By Sean G. King, JD, CPA, MAcc
Principal, CIC Services, LLC
Congress believes that placing captives on an even playing field with third-party insurers makes business and tax sense. The Service, however, is increasingly devoting resources to scrutinizing potential abuses. This outline focuses upon how to form and operate a captive to withstand an audit by the Service as well as how to defend captives under attack.
A Captive Insurance Company (“Captive”) is an insurance company formed by a business owner to insure, primarily, risks of related or affiliated businesses. Captives may be used to replace or supplement existing third-party insurance arrangements or to formally insure legitimate business risks that a business may currently informally self-insure. Captives may issue property and casualty insurance coverages protecting against a wide variety of possible risks, and the captive marketplace has created a wide variety of non-traditional insurance coverages. A captive permits a business to manage its risks while potentially providing substantial ancillary benefits to the related business and its owners. These “ancillary benefits” make captives attractive for business and tax planning.
Because a captive is generally owned within the family of the business owner, either by the business owner, an affiliated entity, or a trust for the benefit of the owner’s family, any premiums paid and investment earnings on those premiums are kept inside that “family.” Thus, any profit remaining after the payment of administrative costs and claims remain within the family business structure. This ownership provides significant wealth retention opportunities because funds that otherwise would have been paid to a third party to purchase insurance, or to the government (for estate, gift or income taxes) are retained within the family. Such an ownership structure provides significant wealth preservation and transfer opportunities.
Furthermore, insurance premiums paid to a captive are generally deductible as an ordinary business expense under Section 162 of the Internal Revenue Code (the “Code”). Thus, any premium paid to the captive creates a deduction for the operating business that may result in substantial income tax savings. If the captive makes a tax election to be taxed as a “small insurance company” under Section 831(b) of the Internal Revenue Code (the “Code”) and receives less than $1.2 million per year in premiums income, it is exempt from paying federal income tax on its underwriting profits each year. “Underwriting profits” is premium received less claims paid each year.
Given the substantial transfer and income tax benefits associated with a Captive Insurance Company, it is not surprising that the IRS scrutinizes captives. However, the taxation of captives is specifically provided for by Congress via the Code, and the IRS success in challenging captives in court has largely been unsuccessful. Consequently, IRS attacks on captives have become more creative in recent years. Where the structure of the transaction or arrangement permits, the IRS has recently been inclined to make one of the following three arguments to challenge captives:
(1) The captive does not provide real insurance due to insufficient risk shifting and risk distribution.
(2) The captive charged inflated premiums.
(3) The captive business structure does not have economic substance or a legitimate business purpose apart from tax savings.
Consequently, it is critical that a captive not only be formed and administered correctly, but also that it issue true insurance to its affiliates.
History of Captives
In 1956, the general counsel for Youngstown Steel formed what later became known as the first “captive” insurance company – that is, an insurance company owned and/or controlled by a small group of insureds. From a policy perspective, captives align the interests of the insurer and insured in minimizing claims. Over time, most large companies formed their own captives, now including most Fortune 500 companies. Captives permit those companies to cover previously self-insured risks, uninsurable risks, and risks that cannot be obtained more economically from a third party. In due course, Congress recognized that a company paying (previously non-deductible) premiums to a captive insurer should not be placed on an uneven playing field versus businesses paying deductible premiums to unrelated insurance companies. Further, Congress enacted Section 831(b) as a remedial provision to assist smaller businesses in forming captives.
Captives evolved across the years into a number of different types, including but not limited to:
(1) Single Parent Captives formed primarily to insure the risks of its parent or affiliates.
(2) Association Captives owned by a trade, industry or service group for the benefit of its members.
(3) Group Captives created to provide a vehicle to meet a common insurance need for multiple companies.
(4) Agency Captives whose purpose is to reinsure a portion of an insurance companies’ clients’ risks.
(5) Rent-a-Captives that provides “captive” facilities to others for a fee.
(6) Protected Cell Captives in which assets and liabilities can be segregated among different cells separate and apart from each other as well as its overall Protected Cell Company.
(Note that Rev. Rul. 2008-8, 2008-5 I.R.B. 340 suggests that each cell of a Protected Cell Captive must meet the definition of an insurance company and have appropriate risk shifting and risk distribution).
