Captive Insurance: Too Good to Be True?

Is Captive Insurance Too Good To Be True?
By: Mark L. Nachbar, Principal, Ryan

The Maryland Tax Court said essentially just that in its opinion in Leadville Insurance Company v. Comptroller of the Treasury.1 The court acknowledges that “the predominant complaint to Leadville’s position that it is not subject to the Maryland income tax, is that it ‘defies logic or common sense.’” However, the court found that the Maryland Legislature did, in fact, mean that for insurance companies, the premiums tax is imposed in lieu of all other taxes, including the corporate income tax.

The controversy began when one of Macy’s Inc. (“Macy’s”) subsidiaries (“MRHI”) was audited by the state of Maryland. The audit revealed that MRHI claimed substantial deductions for interest paid to its sister company, Leadville Insurance Company (“Leadville”). Leadville is a captive insurance company formed under the laws of Vermont. It provides insurance for Macy’s subsidiaries and affiliates. For the audit years 1996–2003, Leadville earned more than $2 billion in intercompany interest compared with $52 million in insurance premiums. Maryland assessed Leadville more than $23 million in tax, interest, and penalties on the interest income. The Comptroller claimed that Leadville did not qualify as an insurance company and was therefore subject to Maryland’s corporate income tax.

In Maryland, as in many other states, insurance companies are taxed solely on their premiums in lieu of all other taxes. Therefore, at the circuit court level,2 the Comptroller argued that because Leadville was regulated by the laws of Vermont and did not pay premiums taxes in Maryland, it was not able to qualify for the exemption from corporate income tax. The circuit court ruled that Leadville was an “unauthorized” insurer in the state of Maryland and remanded the matter to the Maryland Tax Court.

In the 2020 decision,3 the Maryland Tax court confirmed that the exemption for corporate income tax applied both to authorized and unauthorized insurers in the state of Maryland. The court found that the Comptroller’s position that not taxing the interest income received by Leadville “defied logic and common sense” and was a dismissive interpretation of the plain meaning of the law and intent of the Legislature. The court found Leadville exempt from the Maryland corporate income tax.

This case is very similar to the Illinois case, Wendy's International, Inc. v. Hamer.4 In that case, the Illinois Department of Revenue also sought to not treat a captive insurance company formed under Vermont law as an insurance company for Illinois tax purposes. The Illinois Appellate Court ruled that if the company met the federal provisions for risk shifting and risk distribution, and the company was not formed as a sham business or lacked business purpose, it must be respected as a bona fide insurance company for Illinois tax law purposes.

However, had this fact pattern been tried in New York, we would have seen a different outcome. The New York Legislature has specifically singled out captive insurance companies under the tax law. If a captive insurance company meets four requirements, it will be taxed as a regular corporation under New York law. The first three requirements contain tests to determine whether the company is a captive insurer. The fourth requirement specifically addresses the issue in the Leadville scenario. A company will not be considered an insurance company if “50 percent or less of its gross receipts for the taxable year consist of premiums.”5 Thus in New York, Leadville would not be considered an insurance company exempt from the corporate income tax, as over the audit period it received only 0.026 percent of its income from premiums.

If this fact pattern were considered by the Internal Revenue Service, it would also conclude that Leadville would not be considered an insurance company. To be an insurance company for federal income tax, more than half of its business must be issuing insurance or reinsurance contracts.6 The retention of retained earnings beyond the reasonable needs of the business is subject to an additional tax under Internal Revenue Code (IRC) § 531. Investment income is just as much a part of the business of insurance as underwriting, but at some point, it becomes the primary business. It is interesting that the Maryland comptroller never brought up the federal tests for insurance companies.

In conclusion, while at a passing glance captive insurance companies may appear to provide tax benefits that are too good to be true, the details in both state law, federal law, the business purpose, and operation of the captive will ultimately determine the tax benefits that a captive insurance company will sustain.

1 Leadville Ins. Co. v. Comptroller of the Treasury, Appeal No. 13-IN-OO-0035, Maryland Tax Court, July 13, 2020.
2 Comptroller of the Treasury v. Leadville Ins. Co., 2019 WL 1376046 (Md. Spec. App., March 26, 2017).
3 Leadville Ins. Co. v. Comptroller of the Treasury, Appeal No. 13-IN-OO-0035, Maryland Tax Court, July 13, 2020.
4 Appellate Court of Illinois, Fourth District, No. 4-11-0678, 2013 IL App (4th) 110678, 996 N.E.2d 1250, October 7, 2013.
5 N.Y. Tax Law § 2(11); N.Y. Tax Law § 210-C(2)(b).
6 IRC § 816(a).