When Is Insurance Not Insurance?

New tax guidance adds a clarification and eliminates a tax deduction for some small-business owners.
Marie LeoneJune 30, 2005

The Internal Revenue Code doesn’t define it; neither do tax regulations. To understand what constitutes an insurance arrangement for tax purposes, the best guidance remains the definition handed down by the Supreme Court in its 1941 decision Helvering v. LeGierse. The justices concluded that two criteria must be met: Risk of economic loss must be transferred, and it must be distributed among several parties.

A company whose arrangements meet those criteria is entitled to claim a federal tax deduction for its premium payments. In Revenue Ruling 2005-40, issued June 21, the Internal Revenue Service further clarifies when such deductions are allowable.

In one notable instance, the ruling disallows the premium deduction for a company that is the sole client of an insurance company. Since such coverage fails to spread risk among more than one policyholder, the IRS maintains, it does not qualify as a true insurance transaction. In effect, say IRS officials, these single policyholders are simply insuring themselves. In the eyes of the federal government, the transaction might be considered a deposit, a loan, a contribution to capital, or a non-insurance indemnity arrangement — none of which are tax-deductible — but it wouldn’t be considered insurance.

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IRS officials stress that the ruling does not call into question the vast majority of insurance contracts that are issued by commercial insurance companies in the ordinary course of business.

Rev. Rul. 2005-40 also aims to clear up any taxpayer confusion regarding single-member limited liability companies, which conceivably could have been used to sidestep the distribution-of-risk issue.

A single-member LLC is a wholly-owned subsidiary of a sole-owner business, and an alternative to a sole proprietorship, an S corporation, or a C corporation; it’s often formed to secure corporate-style protection without saddling the subsidiary with corporate taxes. For example, a small trucking company could set up a separate single-member LLC for each of its 10 trucks. Generally, the trucks would operate as independent businesses, but all assets, liabilities, and taxes would flow up to the trucking company. For tax purposes, the LLCs would be “disregarded” entities and not subject to tax collection.

In this instance, the IRS suggests, the trucking company might also maintain that it is not the sole client of an insurer, but just one of many — namely, the LLCs as well as the company itself. Therefore, the argument might follow, the insurer’s risk is spread among a number of policyholders, and the trucking company should be eligible for the tax deduction.

Unfortunately for the trucking company and other such hypothetical businesses, the IRS doesn’t see it that way. A business cannot claim to be a single company for general tax purposes yet multiple companies for insurance tax purposes.

While the ruling specifically cites single-member LLCs, IRS spokesman John Lipold says that there was no particular catalyst for issuing Rev. Rul. 2005-40 last month. According to Lipold, over the years the agency has received a number of letters requesting rulings on the topic, as well as questions at conferences and other public events. The timing of the ruling was simply the “regular process that spurs guidance,” he says.

Although the new ruling “does not add a tremendous amount of knowledge” to the tax code, says Leman Brothers tax expert Robert Willens, “it may be incrementally helpful.” Willens believes that the IRS ruling was the agency’s way of telling small-business owners that they “won’t get away with this kind of activity any more.”