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Tax Benefits Of Captive Insurance

How Is The Insurance Company Structured

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These companies are structured so that reasonable insurance premiums can be paid from the affiliated entity to the insurance company and be fully tax deductible by the insured. The code allows the first $2.3 million indexed by inflation to be tax exempt upon receipts into the captive insurance company. This results in an excellent opportunity for owners looking to reduce their current income tax liability and transfer wealth without excellent estate planning tools.

The captive company is required to be a C corporation and is subject to chapter C and chapter L of the Internal Revenue Code. There are a variety of different captive insurance companies. This includes pure captives, risk retention groups, group captives, and producer-owned reinsurance businesses. This post focuses on pure captives, which are designated and structured to ensure the risks of business entities related to or affiliated with the ownership of the captive.

When these structures were initially approved, they were typically used by Fortune 500 companies in an attempt to lower insurance costs. The fees involved were very high, and the plans covered a lot of complexities. But for large corporations, the benefits far outweighed any of the costs.

The Future Of Captive Reinsurance Companies Under President Biden

Budget proposals sent to Congress by President Biden, if enacted, would reduce the value of the tax benefits from captive insurance by overhauling how the government taxes high-income taxpayers and capital assets.

The fiscal 2023 Biden budget proposal now before Congress would increase the top marginal tax rates for wealthy individuals and overhaul taxation of capital assets, taxing some previously long-term gains by high-wealth individuals at higher ordinary income tax rates. The most controversial part would require gains and dividends to be recognized on or after the date of enactment.

These controversial Biden tax proposals would diminish the tax benefits of captive insurance company arrangements. Washingtons focus on captives and tax reform generally has eased during the COVID pandemic, ensuing inflation and concerns about war in Eastern Europe.

Access Reinsurance Market & Premium Recovery

Reinsurance is referred to stop-loss insurance or insurers insurance. Owning your own captive gives you access to the reinsurance markets that arent available to the general public. This access allows for direct access to the underwriter by removing the middle-man and give you wholesale level pricing with more flexibility of insurance coverage.

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Benefits Of A Captive Insurance Company : Risk Funding

Businesses in industries such as construction, manufacturing, healthcare, and others, can write coverages with a captive insurance company that are otherwise too expensive or unavailable in the conventional marketplace.

Policies written through a captive insurance company may include coverage for cyber-attacks, equipment failure, legal expense reimbursement, pollution liability, and a lot more. Coverages can offset both business risks, such as employer liability, and operational risks, such as business interruption. Overall, the risk funding benefits of a captive insurance company are significant.

To determine what true risks exist inside your business, and realize the full advantages of captive insurance, from a risk funding perspective, an objective, on-site feasibility study should be conducted. This is an objective assessment of uninsured risks found inside your business a process that is best handled by seasoned professionals in the captive area.

Insurance Risk And Common Notions Of Insurance

Captive Insurance Has Significant Benefits

The IRS has also raised issues regarding whether certain types of coverage should be treated as insurance for federal income tax purposes. Thus, for example, imbedded warranty, retroactive coverage , and currency value protection have been questioned. Recently, the IRS litigated, and lost, the question of whether residual value insurance was insurance for tax purposes.

In addition, the IRS has questioned other elements of captive formation that to some degree overlap with the risk transfer and risk distribution categories, for example, whether loanbacks to insureds or guarantees provided by the parent or another member of the consolidated group affect insurance status, whether unrelated business must be “homogeneous” or similar to the related business written by the captive, and whether the method of calculating premium , and its allocation among subsidiaries or members of a corporate group was appropriate.

Although this article does not provide a complete discussion of all of the issues described, it provides a meaningful start to an analysis. For much greater detail, please see “Tax Implications of Risk Financing,” by P. Bruce Wright, Esq., and Saren Goldner, Esq., in the section titled “Insurance Characterization for U.S. Federal Income Tax Purposes” of the IRMI reference serviceRisk Financing. If you subscribe in IRMI Online, you will find the discussion here. If you subscribe in ReferenceConnect, you will find the discussion here.

