007, which it deducted on its 2007 tax return.  It thought this unusual, because Caylor Construction had not yet provided any underwriting information to Tribeca and the actual insurance policies were not issued until sometime in 2008.  The Tax Court found this strange, because the policies were “claims-made” policies but were not issued until after the policy coverage period had ended.  In addition, it found that Caylor Construction had paid premiums of $1.2 million for, at most, ten days of coverage in 2007 and possibly for “none at all”.

What the Tax Court did not say in its opinion, but must be true, is that the policy coverage period was the calendar year.  Otherwise, if the policy coverage period were December, 2007, to December, 2008, a policy delivered in early 2008, would not have been issued after the expiration of the policy coverage period.  In addition, premiums paid in December, 2007, would not have been for ten days of coverage.

IRS Audit

The IRS audited all of the entities for the 2009 and 2010 tax years.  It denied Caylor Construction’s deduction for the “consulting fees” paid to Caylor Land.  In addition, it denied a deduction for the payments made by the other entities to Consolidated.  The cases of all taxpayers were consolidated were trial.

Since the years under audit were 2009 and 2010, whatever happened in 2007 should have been immaterial to the result in this case.  However, the Tax Court clearly was affected by what happened in 2007.  In addition, it found that this pattern repeated itself in subsequent years – premiums were paid before the policies were even priced, and the policies were not issued until after the expiration of the policy coverage period.  In addition, the Tax Court found that, while premiums were paid by all of the entities, actual policies were issued to only a small number of the Caylor entities.  If the other entities were even covered under the policies, they were covered as additional insureds.

The Tax Court’s Opinion

In the opinion, the Tax Court said that there are three issues in the case:

  1. whether the “consulting fees” paid by Caylor Construction to Caylor Land were deductible as ordinary and necessary business expenses;
  2. whether the payments to Consolidated were “insurance expenses”; and
  3. whether the IRS could impose accuracy-related penalties.
1. Consulting Fees

The Tax Court resolved this issue fairly easily.  It found that there was no consulting agreement between Caylor Construction and Caylor Land, no invoices for consulting services and no evidence that consulting services were actually provided.  As a result, the money transferred from Caylor Construction to Caylor Land was more like a distribution of profits and not an ordinary and necessary business expense.

2. Insurance

The Tax Court’s analysis of whether the payments made by the various Caylor entities to Consolidated were insurance premiums should be familiar to anyone who has read the opinions in the Avrahami, Reserve Mechanical and Syzygy cases.  In fact, the judge in the Caylor case is the same judge who decided Avrahami.

The Tax Court repeated that insurance premiums are generally tax deductible as ordinary and necessary business expenses.  However, money set aside as “a loss reserve or a form of self-insurance are not”.  So, the issue in the case was whether the amounts paid to Consolidated were insurance premiums or a loss reserve.

The Tax Court also repeated the familiar refrain that the Internal Revenue Code does not define the term “insurance”.  That has been left to case law, and the Supreme Court has said that insurance has four characteristics:

  • risk-shifting;
  • risk-distribution;
  • insurance risk; and
  • whether an arrangement looks like commonly accepted notions of insurance.

Finally, the Tax Court said that it would focus on two of those factors – risk-distribution and commonly accepted notions of insurance – as it had done in Avrahami, Reserve Mechanical and Syzygy.

a. Risk Distribution

Risk distribution depends upon the concept of the “law of large numbers”.  By accepting premiums and risk from a large number of insureds, an insurance company protects itself against the adverse experience of a small number of insureds.  In Avrahami, Reserve Mechanical and Syzygy, the captives used a reinsurance pool to establish risk distribution.  In each of those cases, the Tax Court had found that the pool was not insurance, so it could not be used to establish risk distribution.  The implication is that, if the pool had been properly managed and, as a result, had been found to be insurance, it could have been used to establish risk distribution.

However, in the Caylor case, this issue was moot.  Although Tribeca maintained an “insurance pool” and told its clients that they had to participate in the “insurance pool” in order to have adequate risk distribution, Consolidated chose to not participate in the pool.  Of all the bad facts in this case, this is perhaps the worst and most curious.  It is also the reason why this case may have little impact on the captive insurance industry as a whole.  Why would a captive insurance company make the conscious decision to forego the best tool available to distribute risk among other captives and other insureds?

Instead of participating in a reinsurance arrangement to distribute risk, Consolidated chose to rely on the fact that it was providing insurance to twelve brother and sister entities.  This argument was based on the holding of Revenue Ruling 2002-90, in which the IRS said that there would be sufficient risk distribution, if a captive provided insurance to at least twelve related entities and no entity represented less than 5% or more than 15% of the total risk insured by the captive.

Unfortunately for the petitioners, the Tax Court did not buy this argument.  First, the Tax Court said that the number of related entities is not determinative.  Instead, the issue is the number of risk exposures assumed by the captive that matters.  This position is very troubling for a couple of reasons.  First, the Tax Court relied on cases that involved captives that were not microcaptives to support its position.  These cases involved multi-national corporations and thousands of insureds.  No microcaptive could possibly satisfy that test.  Second, and perhaps, most importantly, the Tax Court completely ignored Revenue Ruling 2002-90, which is one of the few pieces of guidance that the IRS has issued in the area of captive insurance and has never been withdrawn.  If a court can overrule the stated position of the IRS, no taxpayer can be safe from persecution.

