IRS Gives Up on “Economic Family Theory”
Revenue Ruling 2001-31 (133 KB)Issued June 4, 2001
With this ruling, the Internal Revenue Service has acknowledged that it will no longer invoke and follow the “economic family theory” with respect to captive insurance transactions.
The courts have accepted that insurance involves the following elements of risk:
Risk Shifting
the transferring of the financial consequences of the potential loss to the insurer, and
Risk Distribution
allowing 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.
The sharing and distribution of the insurance risk by all the parties insured is essential to the concept of true insurance.
The “economic family theory” argues that where insurance risk has not been shifted or distributed outside the “economic family” there cannot be valid or bona-fide insurance contracts. Valid and bona-fide insurance contracts are essential in obtaining deductions for premiums paid to a related party insurer.
As an alternative to the “economic family theory,” the courts have historically employed a balance sheet test to determine if bona-fide insurance exists. Thus, where the risk of loss has been removed from the insured’s balance sheet, shift of risk has occurred.
Although the IRS has indicated that it will no longer invoke the “economic family theory” as an argument that risk has not shifted between related parties, the Service has indicated that it will continue to scrutinize each entity involved in an insurance transaction on many levels to determine if bona-fide insurance contracts exist.
These areas may include:
- Amount of capitalization of the insurance company
- Ability of the insurance company to pay claims
- Adequacy of corporate governance and formalities of the insurance company
- Financial performance of the insurance company
- Separate financial reporting for the insurance company