The Insured Roll-Up – Where Are We?
by
P. Bruce Wright, M. Kristan Rizzolo and Saren Goldner1
In Humana Inc. v. Commissioner, 881 F.2d 247 (6th Cir., 1989), the Court stated, in
essence, that if premiums were paid from an operating subsidiary to a subsidiary which was a
captive insurance company there was a transfer of risk because the losses would be transferred
from the balance sheet of the operating subsidiary to the balance sheet of the captive which
would not occur if a premium payment were made from a parent company to such a subsidiary
that was a captive insurance company. Under the facts of Humana, there were numerous
subsidiaries.
In 2002, the Internal Revenue Service (“IRS”) published Rev. Rul. 2002-90, 2002-2 C.B.
985, which was to serve as a “safe harbor” ruling for taxpayers who wanted to comply with the
Humana case from the perspective of the IRS. In general, this ruling provided a safe harbor
involving 12 subsidiaries paying premium to an insurance subsidiary in circumstances in which
no one of the 12 subsidiaries accounted for more than 15% or less than 5% of the risk. For
practical purposes, this percentage of risk parameter has been applied in terms of the relative
amounts of premium paid by each of the operating subsidiaries to the captive. Thus, it is
contemplated that each of the 12 subsidiaries would have risk being insured with the subsidiary
insurer.
In 2005, the IRS issued Rev. Rul. 2005-40, 2005-2 C.B. 4, in which it considered the
following fact pattern among others:
X, a domestic corporation, operates a courier transport business
covering a large portion of the United States. X conducts the
courier transport business through 12 limited liability companies
(LLCs) of which it is the single member. The LLCs are
disregarded as entities separate from X under the provisions of §
301.7701-3 of the Procedure and Administration Regulations. The
LLCs own and operate a large fleet of automotive vehicles,
collectively representing a significant volume of independent,
homogeneous risks. For valid, non-tax purposes, the LLCs entered
into arrangements with Y, an unrelated domestic corporation,
whereby in exchange for an agreed amount of “premiums,” Y
“insures” the LLCs against the risk of loss arising out of the
operation of the fleet in the conduct of their courier business.
None of the LLCs account for less than 5%, or more than 15%, of
the total risk assumed by Y under the agreements.
1
Mr. Wright and Ms. Rizzolo are partners and Ms. Goldner is counsel in the tax department of Sutherland Asbill &
Brennan LLP. Mr. Wright and Ms. Goldner are located in New York and Ms. Rizzolo in Washington, D.C.
It concludes that:
Y contracts only with 12 single member LLCs through which X
conducts a courier transport business. The LLCs are disregarded
as entities separate from X pursuant to § 301.7701-3. Section
301.7701-2(a) provides that if an entity is disregarded, its activities
are treated in the same manner as a sole proprietorship, branch or
division of the owner. Applying this rule in Situation 3, Y has
entered into an “insurance” arrangement only with X. Therefore,
for the reasons set forth in Situation 1 above, the arrangement
between X and Y does not constitute insurance for federal income
tax purposes.
Thus, the IRS takes the position in the ruling that the assets of the LLC, which is a
disregarded entity, “roll-up” to the single member.
A seminal internal legal memorandum the IRS drafted in 1999 illustrates the IRS’s first
acknowledgement that a single member LLC must be regarded in certain circumstances. In ILM
1999-30-013, the sole member of a disregarded entity (the “taxpayer”) performed services and
directed that payment for the services be made to the disregarded entity rather than to the
taxpayer. The question presented was whether the IRS could file a lien against the disregarded
entity in an effort to collect taxes owed by the taxpayer on the ground that the disregarded entity
was disregarded for federal tax purposes and had a single owner. The IRS, citing United States
v. National Bank of Commerce, 472 U.S. 713 (1985), and Aquilino v. United States, 363 U.S.
509 (1960), noted that state law determines the nature of a person’s interest in property for
purposes of determining whether a tax lien or levy attaches. Accordingly, the IRS looked to the
state law that governed the disregarded entity to determine what property interest the taxpayer
had in the property owned by the disregarded entity. Under the applicable state law, a member
of an LLC had no property interest in the property owned by the LLC; rather, a member of an
LLC only had a property interest in any distributions due to it from the LLC.
Accordingly, the IRS determined that it was prohibited from filing a lien against the
disregarded entity in an effort to collect taxes owed by the taxpayer because the taxpayer did not
own the property owned by the disregarded entity.