Due to the tension between the prohibition against currently deducting self-insurance loss reserves and the authority to deduct property & casualty premiums paid to an insurer, much of the tax controversy focuses upon whether the payer (insured) remains fully exposed on the loss versus whether some of the risk of loss is shifted to someone else.
IRS’s Required Elements for Insurance
To obtain the benefits of a captive, it must actually provide “insurance” and have appropriate “risk shifting” and “risk distribution”. The concept of what constitutes insurance has long been debated in the courts, but more specific guidelines and some safe harbors have now been developed. These guidelines and safe harbors, if followed, should protect a captive in the event of an IRS challenge based on whether “insurance” is being issued.
The Code does not provide a definition for the term “insurance.” In Helvering v. Le Gierse, 312 U.S. 531 (1941), the Supreme Court set forth the standard that true insurance must have risk shifting and risk distribution. In Helvering, an elderly taxpayer who was uninsurable purchased a life policy and a life-only annuity policy one month before her death. By purchasing the annuity policy from the same insurer, the taxpayer offset the insurer’s risk. The primary purpose for the taxpayer purchasing the life insurance policy was to obtain special estate tax advantages that were available for a life insurance death benefit. The Court decided that there was no risk shifting in this case because the life insurance policy and the life-only annuity contract offset one another. Thus, the taxpayer’s economic position did not change.
Insurance requires both risk shifting and risk distribution. Risk shifting transfers the risk from the insured to the captive insurance company. On the other hand, risk distribution spreads the risk borne by the captive insurance company among an adequate number of other parties. That distribution results in the risk pooling effect characteristic of traditional insurance arrangements. Although theoretically these two concepts are separate, the courts often analyze them together. In addition to risk shifting and risk distribution, the policy must constitute insurance in the commonly accepted sense of protecting against uncertainty.
Achieving the Appropriate Level of Risk Shifting and Risk Distribution
Adequate risk shifting has been a frequent topic since the 1970s. Taxpayers and the Service have spent decades litigating over what establishes adequate risk shifting. To thwart the taxpayer’s use of captives, the Service initially pressed the “Economic Family Doctrine.”
The Economic Family Doctrine
In Rev. Rul. 77-316, 1977-2 C.B. 53, the Service created the “economic family doctrine” to attempt to deny taxpayers the benefits of being a captive. This doctrine stated that the risk must be transferred outside of the economic family to be true insurance. Under this approach, the IRS cast both the parent-child captive structure and the brother-sister captive structure as failing to constitute insurance in the sense the family who owned continued to bear the full risk. Under the parent-child captive structure, the parent company owns the captive as a subsidiary. In a brother-sister captive structure, one company pays the premiums to an affiliate captive. The Service asserted that the group shifted no risk outside of the economic family, the captive provided no “insurance,” and the premiums are not deductible.
In analyzing the economic family doctrine, some Courts implemented the Balance Sheet Test to disallow deductions for premiums paid. The Balance Sheet Test states that a company will be able to deduct premiums paid only if there will be a net change on the company’s balance sheet when the loss is paid. This test works by not allowing deductions by companies that are too closely related to a captive (like in a parent-child captive structure), while allowing deductions by companies that are not as closely related (à la brother-sister captive structure).
Rejection of the Economic Family Doctrine
The economic family doctrine contradicted the Supreme Court decision in Moline Properties, Inc. v. Commissioner, 319 U.S. 436 (1943). In Moline, the Court held that separate corporations must be treated as separate taxable entities provided they pursue business activity.
In Carnation Company v. Commissioner, 640 F.2d 1010 (9th Cir. 1981), and Clougherty Packing Co. v. Commissioner, 84 T.C. 948 (1985), the Ninth Circuit and the Tax Court relied on the Balance Sheet Test in disallowing premiums paid from a parent company to a subsidiary captive. Based on that test, the premiums constituted nondeductible reserves against future losses, rather than insurance.
In Humana, Inc. v. Commissioner, 881 F.2d 247 (6th Cir. 1989), the Sixth Circuit stated that “under no circumstances do we adopt the economic family argument advanced by the government.” The Court allowed subsidiary corporations to deduct premiums paid to an affiliate captive insurance company. This ruling meant that a brother-sister captive structure would be allowed by the courts. However, the Court went on to state that the parent could not deduct premiums paid to its subsidiary, thereby holding that a parent-child captive structure was not permitted. This holding was based primarily on inadequate risk distribution in a parent-child captive structure under the balance sheet test. The parent’s balance sheet is effectively unchanged in this structure. As a result, the premiums are recast as nondeductible reserves.
