But the agency nonetheless continues to challenge arrangements it deems to be nothing more than abusive tax shelters. It is more important than ever, therefore, that organizations comply with best practices that reflect IRS expectations for valid captive insurance companies. Those that do not comply could face significant negative tax ramifications.
Captive insurance in a nutshell
A captive insurance company is a legally licensed, limited-purpose property and casualty insurance company whose main business purpose is to insure the risks of its owners or companies affiliated with the owners through ownership, management, or control. Federal tax law allows a business to create a captive insurance company subsidiary to insure operating risks that are not covered by the traditional commercial insurance market (for example, cyberrisks, employment practices liability, and reputational damage) or where the available commercial coverage is too expensive. The parent company claims a tax deduction for the full amount of premiums paid to the captive subsidiary for the insurance.
The premium revenue generally is subject to federal income tax for the captive. Under IRC Section 831(b), though, small captive insurance companies (also known as micro captives) whose premium revenues fall under a certain threshold can elect to be taxed solely on taxable investment income, essentially making all premiums net of claims paid by the captive tax-free. The revenue threshold is $2.3 million for years beginning on or after Jan. 1, 2018, $2.2 million for years beginning Jan. 1, 2017, through Dec. 31, 2017, and $1.2 million for years beginning before Jan. 1, 2017.
Small captive insurance companies also must satisfy one of two diversification requirements set forth in the Protecting Americans From Tax Hikes Act of 2015 (PATH Act). This hurdle should not prove difficult for most financial services organizations’ captive insurance arrangements.
Captives under the microscopeThe IRS shows no signs of relaxing its stance on potentially abusive captive insurance arrangements. For example, certain micro captive structures that lack many of the attributes of genuine insurance arrangements have been identified as abusive tax shelters on the IRS’ annual “Dirty Dozen” list of tax scams since 2015.
Moreover, IRS Notice 2016-66 classifies certain micro captive insurance structures as “transactions of interest” that require taxpayer disclosure. The disclosure must identify and describe the transaction in sufficient detail for the IRS to understand the transaction’s tax structure and the identity of all parties involved in it.
The IRS also is conducting issues-based examinations to determine whether captives are operated for permissible business purposes rather than to avoid or evade tax. Several IRS examinations of captive insurance arrangements have landed in court in recent years, with more than 500 docketed court cases to date. (Read an in-depth examination of one such case, Avrahami v. Commissioner.) Like its predecessors Avrahami and Reserve Mechanical Corp. v. Commissioner, the most recent case (Syzygy Insurance Co., Inc. v. Commissioner) illustrates well the factors the IRS will weigh when determining a captive insurance arrangement’s legitimacy.
Best practicesTogether, case law, Notice 2016-66, and earlier revenue rulings provide valuable guidance to financial services organizations that wish to obtain the benefits of captive insurance. The revenue rulings, for example, demonstrate that the IRS looks for, among other things, commonly accepted notions of insurance, including:
- The captive has a valid, nontax business purpose (that is, the insurance is necessary).
- The captive is adequately, not “thinly,” capitalized.
- The captive has the ability to pay claims when they arise.
- The captive is a licensed and regulated insurance company in the state where it operates.
- The captive charges arm’s-length premiums, which are determined according to customary industry rating formulas and paid in a timely manner. No parental (or other related party) guarantees in favor of the captive exist.
- The captive does not loan any funds to its parent (or other related party).
- Whether the insurance covers implausible risks or duplicates existing coverage
- How the premiums compare with prevailing commercial insurance coverage with similar loss profiles
- How the premiums are allocated to each entity, if multiple entities are involved
- Whether the captive issues proper policies and binders on a timely basis
- Whether the feasibility was timely finalized before the establishment of the captive
- Whether the claims procedures are standard
- Whether the taxpayer files claims for all covered losses and the captive pays them in a timely manner after determination of validity
- Whether the captive has adequate liquid assets to cover losses
- Whether the captive invests in illiquid, speculative, or unusual assets
- What the captive does with its profits
- Whether there is risk shifting to the captive and risk distribution among policy holders
- If risk pooling is involved, whether those premiums and risk-sharing percentages are determined using underwriting and actuarial principles and methodologies
- Whether investments of the captive are appropriate
- Whether the captive operates as an insurance company