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Internal Revenue Code Section 831(b) and Small Captive Insurance Companies a must do or an IRS target?

Internal Revenue Code Section 831(b) and Small Captive Insurance Companies – A “Must Do” Idea or the Next Big IRS Target?

Captive insurance companies have been utilized by large corporations for years as a means to manage corporate risk, often providing coverage otherwise unavailable or unreasonably priced.  Indeed, according to The CPA Journal (June 2008), upwards of 80% of the Standard & Poor’s 500 companies use captive insurance programs.  However, driven in part by favorable tax law, in particular Internal Revenue Code (“IRC”) Section 831(b) enacted in 1986, mid-market and family businesses have increasingly been considering the merits of captive insurance.  Not surprisingly, solicitation of captive insurance into that market too has been on the rise.  So, what is captive insurance all about?  What are the potential benefits?  What are the risks?

Simply put, a captive insurance company (“captive”) is a bona fide insurance company that covers the insurable risks of affiliated entities (and others) and not just investment and/or credit risk.  Examples of risks that a captive might insure include property/casualty, general liability, employee benefits, business interruption, worker’s compensation, extended warranty, directors and officers and other self-insured items.  After the payment of losses and expenses, profits in the captive can be maintained for future claims or distributed as a dividend to shareholders or in liquidation. The captive must provide proper “risk shifting” (an operating company must show that it has transferred specified risks to the insurance company for a reasonable premium) and “risk distribution” (the captive must accept risks from multiple separate entities directly or by participating in a risk pooling (or reinsurance) arrangement with unrelated businesses.) 

The Internal Revenue Service (“IRS”) has issued guidance on arrangements it views as providing the requisite risk shifting and risk distribution and they include but are not limited to the following:

  • Risks of a parent cannot be insured by a captive subsidiary unless the captive has at least 50% of its risks insured by third parties;
  • Risks of 12 brother-sister operating corporations can be insured by a captive, to the extent the insureds each pay no more than 15% of the total premiums to the captive;
  • Risks of unrelated parties in a group captive can be insured by a captive so long as no one insured pays less than 5% or more than 15% of the total premiums to the captive; and
  • Risks of 12 single-member limited liability companies that are disregarded by their parent cannot be insured by the captive since all of the risk would be considered parent risk.  

What is the federal income tax treatment of a “small” captive?  In general, captives are taxed in a similar manner to insurance companies generally (other than life insurance companies).  However, in lieu of normal corporate tax on the taxable income of the insurance company, IRC Section 831(b) and other applicable tax code sections provide an alternative tax regime for small captives making a valid Section 831(b) election (which election cannot be revoked without the consent of the IRS).  IRC Section 831(b) as well other related IRC sections provide for the following:

  • Annual new written premiums (or if greater direct written premiums) received are tax-free if the total amount received does not exceed $1,200,000 (this applies only if more than 50% of the captive’s total revenue is from the issuance of insurance or annuity policies or reinsurance);
  • If properly structured, premium payments may be tax-deductible to the operating company;
  • The captive’s net investment income is taxed at regular “C” corporation income tax rates; and
  • A captive cannot carry forward net operating losses; also, underwriting losses may not be deducted against investment income.

State taxation of the captive, which depends on the state in which the captive is domiciled, also needs to be taken into account. 

From an estate planning perspective, the captive is an ideal asset to own with children and/or grandchildren because of its ability to accumulate premiums tax-free.   By sharing ownership with heirs, a business owner can shift the captive’s potentially significant accumulation of premiums without any gift or generation-skipping transfer tax implications.  Apart from the potential tax savings just described, there are other potential benefits which include:

  • Reduction in the amount of insurance premiums paid by the operating company;
  • Steadier premiums than in the non-captive market;
  • Better access to the reinsurance market;
  • Ability to insure risks that would otherwise be uninsurable;
  • Retention of the profit that would otherwise be made by an outside third-party insurance company;
  • Accumulation of premiums in the captive on a pre-tax basis in advance of future claims;
  • Ability to give key employees restricted ownership in captive through, for example, use of preferred stock, thereby incentivizing them and enhancing loyalty; 
  • Opportunity to accumulate wealth in a tax-favored vehicle;
  • Distributions to captive owners at tax-favored rates;
  • Asset protection from the claims of business and personal creditors; and
  • Opportunity for captive to operate as a profit center in providing insurance to third parties.

Nonetheless, establishing a captive insurance company is not without meaningful risk to all involved.  First and foremost, as previously noted, a small captive insurance company is an insurance company.  Managing corporate risks is therefore paramount; tax benefits and estate planning must be secondary though it can certainly be a significant incidental benefit.  There must be a valid non-tax purpose for the formation of the captive.  The IRS is acutely sensitive to how captive insurance is marketed and the motivations for its use, both legitimate and more suspect.  Risks being insured must truly apply to the business (for example, hurricane insurance in Colorado would be rather questionable), and the premium must reflect the likelihood of an insurable event.  There must be adequate risk shifting and risk distribution.  Similarly, in setting up a captive program, failure to engage in an actuarial study supporting the premiums to be made might be suggestive of a tax shelter rather than a business-driven arrangement, as would the failure to analyze the cost and availability of commercial insurance in a non-captive context.  If the captive does not satisfy the requisite requirements, the IRC Section 831(b) election will not be able to be made, or, if already made, could subject the captive, the operating company and their principals to unpleasant IRS scrutiny.  The election could be invalidated with rather unpleasant consequences -- including the payment of the underlying tax liability, plus interest and potentially significant penalties.  Many cases dealing with captives are presently being adjudicated in the courts.

Establishing a small captive insurance company may be appropriate in many business situations, but it requires a great deal of thought and careful analysis before being implemented.  There can be many benefits, but it can also create unnecessary and unanticipated headaches if addressed without competent professional advice.

 

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Richard Shapiro, Tax Director and member of EisnerAmper’s Financial Services and Corporate Tax Groups, has more than 40 years’ experience in federal income taxation, including the taxation of financial instruments and transactions, both domestic and international, corporate taxation and mergers and acquisitions.

About Jon Zefi

Jon Zefi in Tax Services provides tax planning and compliance advice with a focus on mergers and acquisitions, tax rate minimization and tax risk mitigation. Member New York State Bar Association and the American Bar Association Tax Sections.