Wednesday, April 13, 2011

Doctors' Captive Insurance Arrangement Gets Clean Bill Of Health

PLR 201114015

In a new private letter ruling, IRS gave its OK to a captive insurance arrangement set up by a number of medical practices. The arrangement exhibited sufficient risk shifting and risk distribution to be treated as insurance for income tax deduction purposes.

Background. Premiums for insurance against various types of business risks, such as property damage or professional liability, are generally deductible as business expenses. (Code Sec. 162; Reg. §1.162-1(a)) Payments to “captive” insurance subsidiaries or other similar arrangements are not deductible where there's no true risk shifting. A limited deduction is allowed, however, for certain payments made to a medical malpractice self-insurance pool.

Under Code Sec. 263, no deduction is allowed for any amount paid for permanent improvements or betterments made to increase the value of any property or estate. Under Reg. §1.263(a)-4(d)(3), prepaid expenses, such as prepaid insurance, must be capitalized.

Neither the Code nor the regs define the terms “insurance” or “insurance contract.” The U.S. Supreme Court has said, however, that both risk shifting and risk distribution must be present for an arrangement to be treated as insurance. (Helvering v. LeGierse, 25 AFTR 1181, 312 US 531 (1941))

IRS says that:

... Risk shifting occurs if a person facing the possibility of an economic loss transfers some or all of the financial consequences of the potential loss to the insurer, so that an actual loss won't affect the insured because the loss is offset by the insurance payment.

... Risk distribution allows the insurer to reduce the possibility that a single costly claim will exceed the amount taken in as premiums and set aside for the payment of such a claim. By assuming numerous relatively small, independent risks that occur randomly over time, the insurer smooths out losses to match more closely its receipt of premiums. (Clougherty Packing Co v. Com., (1987, CA9) 59 AFTR 2d 87-668, 811 F2d 1297, affg (1985) 84 TC 948) Risk distribution necessarily entails a pooling of premiums, so that a potential insured is not in significant part paying for its own risks. (Humana Inc v. Com., (1989, CA6) 64 AFTR 2d 89-5142, 881 F2d 247)

Rev Rul 2002-90, concerns a situation where twelve domestic subsidiaries provide professional services in separate states and are all owned by Parent. Together the twelve subsidiaries have a significant volume of independent risks that are of the same or similar nature. Parent, for a valid non-tax business purpose, forms Sub as a wholly-owned insurance subsidiary licensed in all states where the operating subsidiaries do business. Sub directly insures the professional liability risks of the twelve operating subsidiaries and charges each arms-length premiums. None of the operating subsidiaries have liability coverage for less than 5%, nor more than 15%, of the total risk insured by Sub, which retains the risks that it insures from the operating subsidiaries. There are no parental (or other related party) guarantees made to Sub and in all respects, the parties conduct themselves as unrelated parties would. Sub doesn't provide insurance coverage to any entity other than the twelve operating subsidiaries.

Rev Rul 2002-90, concludes that the professional liability risks of the twelve operating subsidiaries are shifted to Sub, and that the premiums paid by them are pooled such that a loss by one operating subsidiary is borne, in substantial part, by the premiums paid by others. The arrangements between Sub and each of the twelve operating subsidiaries of Sub's parent are insurance for tax purposes.

Passing muster as insurance. In essence, PLR 201114015 demonstrates how a medical capital insurance group can pass muster under IRS's pre-existing guidance. It involves Medical Practice, an LLC treated as a partnership for federal tax purposes, which provides physician services to hospital centers and surgery centers. It, together with an undisclosed number of other medical practices, will form Risk Retention Group (RRG) to issue insurance policies providing (1) medical malpractice liability coverage for active physicians and practices that are underserved by the commercial professional malpractice insurance market, and (2) “tail” or extended reporting endorsement coverage for retired physicians and practices.

A number of the other practices are LLCs whose sole owner is another practice and which are treated as disregarded entities for federal tax purposes. Medical Practice is majority-owned by Holding Company, which in turn has varying degrees of ownership interests in most of the other practices. Of the remaining practices, which are not treated as disregarded entities for federal tax purposes, Holding Company owns a majority interest in an undisclosed number of Practices (including Medical Practice), has a minority interest in other practices, and has no ownership interest in still other practices. The initial members/owners of the RRG will be the practices, each of which will own an equal share in the entity. As the core operations grow and expand, additional entities are expected to join the membership and attain a pro-rata share of RRG's ownership.

Based on the following carefully tailored facts, the private letter ruling concludes that amounts paid by Medical Malpractice to RRG for medical malpractice liability insurance are treated as “insurance premiums,” to the extent that such premiums are for current-year coverage:

... RRG will be registered, admitted, and regulated by the a state department of insurance, and licensed as an association captive insurance company. It will be managed internally and it will maintain all responsibility for underwriting, policy service, claims and risk management, financial management and reporting, and reinsurance procurement and administration.

... RRG will issue policies with standard limits of liability up to a fixed amount per claim and an annual aggregate to physicians providing medical services under the relevant practice's contract. RRG will retain the risk for part of each claim and buy reinsurance for the balance.

... Premiums for both medical professional liability coverage and any extended reporting (or “tail”) coverage will be determined at arms-length. A risk management and actuarial consulting firm will develop premium rates, by state, for RRG risks. Underwritten physicians will be rated according to a scoring system based on training, loss history, and other underwriting factors.

... All base premium rates will be developed after a review of the rates of the market leaders in each state, and rates will continue to be developed utilizing publicly available data of other insurers within each respective state. The goal of the pricing of premiums for the various states and business segments will be parity relative to expected losses.

... No individual practice will encompass more than 15% of the total risk pool of RRG; there will be no guarantees by any of the practices in favor of the RRG with any bank, lending institution, or other entity; and that there will be no loans from RRG to Medical Practice or any other practice.

Observation: In Steger, Merlin A., (1999) 113 TC 227, the Tax Court held that a professional's entire cost of “nonpracticing” malpractice insurance coverage, purchased by him in the year of his retirement, and covering him indefinitely, but only for acts, errors or omissions in professional services rendered before his retirement, was fully deductible in the year of his retirement. The case dealt with an attorney, but the result should be the same for a physician as well.

References: For insurance and risk sharing, see FTC 2d/FIN ¶L-3157 et seq.; United States Tax Reporter ¶1624.032; TaxDesk ¶304,425 et seq.; TG ¶16335.

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