Treasury Department, IRS Continue to Focus on Small Captive Insurance Companies by Lewis Kevelson, CPA
Posted on November 03, 2017
Over the past several years, the Department of the Treasury and the IRS have taken aim at small captive-insurance companies (sometimes referred to as mini- or micro-captives). While it is legal for businesses to create these structures and self-insure themselves against specific risks, the IRS is concerned about those businesses that structure their small captives with the primary objective of generating artificial income tax deductions of up to $2.2 million (in 2017) and avoiding estate and gift taxes on intergenerational wealth transfers. To avoid falling under IRS scrutiny of potentially abusive micro-captive “transactions of interest,” businesses must tread carefully and be prepared for new IRS requirements or risk significant penalties.
What is a Captive and Why is the IRS Concerned?
A captive insurance company is a legal entity formed by a business owner to self-insure certain business risks that might be too expensive or not available from commercial insurance carriers.
The business owner purchases an insurance policy from and pays tax deductible premiums to the captive, which is considered a separate entity from the business and which must meet the definition and regulatory standards of a valid insurance company. Subsequently, the captive can make a Section 831(b) election to be treated as a small insurance company and exclude from its taxable income up to $2.2 million in premium payments it received from the insured business entity and instead be taxed solely on its net investment income.
Captives hold great value to businesses that seek to fulfill a need and plug holes in existing insurance coverage gaps. They allow operating businesses to limit their reputational risk and losses from business interruptions while also providing greater control and flexibility over the underwriting and claims processes. Despite these benefits, the IRS has found that micro-captives are also subject to widespread abuse and has even included these structures on its annual list of “Dirty Dozen Tax Scams.” For example, businesses may artificially inflate the deductible insurance premiums it pays while also providing its captive with the ability to avoid income tax its receipt of those net premiums.
A business may already be adequately insured against a specific risk or the risk they seek to insure is highly unlikely to occur. Similarly, the IRS has found that some high-net-worth families design the personal holding structure for the captive to allow multiple generations to escape estate tax.
Consider, for example, a business owner who has multiple companies that collectively pay $500,000 per year for insurance coverage needed for ordinary and necessary business needs. The business owner could keep in place essentially the same necessary insurance policies and then use a captive structure for other, somewhat questionable policies for which the captive may never be called upon to settle a claim. The taxpayer would be allowed to write off up to $2.2 million of additional premiums paid to the captive, which would accumulate profits in a structure that would not be subject to estate tax but would be able to distribute lower-taxed dividends to family members.
What are Some Recent Law Changes?
Historically, it was common to have a senior family member control an insured business and assign ownership of the captive to a family trust created for the benefit of the business owner’s spouse and children and capable of avoiding estate tax for several generations. However, Congress included in the Protecting Americans from Tax Hikes Act (PATH Act) certain changes to combat the perception that captives are an estate tax avoidance strategy. Effective January 1, 2017, captives that want to benefit from the favorable income tax deduction of up to $2.2 million must meet a “relatedness test” so that its ownership is not shifted to the spouse or lineal descendants of the owner(s) of the insured business. The Act requires that there be common ownership (within a 2 percent range) between the insured businesses and the captive. If the captive is owned 100 percent by the senior family member, then the relatedness test does not apply because the junior generation does not own any shares.
Because the PATH Act does not grandfather in existing estate-planning structures, taxpayers will have to modify their prior arrangements to preserve the favorable taxation of the small captive. Alternatively, an existing captive may meet an alternative diversification test when it broadens its pool of policyholders so that it receives at least 80 percent of its net premiums from unrelated parties. Under this alternative test, no more than 20 percent of the net written premiums can be attributable to any one policyholder. To meet the 20 percent threshold, all policyholders deemed related under the Internal Revenue Code are counted as a single policyholder.
Are Small Captives Still Viable?
There is still a place for small captive insurance companies in the business world, especially when businesses have genuine insurance and risk-management needs. However, businesses should take a conservative approach when structuring these entities and work with professional advisors to ensure there is an arm’s length relationship between the operating company and its captive insurance company. The arrangement must involve insurance risk that shifts from the operating company to captive, which must meet the stringent requirement of an insurance company. Oftentimes, this may require independent review and analysis of risk, feasibility and pricing methodology. Remember, the IRS will want to ensure that a captive is operated in accordance with regulatory requirements and that the taxpayer is guided by a team of trusted advisors with the requisite industry experience.
About the Author: Lewis Kevelson, CPA, is a director with Berkowitz Pollack Brant’s International Tax practice, where he provides tax-compliance planning and business structuring counsel to real estate companies, foreign investors, international companies, high-net-worth families and business owners. He can be reached in the firm’s West Palm Beach, Fla., office at (561) 361-2050 or via email at email@example.com.