Revenue Ruling 83-75 and Premium Deductibility

Revenue Ruling 83-75 from the Internal Revenue Service (IRS) addresses whether a business can deduct premiums paid to its own insurance subsidiary, known as a captive insurance company. This ruling is for any corporate group that uses a captive to insure the risks of its various members. It establishes a distinction between payments the IRS will recognize as deductible insurance premiums and those it will view as non-deductible contributions to a self-insurance fund. The analysis provides a framework for structuring captive arrangements to align with federal tax law.

The Core Concepts of Insurance for Tax Purposes

For a payment to be considered a deductible insurance premium, the arrangement must conform to the concepts of what constitutes “insurance” in the eyes of the IRS. The two primary principles are risk shifting and risk distribution. These ideas have been established through a long history of court cases and IRS rulings, and understanding them is needed to grasp the tax treatment of captive insurance premiums.

Risk shifting occurs when a business transfers the potential financial consequences of a specific loss to another party. For example, a homeowner buys fire insurance, paying a premium to shift the financial burden of a potential house fire to the insurance company. Within a corporate structure, this means the financial impact of a loss must move from the operating business to the insurance entity.

Risk distribution involves the insurer pooling premiums from many different, independent sources to cover the losses of a few. The insurer collects premiums from a large group of policyholders, knowing that only a small percentage will likely file a claim in any given year. This spreading of risk across a broad base is what makes the insurance model work, similar to how a car insurer covers thousands of drivers.

The Factual Scenario and Holding of the Ruling

Revenue Ruling 83-75 presents a specific business structure to illustrate how these principles apply. The scenario involves a parent corporation with a number of separate operating subsidiaries. This parent company also owns a wholly-owned insurance subsidiary, and the parent and its subsidiaries all paid premiums to this single captive to insure their business risks.

The IRS analyzed the premium payments separately. For the premiums paid directly by the parent corporation to its captive, the IRS determined they were not deductible because no true risk shifting had occurred. Since the parent wholly owned the captive, any loss paid by the captive would still reduce the parent’s net worth, meaning the economic risk never truly left the parent entity.

In contrast, the IRS found that the premiums paid by the other subsidiaries to the captive were deductible as insurance expenses. From the perspective of each subsidiary, its risk was successfully shifted to another distinct legal entity—the captive. Furthermore, because the captive insured the risks of multiple “brother-sister” subsidiaries, it achieved risk distribution by pooling these independent risks.

Key Factors for Applying the Ruling

The deductibility of premiums hinges on whether an arrangement achieves risk shifting and risk distribution. While Revenue Ruling 83-75 provided a framework, the IRS’s position has been clarified over time. The analysis now focuses on the specific facts and circumstances of each captive arrangement.

Initially, the IRS’s reasoning was grounded in an “economic family” theory, which treated a parent and its captive as a single entity. The IRS has since abandoned this theory. It now places greater emphasis on whether sufficient risk has been pooled to be considered true insurance.

Subsequent rulings provide more concrete examples of what meets the standard for risk distribution. For instance, Revenue Ruling 2002-89 affirmed that a captive insuring 12 “brother-sister” subsidiaries had achieved adequate risk distribution. This was because no single subsidiary’s risk accounted for more than 15% of the total risk insured. The captive must insure a sufficient number of independent risk exposures to pool and distribute potential losses.

Determining Premium Deductibility

To assess if a captive insurance arrangement aligns with IRS requirements, a business must gather specific documentation. This information is what a tax advisor would need to analyze the substance of the transactions. Gathering these items provides the factual basis for determining whether the captive arrangement facilitates risk shifting and distribution, making the premiums a deductible business expense under Section 162 of the Internal Revenue Code.

• A clear diagram of the complete corporate structure, identifying the parent company, all subsidiary entities, and the captive insurer.
• Copies of the actual insurance policies issued by the captive to each insured entity, detailing the specific risks being covered, the policy limits, and the terms of coverage.
• A detailed schedule of all premiums paid, broken down to show the precise amount each individual subsidiary paid into the captive.
• A description of the types of risks being insured by each entity, which provides context for the arrangement.