Tax Law

Tax Risks Challenge Small Captive Insurers

by Marc T. Finer, William J. Kambas, and Ryan M. LoRusso

A captive insurance company is an insurance company formed primarily or exclusively to insure the risks of one or more affiliated businesses.  Many larger companies form captive insurance companies for the purpose of insuring against risk which is commercially uninsurable or for which the cost of insurance protection is unreasonable.  However, captive insurance companies have become an increasing popular strategy for estate and closely held business planning purposes due to the significant tax benefits they can provide.  Because of this increasing popularity and the attendant tax benefits they can provide, the IRS has begun to closely scrutinize captive insurance companies and their owners.  In fact, the IRS has identified captive insurance on its annual "Dirty Dozen" list of abusive tax schemes seemingly focusing on small captive insurance companies owned by closely held entities.  These captives often involve "poorly drafted insurance binders and policies covering ordinary business risks or esoteric, implausible risks for exorbitant premiums, while maintaining…economic coverage with traditional insurers." 

Aside from the tax benefits, many close-held businesses can derive significant economic benefits from a captive insurance company.  If a business consistently experiences very few insurable losses, a captive can allow a business to retain the underwriting "profit" that results.  In other words, when businesses obtain commercial insurance, those with better loss mitigation programs will tend to be subsidizing those businesses with less advanced or even no such program.  A captive allows the business with the more sophisticated loss mitigation program or more favorable loss experience to capture that benefit.  Additionally, the business can still continue to rely on commercial insurers to provide coverage beyond a given risk retention limit.  The captive also allows the affiliated group an opportunity to earn investment income on the premium paid to the captive before any losses are paid.    For example, if properly structured, a captive can earn an investment return on the premium float allocable to low-severity risks below a given retention level, while obtaining protection from a commercial insurer against a high severity loss. 

For those businesses where a captive can provide an economic benefit, a tax benefit is also available.  The tax benefit of forming and operating a "small" captive insurance company can be found in Internal Revenue Code Section 831(b) which was enacted to create an incentive for smaller businesses to form small property and casualty insurance companies ("small captives").  Unlike large insurance companies, "small captives" qualifying under Section 831(b) are not subject to tax on premium income provided the captive's premiums received for the taxable year do not exceed $1.2 million (Effective January 1, 2017, the $1.2 million limit increases to $2.2 million annually and becomes indexed for inflation).  Rather, small captives are taxed solely on investment income earned during the taxable year.  Furthermore, the small captive provides a tax benefit to its owner in the form of a Section 162 ordinary and necessary business deduction for premiums paid to the small captive and dividends paid from the small captive's earnings and profits are treated as qualified dividends eligible for taxation at currently favorable rates.     

In order to qualify as an insurance company for federal income tax purposes, all captives, large or small, must meet specific qualifications, including:

  1. must be formed for a solid business purpose;
  2. premiums paid must be appropriate;
  3. risks being insured must be insurable (i.e., there must be a likelihood of a future risk of loss event occurring and a quantification of the possible loss);
  4. the captive must operate like an insurance company;
  5. the elements of risk shifting (i.e., transfer of risk to the captive) must exist; and
  6. risk distribution (i.e., risk pooling) must exist.

Where the entity lacks a genuine insurance purpose and instead provides a tax shelter for its owners, the IRS or courts will likely view the arrangement as a sham.  For example, a 2014 Fifth Circuit decision highlights the IRS's heightened scrutiny of captive insurance arrangements and indicates that the IRS is willing to impose monetary penalties where a taxpayer uses a captive insurance arrangement for purposes other than true insurance.  In Salty Brine I, Ltd. v. US, 2013 U.S. Dist. LEXIS 98509 (N.D. Tex. 2013) aff'd 761 F.3d 484 (5th Cir. 2014), the Court of Appeals upheld the IRS's imposition of the 20% penalty for underpayment of tax based on negligence or disregard of rules or regulations where, as part of a captive insurance arrangement, the taxpayer purchased business protection policies (BPPs) to insure remote risks of its oil & gas businesses and deducted the BPP premium payments as an ordinary and necessary business expense.  The court found that the arrangement was not true insurance, in part, because (1) premiums paid by the business were not actuarially determined but were instead based on the business's cash-flow budget for insurance, and (2) the transaction lacked the elements of risk shifting and risk distribution since the BPPs provided coverage against remote and implausible risks and the real risks to which the business was exposed were covered by commercial insurance policies.

In addition to being included on the IRS's annual list of tax scams and abusive structures, Section 831(b) has also been the subject of recently enacted legislation which is aimed at curbing abuse.  The Protecting Americans from Tax Hikes Act of 2015 (PATH Act) signed by President Obama in December 2015 now requires captive insurance companies to satisfy one of two diversification tests: (1) no more than 20% of total premiums can be derived from one policyowner, or (2) the ownership of the captive insurance company must mirror (within a 2% de minimis margin) the owner of the business or assets being insured.

In light of the increased scrutiny paid to captive insurance arrangements and recent legislative developments, it is important for taxpayers considering the implementation of a captive insurance arrangement to make sure it is properly structured.  This includes several key considerations which should be determined with the assistance of a knowledgeable professional legal and tax advisor, including:

  1. the insurable risks faced by the business;
  2. the actuarial premium rate for such insurable risks;
  3. the required capitalization and any investment limitations in accordance with state regulatory requirements; and
  4. whether the insurer qualifies as an insurance company for regulatory and tax purposes. 

With proper structuring, a legitimate captive insurance arrangement can be a powerful economic and tax planning tool for the appropriate business.  It can reduce the cost of doing business and provide a company with protection from the costs associated with business risk while providing substantial income, estate and asset protection benefits for both the business and its owners.