In 1992 the Ninth Circuit again rejected the economic family doctrine in Harper Group v. Commissioner, 979 F.2d 1341 (9th Cir. 1992). The Court held that premiums paid to a captive insurance company by both the parent and subsidiaries were deductible if unrelated third party insureds that made up approximately 30% of the total premiums paid to the captive insurance company each year. As a result, it appears that if the captive only insures a parent and its subsidiaries, the parent will not be able to deduct the premiums; however, if the captive insures other third party insureds as well, the Court is more likely to find risk distribution.
Finally, after years of litigation with somewhat poor results for the Service, it abandoned its economic family doctrine. In Rev. Rul. 2001-31, 2001-1 C.B. 1348, the Service stated that it would no longer raise the economic family doctrine to challenge captives but would continue to challenge risk shifting and risk distrubiton on a case-by-case analysis. In addition, the Service indicated that it would carefully scrutinize capitalization levels and parental guarantees.
Safe Harbor Rulings
Then, beginning in 2002, the IRS issued a series of Revenue Rulings that would finally provide safe harbors for the concepts of risk distribution and risk shifting, thereby providing taxpayers an element of comfort as to whether their captives was truly selling “insurance”.
Under Rev. Rul. 2002-89, 2002-2 C.B. 984, the Service ruled that fifty percent of premiums from unrelated businesses paid to a subsidiary captive established sufficient risk shifting and risk distribution. The Service also stated that ten percent of the total premiums coming from unrelated businesses falls short of adequate risk shifting or distribution. Next, in Rev. Rul. 2002-90, 2002-2 C.B. 985, the Service explained that twelve subsidiaries purchasing insurance from the same captive (with each subsidiary having no more than fifteen percent and no less than five percent of the total risk insured by the captive) constitutes acceptable risk distribution and risk shifting.
Three years later, Rev. Rul. 2005-40, 2005-2 C.B. 4 held that the twelve subsidiary test detailed under Rev. Rul. 2002-90 was satisfied even if all of the insured entities have a common owner provided that no subsidiary or entity was a disregarded entity. This meant that single member LLCs could not be counted as a subsidiary. This dubious Ruling asserted that, even if the insurer was adequately capitalized and completely unrelated, the absence of a sufficient number of insureds may violate the required risk distribution.
In a much disputed memorandum, TAM 200816029 stated that the Service will not treat limited partnerships with a common general partner as separate entities. The Service argued (again mistakenly) that the common general partner bears all risk of loss. The TAM confuses primary and secondary liability in a way that would deny insurance treatment for the universe of carriers who reinsure. This TAM has been highly criticized because a general partner only faces liability if all limited partnership assets have been exhausted or are unreachable by creditors. No authority has been issued on whether a general partnership, S corporation, or Q-sub will be treated as a separate entity for purposes of the twelve subsidiary test.
In Rev. Rul. 2009-26, 2009-38 I.R.B. 366, the Service stated that, when determining risk distribution and risk shifting in a reinsurance contract, the risks of the ultimate insured must be examined. This contract would be the primary (underlying) insurance policy.
Each of these holdings and rulings provide guidance in an area that was previously quite uncertain, but they also demonstrate the Service’s inclination to challenge, often unsuccessfully, many aspects of a captive. However, through the application of these safe harbor Revenue Rulings, a captive insurance company program can be implemented successfully if care is taken.
Risk Distribution – 30% or Twelve Subsidiaries
Risk distribution generally refers to the insurer spreading risks across an array of premium paying insureds. Rev. Rul. 2002-91, 2002-2 C.B. 991 provides that risk distribution allows the insurer to reduce the possibility that a single claim will exceed total premiums received. The Ruling indicates a pooling of premiums is necessary to reduce the potential that the related insured remains exposed for its own risks and while obtaining a tax deduction. Accordingly, the elements of risk distribution are driven by the number of “exposure units” and the pooling of premiums from which to pay losses. The combination of a sufficient number of exposure units and pooling of premiums smoothes out losses so that they more closely match premiums received.
