Tax savings versus informal self-insurance arrangements
Assuming that your captive insurance company (“CIC”) is a proper, licensed insurance company that writes appropriate, relevant insurance policies in exchange for independently-priced or market comparable premiums, then premiums paid to your CIC should be deductible to your business just as if they were paid to a third party insurer. For instance, if you paid $1 million in premiums to your CIC this year for valid insurance, the resulting deduction would save you or your business $400,000 in taxes if you’re in a forty percent combined federal and state tax bracket.
In addition captive insurance companies receiving less than $2.2 million per year in premium income, can elect to have their underwriting profits taxed in a zero percent bracket under Code Section 831(b). For example a CIC which takes in premiums of less than $2.2 million per year with its premium income exceeding claims paid, may have those profits taxed in a zero percent bracket. Assuming $1 million of CIC premiums and a forty percent tax bracket, that represents $400,000/year of potential tax savings by formally self-insuring risks through a captive versus not insuring these risks at all as most businesses do.
Why do captives enjoy such a low tax bracket on underwriting profits? Some hypothesize that Congress may have decided that third-party insurance arrangements should not be favored by the tax code over formal self-insurance arrangement like CICs. Also, it seems that Congress may have intended to incentivize small businesses to begin setting aside reserves to insure risks they have failed to cover via third parties due to cost, lack of available coverages for certain risks, or other considerations. Section 831(b) incentivizes small businesses to responsibly reserve for these risks through captive insurance arrangements.
Despite the obvious and frequently-noted tax advantages of a CIC, no business transaction should ever be completed simply or even primarily to achieve tax savings. In some cases the IRS has authority to deny deductions that result from primarily tax-motivated transactions. Thus, the decision to implement a CIC should be based upon the business owner’s careful considerations of the risks facing his/her business and the various means of mitigating them, and his/her decision-making process should be documented. Unfortunately, it’s the rare business indeed that doesn’t have considerable exposure to innumerable uninsured risks, potentially bankrupting the business if left unaddressed, and which self-insuring via a captive can mitigate. Your captive attorney and his or her insurance manager can assist you in recognizing and developing a plan to protect against such risks.