What’s even more disturbing is that the Tax Court did not even have to ignore the holding of Revenue Ruling 2002-90 in order to achieve its desired, and probably pre-determined, result.  The Tax Court found that Caylor Construction represented more than 30% of the risk assumed by Consolidated.  So, Consolidated could not satisfy the requirements of Revenue Ruling 2002-90, even if the Tax Court were to have given effect to that guidance.

b. Commonly Accepted Notions of Insurance

The Tax Court next discussed whether Consolidated was operated in accordance with the commonly accepted notions of insurance.  The Tax Court acknowledged that it did not have to reach this issue, since the failure of risk distribution would be enough to uphold the tax deficiency.  However, this did not stop the Tax Court from discussing this issue.

There are five factors that a court takes into consideration when trying to determine whether an arrangement looks like insurance:

  • whether the company was organized, operated and regulated as an insurance company;
  • whether the company is adequately capitalized;
  • whether the policies were valid and binding;
  • whether the premiums were reasonable and the result of arm’s-length bargaining; and
  • whether claims were paid.

i. Organized, Operated and Regulated

The Tax Court acknowledged that Consolidated was organized as an insurance company under the laws of Anguilla, although there was some question whether Anguilla had ever actually regulated the company.  Apparently, the taxpayer did not even introduce a copy of Consolidated’s insurance license into evidence.  However, the Tax Court found that did not matter whether Consolidated was regulated like an insurance company, because it found that Consolidated was not operated like an insurance company.

First, the Tax Court was troubled by the way in which the policies were issued.  There was expert testimony that Consolidated backed into the premiums.  According to the expert, no other insurance company priced policies as Consolidated had.  In addition, the expert testified that no other insurance company would issue a policy after the expiration of the policy coverage period, as Consolidated uniformly did.

Second, the Tax Court was troubled by the way in which Consolidated paid claims.  The Tax Court found that, over a period of four years, the insureds had submitted two claims.  In each case, Tribeca, as captive manager, had requested documentation to support the claims.  However, instead of providing such documentation, Rob simply overruled Tribeca and ordered Consolidated to pay the claims.  The Tax Court found that no insurance company would pay a claim without an adequate showing that the claim was covered by the policy.

ii. Adequately Capitalized

The Tax Court found that Consolidated met the minimum capitalization requirements of Anguilla and that is all that is required.

iii. Valid and Binding Policies

As discussed above, the Tax Court found that the policies written by Consolidated were “claims-made” policies.  This means that the policies only cover claims that occur during the policy coverage period and are reported to the insurance company during the policy coverage period or within sixty days thereafter.  However, the Tax Court also found Consolidated did not issue the policies until after the expiration of the policy coverage period.  The Tax Court found this to be abnormal.  No insurance company issues a policy after the expiration of the policy coverage period when there is no longer a risk of loss.

iv. Reasonable Premiums

The Tax Court found that the premiums were not actuarially determined.  Instead, they were “backed into” in order to add up to $1.2 million.  The biggest issue was that Tribeca did not ask for “loss runs” from the insured.  In addition, Tribeca did not review the loss history of any prior policy coverage period before renewing a policy at the same premium as before.  No insurance company would determine premiums, let alone issue a policy, without reviewing an insured’s loss history.

v. Payment of Claims

As discussed above, the Tax Court found that Consolidated’s claims procedure was abnormal and unlike any real insurance company’s.

For all of the foregoing reasons, the Tax Court found that Consolidated was not an insurance company in the commonly accepted notions of insurance.

3. Penalties

The IRS imposed accuracy-related penalties under section 6662 of the Code.  The Tax Court upheld the penalties, and this is, perhaps, the most important takeaway of the case.

Penalties can be imposed in a tax deficiency case if the taxpayer understates the amount of its taxable income by a certain percentage or if the taxpayer is negligent in asserting a tax position.  The Tax Court found that both apply in this case.

However, a taxpayer can avoid penalties if it can establish “reasonable cause” for its position.  In most cases, reasonable cause requires a taxpayer to show that it reasonably relied upon the advice of an independent tax professional.  The tax professional may not have a conflict of interest, must have knowledge and experience in the area and must have all of the facts.

The taxpayers claimed that they consulted with Tribeca, their CPA and their tax attorney before participating in the captive insurance transaction.  However, there were problems.  First, Tribeca was the captive manager and had an obvious conflict of interest.  A taxpayer cannot rely on the advice of the promoter of a transaction to establish reasonable cause.  Second, both the CPA and the tax attorney had advised the taxpayers that they were not familiar with captive insurance and that they were not comfortable with the transaction.  In addition, both testified at trial that they provided no advice to the taxpayers.

A captive insurance company is a complex undertaking.  Taxpayers are always advised to seek independent, knowledgeable advice before entering into the arrangement, if for no other reason than to make sure that they understand the nature of the transaction.  However, Caylor provides another reason to seek independent advice.  It is the only way for a taxpayer to avoid penalties.

Categories
Health and Benefits

Memo on COVID Relief Package for 2021

On December 27, 2020, the Consolidated Appropriations Act of 2021 (the “Act”), was signed by President Trump.  While the Act is mostly known for its $600 payment to most Americans making less than $75,000 per year and the expansion of unemployment benefits, it also impacts employers in a number of ways.  This article discusses a few of those provisions.

1. Flexible Spending Accounts

Many employers maintain what is known as a “Cafeteria Plan”, which enables their employees to prefund certain expenses on a tax-advantaged basis.  An employer’s Cafeteria Plan may include a flexible spending account (“FSA”) for healthcare expenses and an FSA for dependent care expenses.  The Act changes some of the rules that govern both healthcare and dependent care FSAs.

