As laws have become more advantageous, many small to mid-sized privately held businesses have turned to captive insurance companies to better manage their risk.
At the same time, the IRS and Congress are making it increasingly clear that the structures, — which can have substantial tax benefits in some situations — are not to be abused to evade taxes.
With new regulations going into effect, in addition to a notice from the IRS that it is watching such structures closely, it’s important that companies make sure they are following all the rules and safeguards when they take advantage of this tax benefit.
A captive insurer is generally defined as an insurance company that is wholly owned and controlled by its insureds; its primary purpose is to insure the risks of its owners, and its insureds benefit from the underwriting profits.
Captive insurance companies have been around for years, often set up by larger companies to provide themselves insurance coverage for certain risks — either because insurance was unavailable on the outside market for a particular risk or was too expensive. These captives were traditionally based off-shore due to a more favorable regulatory environment.
But laws and regulations have changed in recent years in some states, including Tennessee, resulting in increased popularity and utility of this type of insurance structure for small and mid-sized companies in the United States. In fact, Tennessee is one of the fastest-growing states for captive insurance companies.
One advantage under U.S. tax law is that the IRS allows for small insurance companies that meet certain tests under IRS Code 831(b) to exclude up to $2.2 million a year in premium income and only be taxed on investment income of the premium pool. This can help build up reserves and cash flow.
Business owners can, as normal, deduct premiums to the insurance company as an ordinary expense. But instead of the premiums going to an outside company, they are retained by the insurance company, which is held by the same owners.
The $2.2 million maximum is an increase from the previous $1.2 million limit, and went into effect Jan. 1, 2017. It was passed as part of the Protecting Americans from Tax Hikes Act of 2015 — also known as the PATH Act.
At the same time Congress increased the exclusion amount, it sought to discourage abuse so that a business owner could not simply use the structures as a way to transfer wealth tax-free to their descendants.
Under new provisions, an insurance company must meet one of two alternative tests to reap the tax advantage. Either it must receive no more than 20 percent of the insurance company’s premiums from any one policyholder (diversification test). Or the ownership of the insured company has to mirror the ownership of the insurance company within a de minimis amount (ownership test).
The goal of the diversification test is to make it easier for small insurers with unrelated policyholders (such as farm mutual insurance companies) to make the 831(b) election, while the ownership test helps curb potential estate planning abuses by companies with related policyholders.
Under the ownership test, which would apply to companies who set up their own insurance coverage, if Dad owns 100 percent of the insured company, he must own 100 percent of the insurance company as well to have it treated under 831(b). Whatever the percentage of ownership of the insured company, the insurance company has to closely match.
If the law did not already make clear that it wanted to deter tax abuse of this otherwise legitimate captive insurance structure, a notice from the IRS in November underscored that point by listing “Micro-Captive Transactions” as transactions of interest.
The cautionary message is one step short of a red flag but does let taxpayers know the IRS is “aware of a type of transaction … in which a taxpayer attempts to reduce the aggregate taxable income of the taxpayer, related persons, or both, using exorbitant premium expenses from closely held captive insurance companies. These premiums may be for insurance policies to cover ordinary business risk or may cover what the IRS has termed “esoteric, implausible risks for exorbitant premiums, while the insureds continue to maintain their far less costly commercial coverages with traditional insurers.”
The IRS notes the transaction can have potential for tax evasion and puts businesses on alert that they must be used properly. In other words, when businesses focus only on the deduction instead of actuarially sound practices, the IRS is going to be suspicious.
Captive insurance companies can be a smart tool for risk management purposes for privately held businesses, but they need to be set up and managed correctly to avoid IRS scrutiny.