In rejecting the IRS economic family theory, courts determined that insurance could exist, despite a common insured, provided that sufficient unrelated insurance existed. That is, the existence of the unrelated insurance creates sufficient risk distribution. The Courts, however, never established a floor for sufficient unrelated business, but they have ruled that 2% is insufficient and that 30% is sufficient. See Gulf Oil Corporation v. Commissioner, 89 T.C. No 70 (1987); Sears, Roebuck & Co. v. Commissioner, 972 F.2d 858 (7th Cir. 1992); AMERCO, Inc. v. Commissioner, 979 F.2d 162 (9th Cir. 1992); Harper Group v. Commissioner, 979 F.2d 1341 (9th Cir. 1992).
Risk Distribution Pool
The unrelated premiums requirement remains a substantial concern if a captive insures a business with common owners and does not have a sufficient percentage of unrelated insurance or does not insure an adequate number of affiliated subsidiaries (12 subsidiaries that are not disregarded entities). To acquire a 30% unrelated premium, a captive may participate in a “risk distribution pool.” A risk distribution pool is formed for the exchange of insurance business among captives to spread risk and enhance participation in an unrelated business. The participation of multiple captives in properly structured pools should satisfy the risk distribution requirements.
“Captive” Tax Definitions and Elections
A captive is an insurance company formed, licensed and governed under the laws of a particular state or country, and that issues insurance policies to (primarily) related businesses in exchange for premiums. To form a captive, one must incorporate an insurance company. The Internal Revenue Code defines an “insurance company” as a company which derives over half of its business from issuing insurance or annuity contracts or reinsuring risks underwritten by insurance companies. I.R.C. §§ 816(a), 831(c). The Treasury Regulations elaborate on the Code’s definition stating:
The term insurance company means a company whose primary and predominant business activity during the taxable year is the issuing of insurance or annuity contracts or the reinsuring of risks underwritten by insurance companies. Thus, though its name, charter powers, and subjection to State insurance laws are significant in determining the business which a company is authorized and intends to carry on, it is the character of the business actually done in the taxable year which determines whether a company is taxable as an insurance company under the Internal Revenue Code. Treas. Reg. § 1.801-3.
In accordance with the entity classification rules, an insurance company must be a C corporation for U.S. income tax purposes. The entity classification rules found under Code § 7701 and its accompanying Treasury Regulations determine the classification for business entities recognized for tax purposes based upon the entity’s ownership. Under those rules, an insurance company is treated as a per se corporation and, thus, is ineligible to elect any other classification than a C corporation for U.S. income tax purposes. Treas. Reg. §§ 301.7701-2(b)(4) and 301.7701-3(a).
Large Versus Small Election – Section 831(b)
A property and casualty insurance company may either be “large” or “small.” Small Captive Insurance Companies are those that receive less than $1.2 million per year of premium income and are therefore eligible to elect, and do elect, to be taxed only on their investment. I.R.C. § 831(b). Underwriting profits of 831(b) small insurance companies are not subject to federal income tax. The Section 831(b) election requires tax to be paid only on any taxable investment income at corporate rates. However, partly to compensate for this, net operating losses, which are rare but not unknown in the captive world, do not offset investment income and cannot be carried to or from any taxable year for which the company has made an election under Section 831(b).
The two-fold benefit of making the election to be a “small” property and casualty captive insurance company should be obvious: The operating company (insured) deducts the premiums paid to the captive, but those premiums are not taxed to the captive. Specifically, the business receives a premium deduction paid under Section 162, and up to $1.2 million of those premiums remain exempt from tax at the captive level under Section 831(b).
Congressional intent behind Section 831(b) was specific. First, Congress desired to encourage the formation of new insurance companies. Congress also wanted to create equality between businesses that choose to insure its own risks and those which choose to use third party insurance. In addition, Section 831(b) provided incentives for small businesses that were not purchasing insurance from commercial insurance companies to prepare for uninsured risks.
An election must be affirmatively made under Section 831(b) to receive the exemption from income on premiums. If the election is not made, the captive is taxed in the method prescribed by Section 831(a). The election is made by attaching a statement to the captive’s tax return. A captive operating as a small property and casualty company must file a Form 1120-PC Income Tax Return and report its income on Schedule B. Once a Section 831(b) election is made, it will continue in existence until premiums exceed $1.2 million or until revoked with the consent of the Service. I.R.C. § 831(b)(2)(A). The Service generally does not consent to the revocation of an election unless a material change in circumstances is shown.
