When Does a ‘Protected Cell’ Fail the IRS Test?

Protected cell companies don't always past muster as an insurance captive.

ABC Inc. owns all of the common stock of Alpha PCC. All of the non-voting preferred stock associated with each cell (akin to a tracking stock) is owned by the cell’s participant. Each cell is funded by the particular participant’s capital contribution (the amount it paid for the non-voting preferred stock) and by the “premiums” it paid with respect to the contract it enters into with the cell. In the event a participant ceases its participation in Alpha PCC, the participant is entitled to a return of the net assets of the cell.

The participant in this case, X Corp., owns all of the preferred stock issued with respect to Cell X; and Cell X insures the risks of X Corp. The IRS ruling indicates that X Corp. does not provide any guarantee of Cell X’s performance, and Cell X does not loan any funds to X Corp. In fact, Cell X is deemed to be “adequately capitalized.” Also, Cell X does not enter into arrangements with other entities, other than with X Corp.

Based on the general guidelines with respect to risk-shifting and risk distribution, the IRS ruling found that the first scenario does not constitute insurance. Here’s why. In event of a claim, payment will be made to Corp. X out of its own premiums and contributions to capital. The arrangement, therefore, is akin to an arrangement between a parent and its wholly-owned subsidiary which, in the absence of unrelated risk, sorely lacks the requisite degree of risk shifting and distribution. Thus, the arrangement does not constitute an insurance contract and Corp. X, because it is essentially in a “self-insurance” mode, may not deduct the amounts it pays as insurance premiums.

The second IRS scenario plays out differently. In that case, Y Corp. owns all of the preferred stock issued with respect to Alpha PCC’s Cell Y. Further, Y Corp. owns all of the stock of 12 subsidiaries each of which provides professional services. The categories of professional services provided by each subsidiary are the same, giving the subsidiaries a significant volume of independent, homogenous risks. Cell Y insures the risks of each subsidiary and none of the subsidiaries have liability coverage for less than five percent or more than 15 percent of the total insured risk.

Neither Y Corp. nor any of its subsidiaries guarantees the performance of Cell Y. And Cell Y does loan any funds to Y Corp. or to any of its subsidiaries. In this case, Cell Y is a “captive” entity in the sense that it does not enter into any arrangements with entities other than Y Corp. or its subsidiaries. Cell Y, like Cell X, is adequately capitalized relative to the risks it has assumed under the arrangements with the subsidiaries of Y.

As a result, in the second scenario, the subsidiaries in question shifted their risks to Cell Y in exchange for premiums. Here, however, unlike the first case, the premiums paid are “pooled” such that a loss by one subsidiary in not, in substantial part, paid from its own premiums. Had the subsidiaries entered into an identical arrangement with a sibling corporation that was registered as an insurance company, the arrangement, quite clearly, would constitute insurance because it entails both risk shifting and distribution.

Accordingly, because the qualification of an arrangement as an insurance contract does not depend on the regulatory status of the issuer, the arrangement between the subsidiaries of Corp. Y and Cell Y is properly classified as insurance with the result that the premiums paid by the insured subsidiaries of Y are fully deductible.

Despite the limited history of PCCs, the IRS was able to apply longstanding principles to analyze the nature of the arrangements. And by following those principles, the tax agency concluded that the use of a PCC cannot, in the absence of risk shifting and distribution, permit a financial arrangement to be classified as insurance.

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