As noted in last week’s Captivating Thinking, cell captive insurance companies have burgeoned in the last few years. There are numerous varieties of cell structures including series cells, protected cells, incorporated cells and other varieties of cell captive.
What is a Cell Captive?
While cell captives take different forms, in essence they involve a group of related or unrelated people working together to share certain costs and benefits of owning captive insurance companies. They involve (essentially) purchasing your own segregated piece, or “cell”, of an existing captive insurance company. They are often positioned as a very low cost way for a small or mid-market business to benefit from captive ownership. Cell captives are tethered to a “core,” and the core is the center-of-gravity, where sharing of function and services occurs. For example, in some arrangements, the core obtains an insurance license and all related cells operate under one license.
The alternative to participating in a cell captive is to instead form a free-standing captive under the exclusive control of the interested business owner, often called a “pure” captive.
What are the Core Benefits of a Cell Captive?
The primary benefits of cell captive insurance companies are 1) modestly lower set-up and operating costs and 2) reduced initial capitalization requirements.
It’s worth noting that both are benefits that should be carefully weighed against the trade-offs that accompany cell captive arrangements. Furthermore, the second – lower capitalization – is a potential double-edged sword that could hurt the captive owner in the event of an audit by the IRS.
It is no secret that the IRS has routinely attacked captive insurance arrangements – large and small. In recent months, the IRS has added “abusive” small captive insurance companies that make an 831(b) tax election to its “dirty dozen” list. Not surprisingly, one attack frequently leveled by the Service against small insurance companies is that undercapitalization is evidence that risk management and real insurance protection were not the primary motivators in the decision to form a captive. If the IRS can prove this point, it would negate the legitimate business purpose of the captive.
As noted last week, cell captive arrangements are quite similar to condo associations. Condo associations have many benefits – shared costs often being one of them – but they also include encumbrances that don’t plague single-family home owners.
As last week’s article pointed out:
A cell captive is more like a condo because, with a cell captive, your “cell” is legally and contractually “linked” to various others, like a condo unit is linked to its neighbor units. You usually won’t have any say in who your fellow cell mates are, and some of them might behave in dangerous ways unknown to you.
Other trade-offs include:
- Being “rolled-up” in an audit: This occurs when one cell captive owner or business is audited and it triggers all cells and related businesses to be audited.
- Defense cost contagion: This occurs when multiple cells are audited and attorneys and CPAs representing those cells spend countless hours coordinating their audit defense.
- Fire-wall failure: This occurs when the legal walls between cell captives fail (either due to oversight or court interpretation) and the obligations of one or more cells “spill-over” and become the obligations of other cells. Cell captive structures are relatively untested in court.
The Parent Trap
In the same way that condo associations have final authority over their unit owners, cores of cell structures have the same type of authority. Condo associations can increase dues and level assessments on unit owners, and core entities can access the funds in individual cells. Cells are not only tethered to the core, but they are beholding to it as well and can be financially obligated and called upon should the core require it. For this reason cell captives can file a consolidated tax return.
Cell captives, just like condos, have their place in the world. For example, where all cells in a given structure insure primarily a single insured or a group of related insureds, the benefits are compelling and easily offset the trade-offs. Also, cell captives are a good solution for small businesses that simply can’t afford their own free-standing captive, just as condos are a good option for homeowners who can’t afford to build their own free-standing home.
Nevertheless, in our view, businesses that can afford their own free-standing captive should choose that option over a cell captive structure. At a minimum, they should carefully evaluate all potential trade-offs before latching onto the cost saving benefits of a cell arrangement.