A. Changing Election

Generally, an employee is permitted to make an election regarding participation in an FSA only once per plan year, without a “change in status”.  In addition, the election is generally required to be made before the start of the plan year.  The Act provides that, for plan years ending in 2021, an employee may change the amount of his or her contributions to an FSA during the plan year, without a change in status, as long as the total of the contributions does not exceed the statutory maximum.  Any change in the employee’s election will be effective prospectively.

B. Carryover Amounts 

FSAs used to be subject to a “use it or lose it” rule.  However, the Internal Revenue Code now permits an employee to carry over unspent funds remaining in his or her healthcare FSA at the end of one plan year to the next plan year.  An added benefit is that the carryover amount does not count against the maximum reimbursement amount for the following plan year.  However, the amount that an employee may carry over is limited.  For plan year 2021, the maximum carryover amount was $550.  The Act suspends this limitation for plan years 2020 and 2021.  Under the Act, an employee may carry over the entire remaining balance in his or her healthcare FSA to the following plan year.  The Act also extends this carryover provision to dependent care FSAs.  Prior to the Act, the carryover provision covered only healthcare FSAs.

C. Extension of Grace Period

An employer’s Cafeteria Plan may include a “grace period”.  During the grace period, an employee may use funds remaining in his or her FSA at the end of a plan year to pay costs incurred in the following plan year.  There are no limits on the amount that may be used in the next plan year.  However, the grace period cannot extend more than two and one-half months into the next plan year. Both healthcare FSAs and dependent care FSAs may provide a grace period.  The Act changed the upper limit of the grace period for plan years ending in 2020 or 2021.  For plan years ending in 2020 or 2021, the grace period can extend up to twelve months.

A plan may not have both a grace period and a carryover provision.  What is the difference?  A grace period generally does not limit the amount of funds, which may be used in the next plan year but does limit the period during which such funds can be used.  A carryover provision limits the amount that may be carried over from one plan year to the next but does not limit the period during which the funds can be used.  However, since the Act changed the grace period to twelve months and eliminated the dollar limitation on carryover amounts, there does not seem to be much difference between a grace period and a carryover provision for 2021.

D. Extension Period for Reimbursements

A participant is generally permitted to obtain reimbursements from an FSA only while actively covered by the employer’s Cafeteria Plan.  Under the Act, an employee may continue to receive reimbursements from a plan for the balance of the plan year, including any grace period, during which his or her participation in the plan ceases.  This provision applies only to healthcare FSAs and not dependent care FSAs.

E. Plan Amendment 

The foregoing plan provisions are permissible, not mandatory.  This means that an employer may offer a Cafeteria Plan but is not required to.  In addition, an employer’s plan may contain a carryover provision or a grace period but also may contain neither.  In order to add or change a carryover or grace period provision, an employer must adopt an amendment to its plan.  Generally, amendments must be adopted prospectively.  For 2020 and 2021, the Act permits an employer to amend its plan retroactively.  The amendment must be adopted by the last day of the first plan year after the plan year for which the amendment is to be effective.  That means that, for a 2020 calendar year plan, the amendment must be adopted by December 31, 2021.  For a 2021 calendar year plan, the amendment must be adopted by December 31, 2022.

2. Paycheck Protection Program

The Coronavirus Aid, Relief, and Economic Security Act (“the “CARES Act”), which was signed into law on March 27, 2020, created the Paycheck Protection Program (“PPP”).  The purpose of the PPP was to support small businesses in retaining and paying employees.  In addition to adding new money to the existing PPP program, the Act made other changes to the PPP program.

A. Second Draw

The Act creates what is known as a “second draw”.  This enables employers that received a PPP loan during the first phase of the program to apply for a second PPP loan.  In order to be eligible for a second draw, an employer must have:

i. no more than 300 employees;

ii. used or will use the full amount of the first PPP loan; and

iii. experienced a reduction in revenue of at least 25% for a 2020 quarter compared to the same 2019 quarter.

Like the original PPP program, the second draw is administered by lenders authorized by the Small Business Administration. A business that desires to apply for a PPP loan, whether a so-called “first draw” under the CARES Act or a “second draw” under the Act, should contact their lender.

B. Eligible Expenses

The intent of the PPP program is for loan proceeds to be used for payroll expenses.  However, both the original PPP program under the CARES Act and the revised PPP program under the Act permit loan proceeds to be used for expenses other than salary.  The Act expands the percentage of loan proceeds that may be used for expenses other than salary from 25% to 40%.

C. Deductibility

There was some uncertainty under the CARES Act whether an employer whose loan was forgiven could also deduct the business expenses paid for with the loan proceeds.  The IRS took the position that an employer could not receive both loan forgiveness and deductions.  The IRS characterized this as double-dipping.  The Act makes clear the intention of Congress that a business may receive loan forgiveness under the PPP and deduct the business expenses paid for with the loan proceeds.

3. Employee Retention Credit

The CARES Act created an Employee Retention Credit (“ERC”), which provided a credit for eligible employers for payroll taxes paid by the employer.  To the extent that the employer’s payroll taxes exceeded qualified wages, the credit resulted in a refund to the employer.  The Act amends the ERC in a number of ways.

A. Extension

The Act extends the term of the ERC to June 30, 2021.  Previously, the Act was set to expire on December 31, 2020.  So, employers can now take advantage of the ERC through the first six months of 2021.