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How Do You Get Funds Out Of The Captive

For an annual insurance policy, the premiums are typically tied up in the insurance company for one year. After the one year expiration, the reserves are held in the insurance company. Remember that the insurance company is taxed as a C-Corp.

The owners of the insurance company can take dividend distributions that are taxable to the shareholders at the qualified dividend rate. Dividends will be limited to surplus reserves.

It may make sense to leave the excess reserves in the C-Corp to invest in dividend paying stocks to take advantage of the 50% dividend exclusion.

The owner can also take money out of the insurance company by using a loan. It must be documented and pay fair interest.

Captive Insurance Companies Give You Control Of Your Risk Financing With Substantial Tax Advantages

Business owners too often take a passive approach to tax planning only thinking about taxes once April approaches or quarterly payments are due. But as your business thrives, the only way to avoid unnecessarily painful payouts to Uncle Sam is by proactively creating a long-term strategic tax plan.

In this second installment of our series on long-term tax strategies, we explore how captive insurance companies can help you achieve your financial goals.

Captives were mostly unaffected by the new Tax Cuts and Jobs Act of 2017, and an experienced certified public accountant can help you weave them into a thoughtful long-term strategy that minimizes your tax liability as your company enters new stages of growth.

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The Best Candidates For Captives

  • Entities that meet the following criteria should use captives:
  • Major annual adjustable tax deductions are pursued by profitable company organizations.
  • Businesses of multiple organizations or others who may create multiple branches or affiliates
  • Companies with a sustainable annual income of $500,000 or more.
  • Uninsured or underinsured enterprises with the requisite risk
  • Company owners who are involved in methods for acquiring personal capital and/or shifting family wealth.
  • Companies in which the owners want wealth security

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Biggest Risks Of Captive Insurance Companies

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  • The IRS is especially skeptical of micro-captive companies. Always make sure the entity has been formed for risk and management purposes, and not just for the tax savings.
  • The IRS requires risk distribution and risk shifting to exist for a transaction to qualify as insurance, and any suspicious transactions could be scrutinized to check for tax-evasion tactics.
  • There will likely be additional costs associated with running a separate entity, including setup, administrative, and management expenses.
  • A traditional insurance company spreads the risks among its insured parties. With a captive insurance company, that shared risk doesnt exist, and reinsurance is usually used to further protect the insured. If a large claim comes along, the reinsurance cost could increase quickly.

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Is It A Listed Transaction

The IRS has issued Notice 2004-65 which has successfully de-listed the Section 831 statutory captive insurance company as a tax shelter. So, it is not a listed transaction and the IRS does not require special notification that one is participating in such a program. IRS Commissioner Mark. W. Everson has states, Based on disclosures from taxpayers and examination of tax returns, we have determined problems associated with these transactions are no as prevalent as initially believed. Accordingly we are no longer classifying them as listed transactions.

See Captive Insurance Minimum Capital and Surplus Requirements by jurisdiction.

The Principles Of Captive Insurance And The Controversy

The IRS defines a captive insurance company as a wholly owned insurance subsidiary. Insurance can be defined by three basic tenets initially derived from Harper Group v. Commr , which states that all captives must comply with the following three factors: 1) the arrangement involves the existence of an insurance risk, 2) there is both risk shifting and risk distribution, and 3) the arrangement is for insurance in its common accepted sense. United States Tax Court decisions have, over time, brought clarity to captives established in a compliant manner.

Because of the prevailing state insurance regulations in the 1950s, Reisss initial captive insurance company was established in Bermuda. Thus, the initial growth of the captive insurance industry was offshore, and many still believe that captives are a strictly offshore business phenomenon. The IRS initially questioned the concept of deductible self-insurance and, in 1977, issued Revenue Ruling 77-316, which denied the deductibility of captive insurance premiums based on what was referred to as the economic family doctrine. This doctrine, which called into question the basic tenets of risk shifting and distribution established in 1941, was fought in the courts and ultimately repudiated.

