The Tax and Other Benefits of Forming a Captive Insurance Company
Captive insurance companies are often used by large corporations to lower their insurance costs and are often created in offshore tax havens. However, small, closely held companies can take advantage of a number of tax and business benefits if they set up their own captives. These captives can be set up in the jurisdiction that makes the most sense for the captive’s business
Captive insurance companies are formed for both economic and risk management purposes. For example, by forming a captive insurance company, a business can dramatically lower insurance costs in comparison to premiums paid to a conventional property and casualty insurance company. By establishing one’s own insurance vehicle, costs for overhead, marketing, agent commissions, advertising, etc., may result in significant savings in the form of underwriting profits, which can be retained by the owner of the captive company.
Additionally, a captive insurance company can provide protection against risks which prove to be too costly in commercial markets or may be generally unavailable. The inability to obtain specialized types of coverage from commercial third-party insurers is another reason why clients may choose to establish a captive insurance company. With a captive insurance company, a business owner can address their self-insured risks by paying tax deductible premium payments to their captive insurance company. To the extent the captive generates profits, those dollars belong to the owner of the captive.
In general, your captive insurance company will be capable of delivering better service to your operating company than a commercial insurance company can.
The formation of a captive insurance company is a lengthy process including feasibility studies, financial projections, determining domicile, and, finally, preparing and submitting the application for an insurance license. A professional captive manager, risk management expert and actuary should be engaged to help you to determine the best balance between coverage retained from commercial carriers and your captive insurance carrier, and an appropriate amount of premium to be paid for the coverage being provided. Premium payments made by the operating company to the captive insurance company for property and casualty insurance coverage should be tax-deductible as an ordinary and necessary business expense, just as they would be treated had they been made to a traditional insurance company.
The use of a captive should be considered for entities that meet the following criteria:
The tax benefits associated with captives can sometimes cause business owners to forget that the captive must operate as a true insurance company. The use of an experienced and capable captive management company is an essential element of the normal operations of such an entity. The need for annual actuarial reviews, annual financial statement audits, continuing tax compliance oversight, claims management, and other regulatory compliance needs puts the day-to-day management of a captive insurance company beyond the skills of most general business people. Likewise, the involvement of the management company in the investment activities of the captive is essential from a planning perspective to assure that the captive’s liquidity needs are met.
A properly structured and managed captive insurance company could provide the following tax and nontax benefits:
For the premium payment to the captive to be deductible as an insurance expense, the captive must be able to prove that it is a valid insurance company (payments for self-insurance generally are not). Besides obtaining an insurance license from a state or a foreign jurisdiction, the captive must provide insurance to the operating company or its affiliates. Insurance is defined for tax purposes as including elements of risk shifting and risk distribution. To meet the risk-shifting requirement, the operating company must show that it has transferred specific risks to the captive insurance company in exchange for a reasonable premium.
Internal Revenue Code Section 831(b) provides that captive insurance companies are taxed only on their investment income, and do not pay income taxes on the premiums they collect, providing premiums to the captive do not exceed $2.2 million per year. Captive that try to “massage” their premium income need to be very careful because they are putting their tax election at risk as well as potentially putting the captive in jeopardy and the subject of potential scrutiny by the IRS.
In addition, abusive micro-captives have been a concern to the IRS for several years. The transactions have appeared on the IRS “Dirty Dozen” list of tax scams since 2014. In 2016, the Department of Treasury and IRS issued Notice 2016-66 (PDF), which identified certain micro-captive transactions as having the potential for tax avoidance and evasion.
Following wins in three recent U.S. Tax Court cases, the IRS decided to offer settlements to taxpayers currently under exam and started sending notices to up to 200 taxpayers.
The IRS has consistently disallowed the tax benefits claimed by taxpayers in abusive micro-captive structures. Although some taxpayers have challenged the IRS position in court, none have been successful. To the contrary, the Tax Court has now sustained the IRS’ disallowance of the claimed tax benefits in three different cases. The IRS will continue to disallow the tax benefits claimed in these abusive transactions and will continue to defend its position in court.
As discussed above the captive may retain surplus from underwriting profits within reserve accounts, free from income tax. It can also generate profits by controlling or eliminating costs for overhead, marketing, advertising, agent commissions, profits, etc., items normally built into the premiums charged by traditional insurance companies. After adjustment for expenses and claim payments, net underwriting profits are retained within the captive insurance company. Over the years, profits and surplus may accumulate to sizeable amounts, and may be distributed to the owners of the captive company, under favorable income tax rates as either dividends or long-term capital gains.
Amounts set aside as reserves for potential claims payments, plus capital surplus, should be maintained in safe, liquid asset classes so that the captive has adequate solvency to pay claims when called upon. The formation of the captive and eventual issuance of a certificate of authority to do business, are subject to approval by the insurance regulators in the jurisdiction where the insurance captive is formed. The insurance regulators will also oversee the organization and ongoing operation of the captive insurance company to assure ongoing compliance with the rules for that jurisdiction.
The planning, formation, and management of a captive are complex undertakings, and compliance with the formalities of running a true insurance company is mandatory. Establishing a captive insurance company is not feasible for all companies but, where appropriate, it can provide substantial tax and nontax benefits to successful shareholders and their families.