In Revenue Procedure 99-6, 1999-1 C.B. 187, the IRS explicitly addressed the issue
whether an LLC that is treated as a disregarded entity that was an employer under state law
should be treated as the employer for tax purposes, or whether the LLC’s owner should be
treated as the employer for such purposes. The IRS concluded that either the LLC or its parent
could file the tax returns. The IRS also concluded, however, the parent was ultimately liable for
the taxes of both itself and the subsidiary LLC regardless of whether the LLC or its parent filed
the tax returns, presumably because the IRS determined that an entity would be disregarded
under the disregarded entity rules for all tax purposes, including employment tax purposes, even
in apparent conflict with state law. The IRS noted that the fact that the LLC was treated as the
employer for state purposes and the owner/parent was the employer for federal purposes could
create administrative difficulties for employers, but concluded that, as a substantive matter, it did
2
not change the ultimate fact that the parent could always be held liable if the LLC did not pay the
relevant taxes. 2
In T.D. 9356, promulgating Final Regulations in 2007, the IRS reversed its position, and
concluded that the employees should be treated as employees of the LLC and not the parent for
employment tax purposes. In the Proposed Regulations first setting forth its change in position,
the IRS indicated:
Administrative difficulties have arisen from the interaction of the
disregarded entity rules and the federal employment tax provisions.
Problems have arisen for both taxpayers and the IRS with respect to
reporting, payment and collection of employment taxes, particularly
where state employment tax law also sets requirements for reporting,
payment and collection that may be in conflict with the federal
disregarded entity rules. The Treasury Department and the IRS
believe that treating the disregarded entity as the employer for
purposes of federal employment taxes will improve the administration
of the tax laws and simplify compliance.
While the Preamble seems to rely heavily on administrative concerns in rendering its
ultimate conclusion, the IRS also decided to limit liability for employment taxes to the
disregarded entity. Apparently, the IRS decided to rely on state law to determine an employer
for U.S. tax purposes; it was administratively unworkable to allow the disregarded entity rules to
preempt this state determination.
In Technical Advice Memorandum 200816029, the IRS took the position that in
determining whether an entity should be treated as an insured party for federal income tax
purposes, the IRS looked to state law to determine whether the entity itself was liable for the
insured loss or whether the liability for such loss was held by the owner of the entity. The IRS
concluded, in part:
If the entity classified as a partnership for federal income tax
purposes is of the type that does not have a general partner(s); that
is, under applicable law no liability of the entity can in the ordinary
course attach to anyone other than the entity, it is the entity that
should be considered the insured under liability coverage for
purposes of evaluating whether an arrangement constitutes
insurance for federal income tax purposes.
It noted that in the case of a multiple-member LLC, none of the members is exposed to liability
in excess of the LLCs assets and, as such, it is the entity and not the partners that should be
treated as the insured party for purposes of determining whether an arrangement constitutes
insurance.
2
The IRS litigated this position successfully in several cases. See L&L Holding Company, LLC v. United States,
No. 05-0794-A, slip po. (W.D. La. April 30, 2008); McNamee v. Dept. of Treasury, 488 F.3d 100 (2d Cir. 2007);
Littriello v. United States, 484 F.3d 372 (6th Cir. 2007). All of these cases cited judicial deference to the check-thebox regulations and concluded that disregarding the LLC for employment tax purposes was not arbitrary or
capricious. McNamee, 488 F.3d at 109.
3
In Suzanne J. Pierre v. Commissioner, 133 T.C. 24 (2009), the Tax Court in a gift tax
case similarly took the position that transfers of interests in an LLC treated as a disregarded
entity should be treated as such rather than a transfer of the underlying assets and, accordingly,
that the LLC should be regarded for gift tax purposes. See also, ReRI Holdings I, LLC v.
Commissioner, TC Memo 2014-99 (2014).
In Rent-A-Center v. Commissioner, 142 T.C. 1 (2014), the Tax Court took the position
that given a Humana structure, i.e., a number of subsidiaries, paying premium to a sister
company captive, a deduction would be available not based on the number of such operating
subsidiaries but on independent exposure units. In Securitas v. Commissioner, T.C. 2014-225,
the Tax Court again took this position. Although the cases leave open some issues as to how the
Court will define the term “independent exposure limits,” the application of Rev. Rul. 2005-40
would clearly have adverse implications on any benefit these cases may provide in the event the
subsidiaries involved are single member LLCs treated as disregarded entities for federal income
tax purposes.
In Healthmark Group Ltd., Gregory Lentz a Partner Other than Tax Matters Partner v.
Commissioner, Docket No. 8269-14, the IRS had apparently disregarded eight subsidiaries
formed as single member LLCs and had denied a deduction for premium paid to a sister captive.
On March 27, 2015, a decision was entered apparently stipulating an entry of judgment pursuant
to which all such deductions were allowed.
Thus, after ten years, it may be that the IRS is moving away from its position in 2005-40
which on its face appears to be inconsistent with this recent stipulated decision.
4