The election status does not affect the deductibility of premiums paid by the operating companies (that is, the captive’s insureds). The owners of a small property and casualty captive are, however, taxed on dividends received from the company, if and when they are paid. This also implies that investment income earned by the captive will ultimately be double taxed when paying dividends or making liquidating distributions of investment income, unless steps are taken to mitigate this impact.
Choice of Jurisdiction and Its Implications
At least twenty-six states, the District of Columbia, and foreign jurisdictions compete for captive business by offering attractive standards. They vary in the relationship between capitalization and liquidity requirements. The domicile chosen for a captive dictates its capitalization, reporting, and other requirements. If a foreign jurisdiction is chosen, the entity should consider making an election to be treated as a domestic C corporation for income tax purposes under Section 953(d). Such an election taxes the captive as a domestic corporation despite its formation and existence in a foreign jurisdiction. This provides an opportunity to benefit from any attractive standards offered by a foreign jurisdiction without having to deal with the complexity of the taxation of an international entity.
Regardless of whether a captive is formed onshore or offshore, the jurisdiction will set forth minimum operational and administrative requirements. These requirements concern aspects such as ownership, investments, reserves, dividends, loans, and continued operations. Note that the Insurance Commissioner in many jurisdictions must approve any dividend or loan. While the Treasury regulations permit any type of investment allowed by the controlling sovereign, a captive’s investments still must meet the local criteria and liquidity ratios. Furthermore, captives are required to keep a certain amount of reserves and cannot cease operations and dissolve without Commissioner approval.
Avoiding, or At Least Winning, an IRS Challenge
A captive insurance company can be extremely beneficial in many aspects as insurance underwriting profits are kept within the group or family without reduction for taxes. However, as is true with any business planning, the captive must be a legitimate business entity and comply with the local law. There are opportunities for the Service to challenge captive insurance companies; therefore, having a valid business purpose, proper formation, and disciplined administration remains essential. The Service may have abandoned the Economic Family Theory but warned in Revenue Ruling 2001-31 that it may continue to challenge captives based on the facts and circumstances of each case.
Legitimate Business Reason
As is true with any business planning, a captive must possess a legitimate business reason to avoid being characterized as a sham by the Service. The requirement of a legitimate business purpose has been emphasized by the Courts:
A taxpayer is “free to arrange his financial affairs to minimize his tax liability.” Estate of Stranahan v. C.I.R., 472 F.2d 867, 869 (6th Cir.1973). Thus, “the presence of tax avoidance motives will not nullify an otherwise bona fide transaction.” Id. However, the establishment of a tax deduction is not, in and of itself, an “otherwise bona fide transaction” if the deduction is accomplished through the use of an undercapitalized foreign insurance captive that is propped-up by guarantees of the parent corporation. The captive in such a case is essentially a sham corporation, and the payments to such a captive that are designated as insurance premiums do not constitute bona fide business expenses, entitling the taxpayer to a deduction under § 162(a).
Malone & Hyde, Inc. v. Commissioner, 62 F.3d 835, 840 (6th Cir. 1995).
Some legitimate business reasons include (i) covering previously self-insured risks, (ii) obtaining coverage where insurers are unwilling to do so, (iii) reducing premium payments, (iv) controlling risk, (v) increasing cash-flow, (vi) gaining access to the reinsurance market, (vii) creating diversification, (viii) avoiding the marketing and distribution costs built into third-party insurance arrangements, (ix) avoiding “adverse selection”, and (x) balancing coverage. See Randall L. Hahn and William Bailey, Captive Insurance Companies: More Viable Than Ever?, Corp. Taxation (Sept/Oct. 2002). In addition, Rev. Rul. 2001-31 at least implies that taxpayers can now list tax planning as a reason for forming a captive.
Each legitimate business reason for forming a captive should be fully analyzed and documented from the planning stage through the formation of the entity. Any evidence that could be produced upon audit to show the valid business purposes of formation may be extremely useful in combating arguments by the Service that the premium falls short of an ordinary and necessary business expense or constitutes part of a sham.
As mentioned previously, management and operation of the captive is essential to its success, leading to the recommendation that professional insurance advice be sought regarding not only the formation but the ongoing operation of the captive. It is critical that advice from a professional in risk management matters be obtained to set up and run the captive, and even in the selection of a Captive Management Company. Care should be exercised to avoid captive “Mills” that just set up the captive but do not provide meaningful ongoing services and support.
