Captive insurance companies are used to insure against a broad number of business risks, largely for commercial enterprises with certain types of large and complex risks. These insurers are owned by the insured or a related party and are governed by various provisions of the Internal Revenue Code of 1986, as amended, including IRC §831.
When discussing captives, it is critical to understand the difference between widely acceptable §831(a) captives and those captives formed under §831(b), which are increasingly viewed by the IRS as tax avoidance and tax evasion schemes. Let’s examine those differences and explore uses of captives.
Know the difference
There are distinct differences between the two principal types of captive insurers: those that make an §831(b) election to be treated as a small insurance company (i.e. microcaptive) and those that do not and are administered under IRC §831(a).
Those electing to form a §831(a) captive do not face a limit on the amount of premiums that may be paid and there is no restriction on the number of shareholders (participants) for the captive. On the other hand, an election to form a §831(b) captive can be done so only as long as the premiums paid are less than $2.3 million (2022 limit – threshold adjusted annually). In either structure, the premiums paid are often tax-deductible.
For §831(a) captives, underwriting income (the amount of premiums paid, less allowable reserves and expenses) is taxed while with a §831(b) captive, investment income, but not underwriting income, is taxed. Therefore, a company can, in effect, pay a deductible premium to its own captive insurance company without the captive paying tax on it. This appears to be a major distinction in the eyes of the IRS, along with the fact that the underwriting and claims are arm’s length transactions in third-party administered §831(a) captives and not conducted by related parties.
This premium deductibility, along with the lack of taxation on underwriting income, has led to abuses by taxpayers forming captive insurers as well as to scrutiny by the IRS. Many times, microcaptive owners and promoters focus on tax benefits with little or no attention paid to the insurance benefits. This includes failures to properly underwrite coverage, improper coverage pricing, few if any claims paid, and limited or no risk shared with third parties (i.e., reinsurance).
This makes it apparent why the IRS takes a dim view of §831(b) captives and scrutinizes them as potential tax avoidance vehicles whereas §831(a) captives are not viewed in this light. In 2014, the IRS added §831(b) captives to its “Dirty Dozen” list, calling these captives “abusive arrangements.” Then in 2016, the IRS issued Notice 2016-66 in which the agency wrote that §831(b) captives have the potential for tax avoidance or evasion.
As if the message about these forms of captives was not loud enough, three recent U.S. Tax Court decisions have given victories to the IRS in disputes over §831(b) captives. These cases focused on a number of questions:
Does the §831(b) captive insurer operate as an insurance company?
Is the §831(b) captive organized, operated and regulated as an insurance company?
Has there been a feasibility study demonstrating the need for the captive insurance as opposed to existing commercial insurance?
Are the captive insurance company formation, operation and coverages specifically tailored to the business needs of the insured operating company?
Is the §831(b) captive adequately capitalized?
Are the policies issued binding?
Are the premiums paid reasonable and were the premiums determined by an arm’s length transaction?
- Is there a history of payment of claims?
- Are there “risk shifting” and “risk distribution?”
Last year, there was a notable negative ruling for §831(b) captives in Caylor Land & Dev. V. Commissioner, where the court ruled that a §831(b) captive arrangement failed to qualify as insurance for federal tax purposes.
Most recently, on May 13, the 10th Circuit Court of Appeals issued a decision on a taxpayer’s appeal in Reserve Mechanical Corp. v. Commissioner. The appeals court upheld the tax court's decision affirming the IRS'a decision that the company did not qualify for tax-exempt status as an insurance company under §501(c)(15) and that the premiums it received must therefore be taxed at a 30% rate under §881(a). As a consequence, Reserve Mechanical not only lost the deductibility of premiums it paid to its captive, but its captive had to pay tax on the money it received from Reserve Mechanical - an effective double taxation in addition to interest and penalties owed!
Uses of captives
The tax benefits of forming a captive insurance company can be attractive. However, these benefits should be secondary to the need for the various types of insurance a captive can provide. Captive insurance arrangements can provide customized coverage while mitigating costs associated with commercial coverage.
We live in an age with increasing cyber attacks, regulatory risk and supply chain interruptions (to name just a few mounting threats) and have just seen what a communicable virus can do to cripple companies. The protection captive insurers can provide are increasingly important to business continuity. With a focus on providing coverage via an arm’s length transaction and paying taxes, where applicable, §831(a) captive insurers have risen above the negative attention brought on by §831(b) captives.
Some examples of coverages provided by captive insurers include:
Property-related – resulting from equipment breakdowns, natural disasters, remediation and ocean and inland marine instances.
Business interruption – resulting from supply chain disruption, loss of contract, loss of key employee, cyber-attack, transmissible disease and strike or civil unrest.
Regulatory and legal – resulting from litigation defense, loss of license, regulatory change and government audit.
Supplemental – resulting from excess liability, deductible coverage, gap coverage and a difference in conditions.
Jay C. Judas, JD, M.Sc. is the CEO of Life Insurance Strategies Group, an independent life insurance advisory firm. Jay may be contacted at [email protected].