Captive arrangements can increase the probability of success by incorporating the use of independent advisors, including tax advisors, legal counsel, actuaries, risk managers, and captive managers.

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Who Is Responsible For This Tax

Captive insurers licensed in Texas may only insure the operational risks of affiliates and the risks of a controlled unaffiliated business. Premium tax is due on the entire premium these captives receive regardless of the location of the risk.

Single-parent captive insurers may apply for a certificate of authority from the Texas Department of Insurance in order to operate in Texas. An authorized foreign or alien captive that is licensed under the laws of another jurisdiction may redomesticate to Texas with Commissioner of Insurance approval.

How Does An Offshore Captive Insurance Company Work

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The insured companies pay the insurance premiums. The funds are deposited into an account in the name of the captive insurance company. The people who own the insurance company typically own own the insured company or companies as well. So rather than an outside insurance company profiting from the premiums and claims, those who established the entity can benefit from the profit that institutional insurer would normally realize.

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Tax Considerations For Captive Insurance Companies

Congress implemented rules in 1986 that opened up planning opportunities for small insurance businesses.

If a casualty or property insurance company referred to as a mini-captive, meaning it has a gross premium income of $1.2 million or less, requests an election under section 831, it owes tax only on its investment income and avoids tax on its premium income. However, once made, the IRS must consent to the election being revoked. Also, the election is terminated automatically once an entitys gross premium income goes beyond the prescribed limit. If the companys premium income level goes to $1.2 million or below, the company can make another election.

In regards to business structure, an insurance company is taxed as a C corporation, and tax returns must be filed on a calendar-year basis. The exception to this is if it is included in a consolidated tax return. Insurance companies established as a partnership or an LLC must elect to be taxed under the check-the-box regulations of Sec. 7701 as a corporation, so C corporation tax rules apply. With the C corporation tax rules, captives can issue more than one classification of stock and pay out qualifying dividends. These dividends can receive preferential taxation. With that said, if liquidation were to occur, the corporation, along with its shareholders, might be subject to double taxation due to the entity being a C corporation.

Insurance Needs And Introduction To Captive Insurance

For nearly thirty years, Caylor Construction bought commercial insurance to serve its insurance needs, with commercial premiums fluctuating between roughly $50,000 to $70,000 per year. Although the coverages were broad, they did not cover every single loss Caylor experienced: in a ten year period, the Caylor entities had $500,000 of losses not covered by the commercial program, or about $50,000 per year.

In 2007, Rob and Robs accountant attended a captive insurance lunch presentation at a country club. The presenter, Tribeca, covered the basics of captive insurance and stressed microcaptives along with their potential tax benefits. Although Rob was convinced captives would be beneficial, the accountant was less convinced. The accountant informed Rob that captives were outside his expertise, but he offered to conduct an internet search on captives and check with the State Board of Accountancy to see whether any complaints were filed against Tribeca. The accountant concluded that if captives were done right, they had potential to work. He also concluded, however, that he could not determine whether Tribecas specific program would work for federal tax purposes.

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Internal Revenue Service Concerns

Unfortunately, in a few cases, the Internal Revenue Service has rejected some tax claims related to their captive insurance plans. In cases involving Securitas Holdings, Rent-A-Center, and other entities, the taxpayer has gone to tax court to prove the legitimacy of the captive insurance company. In most cases, the tax court upheld the taxpayers right to use captive insurance companies and to reap any associated tax benefits.

However, the main issue that comes up in these cases is the legitimacy of the captive insurer and its relationship to the parent company. To ensure you dont face any tax hurdles like that, you should consider consulting with a professional accountant, but you should also work with an experienced company who can help you set up your captive insurance plan.

