October 3, 2023
A Guide to Tax Considerations for Captive Managers
All organizations face risks that may threaten the institution’s financial health and ability to achieve profit and long-term viability. Many tools in the marketplace are available to help mitigate certain types of risks such as purchasing insurance, also known as risk sharing or risk transferring. The purpose of transferring risk is to distribute the risk in order to share the burden.
The most commonly used method of risk transference for businesses is purchasing insurance and paying a third party, or a traditional insurance company, insurance premiums to assume the risk.
While this assists businesses in transferring risk, traditional insurance companies may charge high premiums and may not offer types of insurance that are targeted or robust enough for an entity’s specific insurance needs.
In this situation, a business may consider forming a captive insurance company to not only lower premium costs and overhead, but to customize policies to unique business risks and pursue additional control of terms of coverage.
While there are many rewards associated with creating a captive insurance company, there are also several risks and tax implications to consider before diving in head first. One of the most important hurdles a captive must overcome is qualifying as an “insurance company” for federal tax purposes.
What is a Captive Insurance Company?
A captive insurance company is a separately formed entity created to provide risk mitigation services to a company or a group of companies. The purpose of an insurance captive is to generate revenue and to pay losses while affording greater control over risk financing and losses that may occur. A captive must be licensed as an insurance company through a state or foreign jurisdiction and qualify as an “insurance company” for federal tax purposes in order for the insureds to deduct their premiums.
What Qualifies a Captive as an Insurance Company?
Under the Internal Revenue Code (IRC) § 816 (a), an insurance company is:
“Any company more than half the business of which during the taxable year is issuing of insurance or annuity contracts or the reinsuring of risks underwritten by insurance companies.”
This definition has long been debated and open to interpretation in the courts due to the vague nature of the statutory language. In Helvering v. LeGierse, 312 U.S. 531 (1941), the Supreme Court addressed the lack of statutory definition of the term, but in AMERCO v. Commissioner, 96 T.C. 18 (U.S.T.C. 1991), the U.S. Tax Court reiterated three basic criteria for a proper framework to be adopted in determining the definition of insurance for federal tax purposes:
- An insurance transaction must involve insurance risk,
- Insurance must involve risk shifting and risk distribution, and
- In the absence of a statutory definition, insurance is to be defined in the commonly accepted sense.
What is Risk Shifting and Risk Distribution?
Generally, risk shifting is when one party shifts risk of losses to another. Risk distribution means the party receiving the risk distributes the potential liability amongst others. Over the years, the courts have opined on the meaning of risk shifting and risk distribution and how these elements factor into determining insurance for tax purposes.
Below are some important precedents and takeaways that both the Internal Revenue Service (IRS) and courts in the United States have used to determine insurance status:
- IRS Revenue Ruling 2005-40 reinforces that if both of these characteristics are not present in an arrangement it will not constitute insurance for federal tax purposes.
- Rent-A-Center,Inc. and Affiliated Subsidiaries v. Commissioner, 142 T.C.No. 1 (2014) looked at the presence of a “sufficient number of statistically independent risks” and not the number of insureds. The court concluded that the captive achieved risk distribution because it assumed and pooled premiums for “a sufficient number of statistically independent risks.”
- In the ruling of Securitas, Securitas Holdings, Inc. and Subsidiaries v. Commissioner, T.C. Memo 2014-255 (October 29, 2014), the court found that risk shifting can be achieved despite a small number of policyholders, as long as there are sufficient risks for the law of large numbers to apply.
Why Does the Designation as an Insurance Company Matter?
While the benefits of an insurance captive may outweigh the risks, it is crucial for a company to understand the nuances of forming a captive and consider all the tax implications that may affect the bottom line. Tax and accounting rules allow favorable deductions for insurance premiums as an ordinary and necessary business expense under IRC § 162 for the insured, and a portion of current unpaid loss reserves for an insurance captive. However, a captive must be appropriately structured as an insurance company for federal tax purposes in order for both parties, the insurer and the insureds, to receive these benefits.
What Do the Regulators Think?
Over the past few years, the IRS has increased scrutiny of captive insurance companies due to abuse and tax avoidance strategies utilized by some for transference of wealth and other improper usage of micro-captives. Recently, the IRS and Treasury Department released proposed legislation to further crack down on these bad actors.
It is now more important than ever for captives to document their compliance with regulations in order to reduce the chance of significant tax penalties or tax audits, particularly in the micro-captive space and those electing 831(b) status.
At Johnson Lambert, our tax professionals are experts in the Captive Insurance space and are here to guide your organization in the process of formation and mitigating risk. The Johnson Lambert tax team can help navigate your organization through ever changing and increasingly complicated tax laws and compliance concerns. Please contact our Tax Partners, Brandy Vannoy and Allan Autry, for assistance.
Disclaimer: The content contained herein is provided solely for educational purposes to Johnson Lambert LLP’s intended audience, and should not be relied upon as accounting, tax, or business advice because it does not take into account any specific organization’s facts and circumstances.