Avoiding Excessive Premiums
Under Section 162(a) and Treas. Reg. § 1.162-1(a), insurance premiums paid by a taxpayer are deductible if they are ordinary and necessary expenses directly connected with the taxpayer’s trade or business. Therefore, a business must be able to prove that any premiums paid to a captive constitute an ordinary and necessary business expense using many of the same techniques used in proving any other business expense – substantiation of payment, business purpose, benefit, and reasonableness.
The Service has challenged premiums as being “excessive” and not an ordinary and necessary business expense on two grounds. First, taxpayers that pay premiums that are too high for the amount of insurance they are receiving will not be able to deduct those premiums. See Non Docketed Service Advice Review, 2002 I.R.S. N.S.A.R. 20160 (April 17, 2002). Second, the Service questions the type and magnitude of new types of coverage such as terrorism. Interestingly, the Department of Homeland Security publication strongly recommends that small businesses prepare for terrorism risks and Congress continues to extend the “Terrorism Risk Insurance Act of 2002” program in recognition of the difficulty in obtaining affordable terrorism coverage – a program operated by none other than the Treasury Department.
Reliable Actuarial Method
In Gulf Oil Corp. v. Commissioner of Internal Revenue, 89 T.C. 1010 (1987), the Tax Court decided that insurance premiums charged by a captive insurance company and the amount of insurance provided by the captive must be based on a reliable actuarial estimation of the risk of loss. If premiums are consistently in great excess of the actual losses paid, it may be an indicator that one of two things is occurring. First, the taxpayer could be attempting to avoid taxes by inflating tax-deductible premiums and sheltering them via the Section 831(b) exclusion. Second, the company (the insured who overpays) could, in reality, be retaining a significant portion of the risk (via the overpayment), and the Service might conclude that the captive was not actually providing insurance (i.e., insufficient risk shifting). While many, if not most, types of property & casualty insurers cover catastrophic events that the insured will likely never suffer (e.g., house fire), the claims history could be probative and some claims should occasionally be paid.
The Service also views charging exactly $1.2 million in premiums as suspect (though one would be foolish to pay more in the same way a couple would be foolish to make a $40,000 taxable gift in December instead of a $20,000 nontaxable gift in December and another in January). See Non Docketed Service Advice Review, 2002 I.R.S. N.S.A.R. 20160. Under Section 831(b), a small insurance company can deduct up to $1.2 million dollars in insurance premiums. If a captive is charging exactly that amount, it may suggest to the Service that the premium was invented rather than actuarially determined.
Consequences of Excessive Premiums
If the Service or the Court determines that the insurance premiums being charged by the captive are excessive, there are likely undesirable consequences. First, the premium-paying company will lose part or all of the income deduction (since the excess was not paid for true insurance). Second, the captive will likely be taxed on part or all of the putative premiums (since only “underwriting profits” are not taxed under 831(b)). Additionally, there also could be gift tax issues if the captive that received the excessive premium is owned by the business owner’s descendants or trusts for their benefit.
How to Avoid Paying Excessive Premiums
Above all else, establish that the captive based the original premiums using acceptable insurance industry methods. Also, to avoid a determination that the premiums being paid are excessive and at the same time increase the amount of the deduction available, the company needs to identify insurable risks for which third party insurance is not commercially available or not economically affordable. Matt Brown, Captive Insurance Companies, A.B.A. Sec Real Prop., Trust and Estate Law, 2009. An insurable risk must have some degree of fortuity or uncertainty. By obtaining insurance on risks that the company would not normally be able to insure through a third party insurance company, the company will likely have to pay higher, but still reasonable, premiums as the private insurance markets demonstrate.
The Role of Life Insurance in a Captive
Since captives must be taxed as C corporations, investment vehicles which are not subject to current income tax are attractive assets. In that respect, permanent life insurance policies would seem an ideal asset for a captive to consider owning since increases in cash value are not subject to current income taxation. On the other hand, Section 264 states that life insurance premiums cannot be deducted either directly or indirectly. Therefore, when a captive owns life insurance, the Service could conceivably attempt to collapse the business’ payment of premiums to the captive and the captive’s payment of premiums to the life insurance company, deeming them to be a single payment of premiums directly to the life insurance company. Such classification would result in a determination that any income tax deductions taken for premiums paid to the captive were actually for life insurance and therefore improper.