B. Eligibility

The Act expands the number of employers eligible for the ERC.  Under the CARES Act, the ERC was available to employers with fewer than 100 employees.  The Act extends the ERC to employers with fewer than 500 employees.  In addition, in order to be eligible for the ERC in 2021, an employer must be prohibited from fully or partially engaging in a trade or business as a result of a governmental order or its revenue during one of the first two quarters of 2021 must be 80% less than its revenue during a comparable quarter in 2019.  The CARES Act required a reduction in revenue of 50% or more.

C. Amount of Credit

The amount of the ERC is 70% of an employee’s “qualified wages” paid from January 1, 2021, through June 30, 2021.  The maximum amount of an employee’s qualified wages is $10,000 per quarter.  So, the maximum ERC per employee per quarter is $7,000.  The amount of the ERC under the CARES Act was 50% of an employee’s annual wages.

D. Coordination with PPP 

Under the CARES Act, an employer could not take advantage of both the PPP program and the ERC in 2020.  The employer had to choose one or the other.  The Act retroactively eliminates that restriction.  An employer that received a PPP loan in 2020 can retroactively claim the ERC for wages that were not paid with the PPP loan.  This is a huge benefit for employers that received a PPP loan in 2020; one that is not shared by employers who forsook a PPP loan in 2020 because the ERC provided a greater benefit.  They do not have the option of retroactively applying for a PPP loan for the same period for which they received an ERC.  A business that did receive a PPP loan in 2020 should consult its tax and legal advisors to determine whether it is also eligible to receive the ERC.

4. Health Plan Provisions

A. Surprise Billing

“Surprise billing” most often occurs in the context of emergency care.  When an employee requires emergency care, the employee is often unable to confirm whether the hospital or doctor is “in-network”.  As a result, the employee may be surprised when he or she gets a bill for the difference between the agreed-upon amount charged by the employee’s in-network provider and the amount charged by the out-of-network provider.

The Act addresses the problem of surprise billing by treating the care provided by the out-of-network provider as in-network for purposes of calculating the employee’s share of the cost of treatment.  As a result, an employee’s obligation is the same whether the treatment is received in-network or out-of-network.  However, this restriction does not cover all medical care and extends only to the point where the employee is stable and able to make informed decisions about his or her treatment.

The provisions of the Act regarding surprise billing go into effect on January 1, 2022.  However, regulations are supposed to be issued by July 1, 2021.

B. Reporting and Disclosure Requirements

The Act imposes a number of reporting and disclosure requirements on group health plans.  Beginning with plan years starting on or after January 1, 2022, group health plan identification cards must show in-network and out-of-network deductibles, out-of-pocket maximums, and a telephone number and website through which a participant can find certain information such as which hospitals and urgent care centers have relationships with the plan.  While an employer needs to be aware of this obligation, the delivery of identification cards is usually the responsibility of the plan’s TPA.

Also beginning with the first plan year after January 1, 2022, if an employer receives notice that an employee is scheduled to be treated by an out-of-network provider, the employer is required to notify the employee that the provider is not in-network.  In addition, the notice must provide the employee with a good faith estimate of the cost of the treatment, the plan’s financial responsibility for the treatment, the employee’s share of the cost and how much the employee has to pay before reaching the plan’s out-of-pocket maximum.  Again, while the employer needs to be aware of this obligation, it is generally the TPA that will provide the notice to the plan participant.

The Act also requires group health plans to submit certain information to the Departments of Health and Human Services, Labor and Treasury.  The first report is due December 27, 2021, and subsequent reports are due on each June1 thereafter.  The information required to be provided includes:

1. the dates of the plan year;

2. the number of participants and beneficiaries;

3. each state where the plan is offered;

4. the 50 most popular brand prescription drugs used by plan participants;

5. the 50 most expensive prescription drugs used by plan participants;

6. the 50 prescription drugs with the greatest increase during the plan year;

7. total spending on health care by the plan broken down by hospital costs, provider costs for primary care and specialty care and prescription drugs;

8. the average monthly premium paid the employer and the plan’s participants; and

9. rebates.

As with the other reporting requirements, the information will need to be gathered by the plan’s service providers.  It seems likely that regulations will be issued prior to December, 27, 2021, more clearly setting forth an employer’s obligations under the Act.

Categories
Risk Management

Why Make a 953(d) Election?

There are a number of reasons why a foreign insurance company would make a so-called 953(d) election.  This article will discuss two of those reasons.

What is a 953(d) Election?

The term “953(d) election” refers to a decision made by a foreign insurance company to be taxed as a United States taxpayer.  For purposes of this discussion, a foreign insurance company is an insurance company incorporated in an off-shore jurisdiction, which is neither licensed, nor engaged in business, in the United States, and can include a captive insurance company.  Typically, a foreign insurance company would not be taxed as a United States taxpayer and would not be required to file a Form 1120-PC with the Internal Revenue Service (IRS).

For the reasons discussed below, a foreign insurance company might prefer to be taxed as a United States taxpayer.  As a result, section 953(d) of the Internal Revenue Code (Code) permits a foreign insurance company to elect to be taxed as a United States taxpayer if certain conditions are met.  Those conditions include the following:

1. The foreign corporation must be a “controlled foreign corporation” (CFC).

2. The foreign corporation would qualify under part I or part II of subchapter L of the Code, if it were a domestic corporation. This simply means that the corporation is an insurance company.

3. The foreign corporation meets the requirements set out by the IRS. The IRS has set out those requirements in Rev. Proc. 2003-47.

