Rent-A-Captive Arrangements, Protected Cell Companies a/k/a Segregated Portfolio Companies
Rev.Ruling 2008-8 -- IRS kills deductibility of premium payments made to most rent-a-captive arrangement and segregated portfolio company arrangements, by holding that each cell must meet the risk distribution requirements as if it were a stand-alone captive. http://www.captiveforum.com/viewtopic.php?f=34&t=31
Where a business does not have enough of its own capital to start a captive, or where a license to sell a particular type of insurance is required, the business may enter into an arrangement with an existing and licensed captive to borrow the captive's facility so that the business can enter into a captive-like arrangement.
In a rent-a-captive arrangement, the captive usually issues a new class of preferred shares to the business owner. The business then purchases insurance from the captive and the business makes payments to the captive. The business owner may also be required to issue a letter of credit to the captive to protect the captive against any underwriting losses.
At the end of the policy period, any excess cash above underwriting losses is distributed to the business owner by way of dividends paid to the preferred stock shares, less of course whatever fee was charged by the captive to rent it. Thus, the business owner was able to realize the benefits of a captive in terms of the deduction within the business and to share in underwriting profits, but without having to bear the expense of creating a new captive. The trade-off is, of course, the fee paid to rent the captive.
Segregated Portfolio Captives
Some jurisdictions have passed legislation that allow for the so-called "segregated portfolio company". The legislation provides that within each portfolio, often called a "cell" or "series", that the assets and liabilities will be segregated from other assets and liabilities of the insurance company. Thus, if a particular cell underwrites risks but suffer losses in excess of its assets, then only that cell will be cleaned out and not the other cells of the company.
Segregated portfolio companies usually try to set up many cells for many insureds, sometimes hundreds, and rake in large rent-a-captive fees. While convenient for the promoter and to a degree convenient for those renting the cells, the arrangement is not without its problems.
While the segregated portfolio concept is interesting in theory, it has many theoretical problems and has never been proven under fire. The most serious problem is that the segregation of cells will probably not be respected outside the jurisdiction where the company is formed, and thus the other assets of the company could be exposed to creditors. In other words, Assume that there are 10 insureds using a segregated portfolio captive, and they have contributed $100,000 in capital each. If Insured #1 gets hit with a $5 million claim, however, the assets of the captive may be exposed to Insured #1's creditors because local law will not respect the internal liability segregation.
Moreover, despite the restrictions on liability of the rent-a-captive agreement, the creditor could still asset claims against all the assets of the company. This is because the creditor is not a party to the rent-a-captive agreement and not bound by its restrictions. The creditor may thus pursue all the assets of the rent-a-captive regardless of what the rent-a-captive agreement says.
Another significant concern goes to the taxation of rent-a-captives; since inRev. Ruling 2008-8 the IRS held that each cell must meet the risk distribution requirements of a captive generally for the premiums paid to that cell to be deductible to the underlying business.
The bad thing is that there are usually many diverse businesses lumped together in a rent-a-captive, and if one business is audited by the IRS then the odds are good that all other businesses that are participating in the rent-a-captive will have to bear the costs of an audit also.
As of the summer of 2007, we had identified no less than four scams involving rent-a-captives being run from variously the Bahamas, St. Lucia, Nevis and the British Virgin Islands (BVI). In most of these arrangements, business owners were told to purchase insurance from an offshore insurance company, take the deduction, and then the premiums would be distributed to either an unreported offshore trust for the business owner or else deposited into an offshore life insurance policy that the business owner is (falsely) told that he doesn't have to report. These arrangements are criminal tax evasion and if you have been caught up in one you need to get out of it immediately.
Another risk of rent-a-captives is that your assets and premium dollars may disappear. This has been the case with several such arrangements over the years, including the rent-a-captive arrangement put together by the Marc Harris Organization of Panama in the late 1990s. However, as recently as 2006, a rent-a-captive arrangement run from the British Virgin Islands through a licensed BVI insurance carrier called Boston Life and Annuity was alleged to have scammed up to $20 million from its policyholders and the BVI had belatedly stepped in to suspend its license.
Securities Laws Issues for the Renter
The party who rents the captive isn't the only one with problems. The party who is leasing the captive by way of issuing stock to the user also faces securities laws issues, if a U.S. person is involved. Suffice it to say that the involvement of securities counsel to work out these issues is critical.
The Bottom Line
At best, Rent-A-Captives are hinky arrangements with lots of theoretical problems and no case law that validates their benefits. At worst, Rent-A-Captives are scams where the odds of your losing your money is as great as your odds of being criminally prosecuted for offshore tax evasion. In either case, Rent-A-Captive arrangements are to be avoided.