Since there is no authority on this issue, prudence and common sense are advisable to reduce any IRS risk. For instance, as much as is consistent with prudent business practice, the decision to form a captive insurance company should be independent of how the captive may eventually invest its assets. This means that conversations about how the captive might invest its assets (whether that involves life insurance or not) should generally be delayed until after the business purpose of the captive has been established and documented and the captive has been formed. The insurance provided by the captive to the insured should, as previously noted, be real, relevant and fairly priced (that is, the captive should clearly NOT be a sham). The captive’s decision to invest into life insurance should, as much as possible, be made on its own (that is, by judging the merits of the life insurance from its own perspective) rather than with a view toward the benefits provided to the business owner and his or her family.
The lending of money from a captive back to an operating business that it insures is often referred to as a “loan-back.” No premium should be paid with the expectation that the captive will promptly loan the funds back. A loan-back is used to invest captive funds back into the operating business and usually takes the form of a bond issuance but is fundamentally no different than a loan. The Service carefully scrutinizes loan-backs and has contemplated issuing regulations relating to them. To date, the Service has issued limited guidance on loan-backs and has not provided an objective standard to determine whether a loan-back will be considered a bona fide indebtedness.
Loan-backs are often analyzed in terms of the loan-back to premiums paid ratio. If a significant portion of the premiums paid are borrowed, concerns of a circular cash flow arise. See FSA 199945009 (November 12, 1999). In a situation where a captive loaned 97.5% of its assets to the operating business the Service determined the loan-back to be invalid and stated “by loaning out substantially all of its assets to an affiliate, Insurance Subsidiary resembles an incorporated pocket-book, representing a reserve for self-insurance.” FSA 200202002 (September 28, 2001). Therefore, a loan-back must be issued with great caution, must constitute a bona fide indebtedness, and should not represent a significant portion of the captive’s assets or premiums paid.
Forming Captives with Legitimate Business Purpose
Captive Insurance Companies should be formed, of course, for economic and business reasons. A captive is a licensed insurance company, and therefore, claims must be expected. Risk management and risk financing are the main drivers of captive formation and operation. These and other reasons are more fully summarized as follows:
- Lower Insurance Costs. Third-party insurance companies must price their policies not just cover the cost of paying claims, but also to cover overhead, compensate its sales force (i.e., pay commissions and conduct advertising), protect against adverse selection, and earn a profit. Often, a significant portion of the premium charged goes for these purposes. By insuring via a captive insurance company instead, a business can avoid much of these costs and the business owner can keep any resulting profits “within the family”.
- Cash Flow. Apart from pure underwriting profit, commercial insurers rely heavily on investment income. Premiums are typically paid in advance, while claims are paid out over a longer period. Until claims become payable the premium is available for investment. By using a captive, premiums and investment income are retained by the owner. Additionally, the captive may be able to offer a more flexible premium payment plan thereby offering a direct cash flow advantage to the parent.
- Risk Retention. A company’s willingness to retain more of its own risk, particularly by increasing deductible or self-insured retention levels, may be frustrated by the inadequate discount offered by insurers to take account of the increased deductible/self-insured retention and by the fact that the company is unable to establish reserves to pay future claims. Establishment of a captive can help address both these problems.
- Unavailability of Coverage. Where the commercial market is unable or unwilling to provide coverage for certain risks or where the price quoted is seen to be unreasonable, a captive may provide the insurance desired.
- Risk Management. A captive can act as a focus point for the risk management and risk financing activities of its parent organization. An effective risk management program will result in recognizable profits for the captive and lower premiums for the insured. Maybe for the first time, risk management can be viewed not as a cost center but as a potentially profitable part of the company’s activities.
- Access to the Reinsurance Market. Reinsurers are the international wholesalers of the insurance world. Reinsurers are able to provide coverage at advantageous rates by operating on a lower cost structure than direct insurers. By using a captive to access the reinsurance market, the parent/owner can more easily determine its own retention levels and structure its program with greater flexibility, thereby “laying off” some of its risk to a third party company.