4. The foreign corporation makes an election to have section 953(d) apply.

What is a Controlled Foreign Corporation?

As stated above, one of the requirements for making a 953(d) election is that the foreign insurance company is a controlled foreign corporation.  The definition of a CFC is provided in section 957(a) of the Code, as modified by section (b) for insurance companies.  A CFC is any foreign insurance company if more than (i) 25% of the total combined voting power of all classes of stock entitled to vote, or (ii) 25% of the total value of the stock of such corporation, is owned by a United States person on any day during the taxable year of the corporation.

The term “person” includes a United States citizen, a domestic partnership, a domestic corporation, an estate and a trust.  Ownership refers not just to direct ownership, but also includes ownership determined by applying rules of attribution.

How Does a Foreign Insurance Company Make a 953(d) Election?

The requirements for making a 953(d) election are set forth in Rev. Proc. 2003-47, which provides that a foreign insurance company must submit a statement to the IRS of its intention to be taxed as United States taxpayer.  The statement must include a list of all United States shareholders, including the name, address, tax identification number and ownership interest of each shareholder.  The foreign insurance company must agree to update the list on an annual basis.  In addition, the foreign insurance company must agree to pay all taxes as they become due.  An acceptable form of the statement is attached to Rev. Proc. 2003-47 as Appendix A.

In addition, the foreign corporation must meet one of two additional requirements.  The first is called the asset test.  To satisfy the asset test, the foreign insurance company must have (i) a place of business within the United States and (ii) assets equal to 10% of its adjusted gross income for the base year, which are physically located in the United States.  The base year is the taxable year immediately preceding the year in which the election is filed or the year of filing for a new entity.  A foreign insurance company that does not meet the asset test will instead be required to enter into a closing agreement with the IRS and post a letter of credit in an amount equal to 10% its adjusted gross income for the base year, but not less than $75,000 or greater than $10,000,000.

The election is not effective until it has been accepted by the IRS.  However, it will be effective as of the first day of the tax year in which the election was filed.  The election remains in effect until it has been revoked.

The Shareholder of a CFC is Taxed on Subpart F Income

The first reason for a foreign insurance company to make a 953(d) election is that, without the election, certain shareholders of the foreign insurance company will be taxed on the insurance income of the corporation.  So, while a foreign insurance company, which is a CFC, may not be subject to United States income tax, its shareholders are.

Section 951(a)(1) of the Code provides that:

If a foreign corporation is a controlled foreign corporation at any time during any taxable year, every person who is a United States shareholder . . . of such corporation and who owns . . . stock in such corporation on the last day, in such year, on whichcsuch corporation is a controlled foreign corporation shall include in his gross income . . .

(A) his pro rata share . . . of the corporation’s subpart F income for such year . . .

The term “United States shareholder” is defined in section 951(b) as any person who owns 10% or more of the voting power of all classes of stock of the foreign corporation entitled to vote or 10% or more of the total value of shares of all classes of the foreign corporation.  The term “subpart F income” is defined in section 952(a)(1) as “insurance income” (as defined under section 953), and section 953(a)(1)(A) defines “insurance income” as any income in connection with the issuance of an insurance or annuity contract.  In addition, the tax is owed on subpart F income whether it is actually paid to the shareholder or not.

The shareholders of a foreign insurance company will be taxed on the gross premiums paid to the foreign insurance company, if the foreign insurance company is a controlled foreign corporation, as most captives are.  This tax is not only paid on money actually paid to the shareholders, but also on phantom income – i.e. income that is not distributed to the shareholders.  However, shareholders of a foreign insurance company, which is a CFC, will not be subject to this tax if the foreign insurance company makes a 953(d) election.  In that case, the foreign insurance company will be taxed as a United States taxpayer and not as a CFC.

A Foreign Insurance Company is Subject to the Federal Excise Tax

The second reason for a foreign insurance company to make a 953(d) election is section 4371 of the Code, which imposes an excise tax on foreign insurance companies that issue policies covering United States risks.  The tax is very straightforward.  It is a certain percentage of premiums without deductions or set offs.

For property and casualty insurance, the tax is 4 cents on each dollar, or fraction thereof, of premium paid on the policy.  For life insurance, the tax is 1 cent on each dollar, or fraction thereof, of premium paid on the policy.  The tax is also 1 cent on each dollar, or fraction thereof, of the premium paid on a policy of reinsurance.

A foreign insurance company that makes a 953(d) election is treated as a domestic corporation.  It is not taxed as a foreign corporation.  Therefore, premiums paid by a United States person to a foreign insurance company, which has made a 953(d) election, are not subject to the Federal Excise Tax.  This is a great reason for making a 953(d) election.  It means that 100% of the premiums received by the foreign insurance company, including a captive insurance company, will be available to pay claims asserted against the insurance company.  This will provide policyholders with peace of mind that the foreign insurance company will have the ability to pay claims as they become due.

Categories
Retirement Plans

Maximum Pension Limits for 2021

Overview

Many employee benefits are subject to annual dollar limits that are occasionally increased due to inflation. The Internal Revenue Service (IRS) recently announced cost-of-living adjustments to the annual dollar limits for various welfare and retirement plan limits for 2021. Most of the limits will remain the same, but some of the limits will increase effective January 1, 2021.

