Occasionally, I am asked if I think the 831(b) tax election for captive insurance companies will be eliminated. While I don’t have a crystal ball, I really see very little reason for Congress to change the law regarding small insurance companies. And, the recent news flurry surrounding Apple’s tax avoidance strategies caused me to ponder the question a bit this week. After doing so, I think the likelihood of changing the tax code for captive insurance companies is even more remote. The tax revenue (if any) avoided by captive insurance companies is a micro-peanut compared to the taxes avoided by Apple. Furthermore, Apple is just one company. There are many other large corporations that reap large profits and employ similar tax avoidance strategies.
Recent reports about Apple’s incredibly low corporate tax rates suggests that, pound-for-pound, Apple’s lawyers are for more valuable than Apple’s programmers. An article in USA Today on Tuesday, May 21, 2013 noted “Apple has avoided tens of billions of dollars in U.S. taxes on its profits, according to a Senate report summary issued Monday…” The article also stated, “The California-based firm has used a web of offshore entities – including three Ireland subsidiaries… to cut some of its tax rates to 0.05%, the Senate Permanent Subcommittee on Investigations reported.” As a large corporation, Apple has scale advantages and access to a legal dream team. Tax avoidance is perfectly legal, while tax evasion is against the law. Apple appears to be the grand master at tax avoidance.
How Does This Relate To Captive Insurance Companies and the 831 (b) Tax Election?
If captive insurance companies are utilizing the 831 (b) tax election to avoid taxes, the impact is wildly insignificant when compared to a $ 3 trillion plus federal budget, $16 trillion plus federal debt and tens of billions of dollars in taxes avoided by large corporations like Apple. Notice, the operating word in the preceding sentence is “if.” Captive insurance companies provide powerful risk management to their parent or related companies, and many non-profits (including many non-profit hospitals) utilize captives.
There really is no such entity as an “831(b) insurance company.” IRC 831(b) is a tax election that a small insurance company can take. The law currently defines “small” as an insurance company collecting less than $1.2 million in premium annually.
My research indicates that there are approximately 2,000 captive insurance companies that have made the 831(b) election. Assuming all of them receive the full $1.2 million in annual premiums (a great many receive much less), and further assuming that none ever have significant claims (most do), then their taxable underwriting profits each year would be a mere $2.4 billion. Under more reasonable assumptions, the profit number is almost certainly less than a billion, maybe far less, and the revenue that results from taxing them therefore amounts to only a few hundred million per year at most.
That’s not exactly pocket change to you and me, but it effectively does nothing to help narrow our deficit or reduce the country’s debt.
How Is This Possible? Basics on Insurance Company Taxation…
Captives, whether they make an 831(a) or 831(b) tax election are insurance companies. Third party commercial insurance companies and 831 (a) captives pay a small premium tax and also pay taxes on underwriting profits. The majority of premiums collected go to reserves to pay claims. Collected reserves are not taxed as they are committed (or potentially committed) for future claims. Hence, the majority of premiums paid to a captive insurance company are not taxed (and this is true of large commercial insurance companies as well).
Calculating underwriting profit is complex, includes the use of many complex math formulas and requires actuaries, accountants and other staff, and is therefore very expensive. The 831(b) election relieves the regulatory, actuarial and accounting burden for small insurance companies.
So, Why Does the 831 (b) Tax Election Exist?
For the reasons mentioned above, the 831(b) tax election exists to help level the playing field for small businesses. The 831 (b) election enables even small companies to enjoy the more robust risk management offered by a captive. Without 831(b), the administrative costs of elaborate actuarial calculations would put captives out of reach for most small business, forcing them to either purchase exorbitantly priced third party insurance, or “go naked”. Either one makes them less robust and more likely to fail as a result of insufficiently reserving for unforeseen risk. When determining the amount of tax revenue lost due to the 831(b) election, adjustment must be made for the fact that businesses that use captives are likely more profitable over the long-term, are more likely to survive, and therefore more likely to pay higher taxes on their operating income as a result.
Improved Risk Management Versus Drinking A Pint of Guinness
While the business function of many of Apple’s off-shore subsidiaries may seem curious, captive insurance companies provide very tangible benefits to their parent companies. They provide for improved, increased or more efficient risk management. Captives issue real insurance policies insuring real risks that have been determined through detailed risk and actuarial assessment. Captives have also played an important role in helping keep commercial insurance prices competitive by giving their parent companies flexibility in risk management approaches.
For this reason, I am hard pressed to believe that Congress would eliminate the 831 (b) captive tax election. Such a move would only hurt small businesses, the engine of our economy, and, as already mentioned, have little net tax revenue impact. Captives have a very well defined and meaningful business purpose. The business purpose of Apple’s subsidiaries in Ireland – where Apple reports large portions of its profits – are not so clearly defined. Perhaps they provide a great reason for Apple executives to convene in Dublin and celebrate their massive profits by hoisting a pint of Guinness.