Treasury Department, IRS Continue to Focus on Small Captive Insurance Companies by Lewis Kevelson, CPA
The Department of the Treasury and the IRS have issued a series of notices that take aim at taxpayers who may use small captive insurance companies (sometimes referred to as mini- or micro-captives) to avoid or evade U.S. taxes. The IRS’s primarily interest is in investigating those taxpayers who create small captives to generate income-tax deductions of up to $2.2 million per year in insurance premiums paid to the captives in 2017 (an amount adjusted annually for inflation).
What is a Captive?
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 entity, which is separate from the business, can make a Section 831(b) election to be taxed solely on the investment income from the premiums the business pays to it, excluding taxable income of up to $2.2 million.
Captives may also include certain types of insurance policies for which a high deductible is in place with a commercial carrier and the captive is used to self-insure the deductible portion. The captive must meet the requisite formalities of an insurance company from a regulatory standpoint, and it must also meet the definition of a valid insurance company operation from the IRS or court cases.
Why is the IRS Concerned?
The IRS has focused its attention on small captives because owners of related businesses have the ability to deduct inflated insurance premiums, and the captives can avoid incurring income tax on the net premiums they receive. In addition, the IRS is concerned that high-net-worth families can 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. In turn, the captive 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 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, taxpayer 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.
Any Good News?
One favorable aspect of the PATH Act is that it increased the deductible net premiums that a small captive could receive, from $1.2 to $2.2 million. Thus, a small captive that can qualify may be in a position to receive net premiums of up to $2.2 million per year tax free.
Are Small Captives Still Viable?
Business owners should continue to consider the use of captives when they have genuine insurance and risk-management needs. The IRS will want to ensure that the 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. With the 2017 increase in premium limits to $2.2 million, business owners may expect some favorable long-term tax benefits as well.
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 firstname.lastname@example.org.