The following are some important limits in effect for 2021:

  • Maximum compensation for plan purposes is $290,000
  • Maximum monthly benefit for defined benefit plans ages 62 to 65 is the lesser of 100% of compensation or $19,166.67 with an annual benefit $230,000
  • Highly Compensated Employee compensation $130,000+
  • Maximum Defined Contribution / Profit Sharing Contribution $58,000
  • Maximum SEP Contribution $58,000
  • Maximum 401(k) Contribution $19,500. Catch-up Contribution for age 50 and over $6,500
  • Maximum SIMPLE Contribution $13,500

Plan Ahead

Employers should update their benefit plan designs with these new limits, and make sure that their plan will reflect the new 2021 limits. Employers may also want to communicate the new benefit plan limits to their employees.

Click here to read the full IRS announcement.

Categories
Technical Memorandum

Notice 2020-29 Makes Health Flexible Savings Accounts More Flexible

In June, 2020, the Internal Revenue Service (IRS) issued Notice 2020-29 to provide increased flexibility under section 125 of the Internal Revenue Code (Code) in connection with employer-sponsored health coverage, health Flexible Spending Arrangements (FSAs) and dependent care assistance programs.

What is Section 125?

Section 125 of the Code sets forth the rules for what is commonly known as a “cafeteria plan”.  A cafeteria plan is a written plan maintained by an employer under which an employee can choose between cash and “qualified benefits”.  A “qualified benefit” is any benefit, which is excluded from an employee’s taxable income under another section of the Code and may include employer-sponsored health plans and FSAs, which are excludable under sections 105 and 106 of the Code, and dependent care assistance programs, which are excludable under section 129 of the Code.  In simple terms, under a cafeteria plan, an employee can choose to receive his or her full salary, as taxable income, or divert a portion of that salary on a tax-exempt basis to pay for certain benefits, such as medical care.

What is a Health FSA?

A health FSA is an account maintained by the employer for the benefit of an employee.  It is funded by salary reductions by the employee and used to reimburse the employee for qualified medical expenses.  The amount that an employee may divert to a health FSA is limited.  In 2020, an employee may contribute up to $2,750 to his or her health FSA.

In order to avoid FSAs turning into plans of deferred compensation, an employee was initially required to spend all of the funds in his or her FSA during the applicable plan year.  Any funds not spent were forfeited.  This was known as the “use-it-or lose-it” rule.  Over time, two exceptions to the “use-it-or-lose-it” rule were adopted by the IRS – the grace period rule and the carryover rule.

What is the Grace Period Rule?

The first exception is the “grace period” rule.  Under the grace period rule, a plan may allow an employee to apply unused amounts, left over at the end of the plan year, to qualified medical expenses incurred during the first two months and 15 days of the next plan year.

What is the Carryover Rule?

The “carryover” rule permits an employee to carryover a limited amount to the next plan year for qualified medical expenses incurred during the entire following plan year.  The amount that an employee could carryover from 2019 to 2020 was $500.  That amount has been increased for the 2020 plan year to $550.

A plan can provide for either a grace period or a carryover, but not both.  In addition, a plan can provide for neither.

What Does Notice 2020-29 Do?

Generally, an employee must make an election regarding his or her employer’s cafeteria plan before the start of the applicable plan year.  Mid-year changes to an employee’s election may be made only in limited circumstances.

In Notice 2020-29, the IRS recognizes the impact of the Covid-19 crisis on the health of employees and provides greater flexibility in making changes mid-year.  More specifically, Notice 2020-29 provides that an employer may amend its plan to allow an employee to:

  1. make a new election to participate in an employer-sponsored health plan on a prospective basis, if the employee initially declined to participate in the plan;
  2. revoke an existing election to participate in an employer-sponsored health plan and make a new election to participate on a prospective basis in a different plan sponsored by the employer;
  3. revoke an existing election to participate in an employer-sponsored health plan and not participate in any plan offered by the employer as long as the employee attests in writing that the employee either is enrolled or will enroll in another health plan, not sponsored by the employer, such as a plan sponsored by the employee’s spouse;
  4. revoke an election, make a new election or decrease or increase an existing election regarding a health FSA on a prospective basis; and
  5. revoke an election, make a new election or decrease or increase an existing election regarding a dependent care assistance program on a prospective basis.

Notice 2020-29 also permits an employer to make a change to its plan to extend its plan’s grace period.  If a plan has a grace period that ends in 2020 or if the plan has a plan year that ends in 2020, the employer can extend the grace period to December 31, 2020.  This extension of time is also available to plans that provide for a carryover, notwithstanding the rule that a plan can either have a grace period or a carryover, but not both.

Plan Amendments

The changes made by Notice 2020-29 are permissible, not mandatory.  An employer can choose to amend its plan, or it can choose to not make any changes.  If an employer chooses to amend its plan to adopt one or more of the changes permitted by the Notice, it must do so by written amendment.  An amendment for the 2020 plan year must be adopted by December 31, 2021, and made retroactive.  However, the employer must provide written notice of the amendments to its employees and operate the plan as if the amendments had already been adopted.

Considerations

There are many factors that an employer must take into consideration when deciding whether to amend its plan.  For example, an employer may want to impose conditions on an employee’s election in order to avoid adverse selection.  Contact your RMC representative to discuss the best path forward for your cafeteria plan.

Categories
Risk Management

Supreme Court Grants Certiorari in CIC Case

In what can only be described as good news for the captive insurance industry, the United States Supreme Court on May 4, 2020, agreed to hear an appeal in the CIC Services, LLC v. Internal Revenue Service case.

