Insurance is not always easy to recognize.
The issue is important for wind farms and low-income housing deals in which investors are offered a minimum guaranteed return through arrangements that sometimes look like insurance. It is also important to deals where third parties protect a synfuel plant or landfill gas project owner against risk of loss of section 29 tax credits due to high oil prices.
How a relationship between two parties is characterized for tax purposes has economic consequences. What looks like an insurance contract may be a partnership, loan, capital contribution or indemnity contract in substance — rather than insurance — the IRS warned in late June in a revenue ruling. Payments to an insurer are deductible as premiums. Payments under other arrangements may not be.
The IRS analyzed four fact patterns in the ruling in June. It said insurance requires both a shifting of risk to the insurer and a distribution of the risk by the insurer among a pool of insured parties. Thus, in one of the fact patterns, a company like United Parcel Service entered into an arrangement with a third party where, for payment of a “premium,” the third party insured UPS against business losses. The IRS said this was not insurance because there was no risk distribution.
Risk distribution requires “the statistical phenomenon known as the law of large numbers,” the IRS said, where premiums are pooled from a number of companies seeking risk protection so that, if a claim has to be paid, the burden is shared among them and is not borne entirely in a two-party bet by the “insurer.” The ruling is Revenue Ruling 2005-40.