It is imperative to emphasize that while captives potentially provide substantial benefits, the client must be willing to undertake the management of their formation and administration and run the risk of claims just as a commercial insurance company does. Thus, an ideal candidate for a captive would be a very profitable operating business.
Captive Implementation and Administration
In addition to establishing one or more of the aforementioned business purposes, the implementation and administration of a captive must include certain elements. The following is a list of considerations for implementing and administering a captive:
1. Conduct an Insurance Audit / Feasibility Study to determine what risk the contemplated captive should consider insuring. This is usually done by your Captive Manager, your captive’s attorney, the actuary or insurance consultant, or some combination of these three.
2. Determine the appropriate type of captive for the particular situation.
3. Determine appropriate shareholders for the captive – businesses, trusts, or individuals.
4. Determine the appropriate jurisdiction for the captive and take the necessary steps to appropriately incorporate and operate it in that jurisdiction.
5. Determine if a large or small captive is appropriate, obtain an Employer Identification Number, and file any required elections with the Internal Revenue Service.
6. Arrange for adequate capitalization. A requirement for obtaining an insurance license, captives are required to have a minimum amount of capital upon formation. For business and IRS purposes, a captive must maintain adequate capital relative to the risk underwritten.
7. Hire a management company. Due to the complexity and reporting requirements of a captive, it is generally recommended that a management company be engaged to handle its insurance operations. Members of the management company (or the management company itself) may also serve as most of the officers and directors of the captive.
8. Conduct underwriting and develop policies. Your attorney and/or management company will often work with an actuary to help determined the type and amount of insurance that will be issued to the operating company.
9. Obtain one or more insurance licenses as appropriate for the captive’s jurisdiction.
10. Adhere to any relevant investment restrictions.
11. Maintain adequate risk distribution, which may be accomplished through participation in a proper risk distribution pool.
12. Implement procedures for the handling and payment of claims.
13. Regulatory management of captives should include: (i) insurance company accounting and records; (ii) regulatory filing and reporting; (iii) quarterly financials; (iv) annual captive efficiency review; and (v) liaison with investment manager, tax preparer, auditor, and regulatory body. The captive management company can assist in processing claims.
Conservative and Not-So-Conservative Captive Defense
The Service continues to challenge some captives under various theories. Meeting safe harbor requirements for risk shifting and risk distribution and issuing insurance are not enough to combat an attack by the Service. Taxpayers must be prepared to defend against the Service’s more “creative” arguments—for instance, alleging a lack of economic substance and/or business purpose. The good news is that economic substance and business purpose issues have been litigated in many contexts, and it is therefore only the inexperienced or unwary taxpayer/practitioner who should fall prey to them today.
In addition, some of the other challenges asserted by the Service may be outside of its realm of regulation. For example, the administrative and operational requirements of a captive are prescribed by the Insurance Commissioner of the jurisdiction in which the captive is formed. Accordingly, in an attack by the Service administrative or investment issues may be largely irrelevant since the Code provides no requirements for issues of the sort. If the Service raises administrative or investment arguments it is imperative to delineate the Service’s actual authority and distinguish that authority from issues over which they have no jurisdiction.
Captives offer truly unique and unparalleled business and tax planning opportunities, but it is important to recognize the risks and responsibilities that accompany them. The captive must underwrite “insurance” in the traditional sense of fortuitousness, risk shifting, and risk distribution.
Also, the captive must be properly formed and structured so as to withstand Internal Revenue Service scrutiny. Choices must be made regarding the type of captive, place of domicile, amount of capitalization, use of a management company, shareholders of the captive, and the drafting of the insurance policies. There are a number of formal requirements as well, such as obtaining an insurance certificate, obtaining a separate bank account, and following reporting and investment requirements. The captive must have a legitimate business interest and may not charge excessive premiums.
A refusal to abide by the requirements in creating a captive could be a costly mistake. The benefits of captive implementation can easily be diminished through a successful audit by the Service. Overall, clients should enter into the captive insurance company realm with their “eyes wide open” and with highly qualified advisors. When done properly, a captive insurance company can be an invaluable planning tool for the right client.
This article does not create or imply an attorney-client relationship and is not intended to provide any legal advice. The reader of this article may not use its contents for the purpose of avoiding penalties that may be imposed with regard to the tax consequences arising from any matters discussed herein or for the purpose of promoting, marketing or recommending to another party any transaction referenced herein.