To recap the procedural history of the case, CIC sued the IRS in 2017, after the IRS issued Notice 2016-66, identifying so-called “micro-captive insurance” transactions as transactions of interest.  This meant that taxpayers participating in a micro-captive insurance transaction were obligated to attach a Form 8886 to their tax returns for all years in which they participated in the transaction.  This requirement extends to the captive, itself, and the insured, as well as the owners of the captive and the insured.

CIC alleged that the IRS had violated the Administrative Procedure Act (APA) when it issued Notice 2016-66 and sought a declaration that the Notice was unlawful and of no effect.  The APA is the federal law that governs the manner in which a federal agency can issue rules and regulations.  It generally requires an agency to provide advance notice of the rule or regulation, as well as an opportunity for public comment.  The rule or regulation is initially issued in proposed form and does not become final until after the public comment period has expired.  Often, the final rule or regulation will differ from the proposed rule or regulation based upon the public comments received by the agency.  The IRS did not follow this procedure when it issued Notice 2016-66.

The IRS moved to dismiss CIC’s lawsuit based on the Anti-Injunction Act (AIA).  The AIA is also a federal law.  It precludes an action against the IRS seeking to enjoin the collection of any tax.  The IRS took the position that the penalty that would be imposed against a taxpayer upon failure to file Form 8886 was a tax and that, as a result, CIC’s lawsuit was seeking to enjoin the collection of a tax in violation of the AIA.

CIC responded that the focus of its lawsuit was the disclosure obligation, not the penalty.  It was not seeking to enjoin the collection of a tax, because no tax had yet been imposed.  It also said that, if the court refused to hear its challenge to the Notice, a taxpayer’s only recourse for challenging the reporting obligation would be to not attach Form 8886 to its return, pay the penalty and sue for a refund.  CIC claimed that this was fundamentally unfair.

Unfortunately, the District Court was not persuaded by CIC’s arguments and held that the AIA required the dismissal of CIC’s action.     CIC appealed the dismissal of its lawsuit to the Sixth Circuit, which upheld the decision of the District Court in a 2-1 decision.  The Sixth Circuit also denied CIC’s request for a rehearing en banc.  CIC then filed a Petition for a Writ of Certiorari with the Supreme Court.

There are certain types of cases where Supreme Court review is mandatory.  For example, if a state supreme court were to hold a federal law unconstitutional, appeal to the Supreme Court is automatic.  A Petition for a Writ of Certiorari is the way that a party gets to the Supreme Court when the Court is not required to hear its case.  The Supreme Court has unfettered discretion in deciding whether to grant a Petition for a Writ of Certiorari.  And, it grants very few Petitions.

While no one can predict how the Supreme Court will ultimately resolve this case, the fact that it granted CIC’s Petition for a Writ of Certiorari is huge news for the captive insurance industry.  If the Supreme Court were inclined to uphold the decision of the Sixth Circuit, there would be no reason to take the case.  Even without Supreme Court review, the decision of the Sixth Circuit is already settled law; at least in the states within the circuit.  It is reasonable to speculate that the Court – or at least the Justices who voted to hear the case – has something else in mind.  It may be that the unfettered power of the IRS to indiscriminately wreak havoc on the captive insurance industry will finally be checked by a higher authority.

Categories
Retirement Plans Technical Memorandum

What Impact Does the CARES Act Have on Retirement Plans?

The Coronavirus Aid, Relief and Economic Security Act (the “CARES Act”) was signed into law by President Trump on March 27, 2020.  It is 880 pages.  This article provides a summary of the some of the key provisions relating to retirement plans.

1. Covid-19 Related Distributions

The CARES Act provides that section 72(t) of the Internal Revenue Code shall not apply to coronavirus-related distributions from certain qualified retirement plans.  This means that a plan participant will not be subject to the 10% penalty for early withdrawal, as long as the aggregate amount of the withdrawal does not exceed $100,000.  The term “aggregate” refers to all plans maintained by the participant’s employer and any member of a controlled group.

Eligible retirement plans include:

  • IRAs
  • Tax-qualified retirement plans
  • Tax-deferred section 403(b) plans
  • Section 457(b) governmental sponsored deferred compensation plans

The exemption from section 72(t) is effective for distributions made during 2020 – calendar year 2020, not plan year 2020.  In addition, the exemption is available only to a plan participant:

  • Who is diagnosed with Covid-19
  • Whose spouse or dependent is diagnosed with Covid-19
  • Who is furloughed or laid off, has work hours reduced or is unable to work due to lack of childcare or is otherwise unable to work due to Covid-19

An employer is required to confirm that the participant meets one of these conditions but can rely on the participant’s certification.

The participant can elect whether to repay the distribution or to have the distribution included in income.  If the participant elects to repay the distribution, it must be repaid in full within three years after the date the distribution is received.  A participant who elects to not repay the distribution is taxed on the distribution ratably over three taxable years beginning with the year of the distribution.

2. Plan Loans

The CARES Act increases the amount of loans that a “qualified individual” can take from a retirement plan.  Beginning on March 27, 2020, for a 180-day period, the loan amount is increased to the lesser of $100,000 or 100% of the participant’s nonforfeitable accrued benefit under the plan.  Prior to this change, the amounts were $50,000 and 50%, respectively.

The CARES Act also changes the terms of loan repayments.  If the due date of any loan repayment occurs between March 27, 2020, and December 31, 2020, the due date is extended for one year.  Subsequent due dates are extended for one year as well.

An employer may need to amend its plan document in order to provide these enhanced rights to its employees.