Accurate Delineation Of A Transaction: A Genuine Insurance Transaction

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A significant emphasis of the guidance is on accurate delineation of the transaction. According to the guidance, in order for the transaction to be delineated as a genuine transaction of insurance, such that it can be respected and priced as such for TP purposes, the following criteria must be met:

  • There is diversification and pooling of risk in the captive insurer

  • The economic capital position of the group has improved as a result of diversification and, thus, there is a real economic impact for the group

  • Both the insurer and any reinsurer are regulated entities with broadly similar regulatory regimes and regulators that require evidence of risk transfer and appropriate capital levels

  • The insured risk would otherwise be insurable outside the group

  • The captive has the requisite skills, including investment skills, and experience at its disposal and

  • The captive has a real possibility of suffering losses.

While the majority of captives should meet many of these criteria, two in particular stand out as being at odds with some captive arrangements.

The second challenge is whether the insured risk would otherwise be insurable outside the group. Captive insurance companies exist in some instances precisely to insure risks that for all practical and commercial purposes are not insurable externally, whether for cost, or on account of the challenges and administrative hurdles associated with insuring unique or special risks with third parties.

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Revisions To The New York Tax Law

Insurance companies are taxed under Article 33 of the New York Tax Law. Chapter 389 of the Laws of 1997 amended various sections of that Article to impose a premium tax on captive insurance companies. These and other tax law provisions were subsequently amended by Chapters 62 and 188 of the laws of 2003 Chapter 57 of the Laws of 2009 and Chapter 59 of the Laws of 2014. The tax on captive insurers is set forth in Section 1502-b. Captives are not subject to any other taxes under Article 33 of the New York Tax Law.

Notwithstanding the foregoing, if premium income makes up 50% or less of a captive insurers gross receipts for any taxable year, then the captive insurer will be deemed a combinable captive insurance company and will be required to file a combined return with its closest controlling stockholder. In such cases, the captives income will be subject to taxation under the provisions of either Article 9-A or Article 32 of the New York Tax Law, and not Article 33.

Captive Insurance Taxation Nuances

Captive insurance companies are usually taxed on underwriting income after required adjustments for tax purposes. Captive owners may also deduct losses on unpaid losses as they are incurred, providing an accelerated deduction timeframe from typical insurance arrangements or traditional self-insurers. Utilizing captives to transfer risk can provide a residual benefit of significant reductions in effective tax rates on insurance activity.

In addition, smaller captives can make a tax election ) to be taxed only on their taxable investment income. The 831 election is currently available to companies with net or direct written premiums of no more than $2.45 million for tax year 2022. Net investment income includes taxable non-insurance income less qualifying investment expenses.

This election can be especially beneficial to captive owners, providing a full tax deduction for insureds paid premiums while the captives are only taxed on net investment income.

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What Are The Benefits Of A Captive Insurance Company

  • You are in the insurance business: many of our clients got into the insurance business to control costs and then discovered the associated underwriting profit. Insurance is a business opportunity and can be more profitable than the existing, successful business that led to the creation of the captive.
  • Draft your own insurance coverage: captives can often provide coverage for unique or specific risks that are not transferrable in the retail market.
  • Protect Your Assets: cash reserves held on the balance sheet of the parent company are subject to claims and lawsuits of general creditors. Having reserves set aside in a licensed, regulated entity helps ensure that you stay in control of your money: every dollar you pay to the captive is one less dollar left in the business. A properly designed captive is a bona fide insurance company where it would be very difficult for a creditor to successfully argue the payment of legitimate premium is a fraudulent transfer of assets.
  • Ability to participate in favorable claims experience: rather than a third party benefiting from these profits, the business can benefit. Technically, the party that owns the captive is the one that receives any profits, so if the captive is a subsidiary captive, the business receives the profits. Otherwise, whichever party owns the captive receives the profits.
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