3. Required Minimum Distributions

The CARES Act provides a temporary waiver of required minimum distributions for participants who turn age 72 in calendar year 2020.

4. Minimum Required Contributions

The CARES Act delays the due date of any employer-contribution to a defined benefit plan required to be made during calendar year 2020 to January 1, 2021.  However, any delayed payment accrues interest from the original due date to the date of payment.  In addition, an employer may elect to treat the plan’s adjusted funding target attainment percentage (“AFTAP”) for the last plan year ending before January 1, 2020, as the AFTAP for the plan year, which includes calendar year 2020.

5. Filing Deadlines

The CARES Act gives the Department of Labor the right to extend any filing deadline under ERISA for a period of one year as a result of the Covid-19 pandemic.

6. Education Assistance

The CARES Act amends section 127(c) of the Internal Revenue Code to include repayment of an employee’s qualified education loan in the definition of non-taxable “educational assistance”.  The payments must be made before January 1, 2021, and are limited to $5,250.

7. Plan Amendments

Some of the provisions of the CARES Act are voluntary, not mandatory.  For example, the provisions regarding coronavirus-related distributions and increased loan amounts apply only if the plan document permits such distributions and loans in the first place.  As a result, a Plan Sponsor may need to amend its plan document in order to afford its plan participants the ability to access such distributions and loans.

A Plan Sponsor can administer the plan in accordance with the necessary amendments, even before the amendments are actually adopted.  However, the amendments must be adopted by the last day of the first plan year beginning on or after January 1, 2022.

8. PBGC

The PBGC has announced the extension of filing deadlines, including premium payments.  Any filing due after April 1, 2020, can be delayed until July 15, 2020.  While this is not part of the CARES Act, it is something that affects defined benefit pension plans.

Some of these provisions will require further guidance, and we will update you as that guidance is issued.  If you have any questions how the CARES Act affects your qualified retirement plan, contact RMC Group.

*Revised April 21, 2020

Categories
Business Insurance Captive Insurance

What Does IRS Letter 6336 Mean For Your Captive?

It has come to our attention that the IRS recently sent a letter (Letter 6336) to all taxpayers who filed a Form 8886 in connection with their participation in a so-called micro-captive transaction.

How does this impact micro-captives?

This letter is not an existing IRS form letter but was specifically crafted for micro-captive transactions.

There is no need to respond to the letter unless you have shut down your captive in the last few years.

It has no legal effect and is nothing new.

The IRS is attempting to induce business owners to abandon their captives.

The letter advises taxpayers that the IRS has won “several” Tax Court cases on the basis that “certain micro-captive arrangements are not eligible for claimed Federal tax benefits”.

What the letter leaves out is that these “several cases” refer to only three, of which one has been appealed. Additionally, arrangements that lost in Tax Court had issues that are no longer generally present in the industry.

The captive insurance industry is hopeful to get a fair hearing in the Appeals Court.

So, what should you do in response to this letter?

As long as you formed your captive for legitimate business reasons, you can and should maintain your captive.

In addition, if your captive made an election under section 831(b) of the Internal Revenue Code, you must continue to attach a Form 8886 to your tax returns.

This includes not only the captive, but the insured business and the owners of the captive and the insured business.

Furthermore, the IRS letter suggests that you consult with your independent tax advisor. This is a good idea, and something that we always recommend.

Conclusion

It is no secret that the IRS does not like micro-captives and that it has been threatening increased audits for several years. And, this letter may forecast increased audit activity.

However, a captive insurance company is a legitimate risk management tool.

In addition, Congress specifically provided a tax benefit for small insurance companies, both captives and non-captives.

Small and mid-sized businesses should not let the IRS scare them from implementing a legitimate risk management tool; especially at a time when the commercial market is hardening.

Do you have more questions about this letter?

Please feel free to comment below or contact us for help.

Categories
Retirement Plans

Prototype Restatement: Best Practice for a Retirement Plan

If you have a client with an existing qualified retirement plan or who is thinking about adopting a qualified retirement plan, we want to talk to you about our prototype plan document.  Using a prototype plan document is one of the best ways to control the cost of maintaining or adopting a qualified retirement plan.  A custom plan document could cost as much as three times the cost of a prototype document.  In addition, whether your client uses a custom or prototype document, the IRS requires that all plan documents be updated to reflect regulatory changes.  Because an administrator can spread the cost of updating a prototype plan document over its many clients, the cost of updating a prototype plan document is much less than the cost of updating a custom plan document.

RMC Group has a proprietary defined benefit plan document, which has been updated and approved by the IRS as of March 30, 2018.  We are currently restating the plan document of each defined benefit pension plan, which we administer.  Restating an existing plan document is necessary, because, in the event of an IRS audit or plan termination, the IRS will want to see that the document has been updated.

If you have a client, who is thinking about adopting a defined benefit pension plan, you should recommend that your client use our prototype plan document.  The cost is much less than a custom plan document, and, because our prototype plan document has been approved by the IRS, your client can be assured that its plan document meets the requirements of the Code and IRS regulations.  In addition, if you have a client, who does not already use the RMC Group to administer its plan, we are happy to restate your client’s existing plan document.  Again, because our prototype plan document has already been approved by the IRS, we can save your client time and money.  Our fee for the restatement of existing plan documents is $2,500.

Whether you are looking to install a new plan or restate an existing plan, call the RMC Group to see how we can help.  You can contact us at 239-298-8210 or at [email protected].  We look forward to helping you.