Many businesses form wholly owned captive insurance companies for legitimate risk management purposes and to take advantage of potential tax savings. Unfortunately, some promoters of so-called “microcaptive” schemes have run afoul of the IRS by helping businesses set up captive insurers solely to evade federal income taxes.
If your business is considering forming a microcaptive insurance company to reduce its tax burden, you should consult with a qualified, objective tax professional before taking any action. The penalties for illegal tax-avoidance schemes can be severe, and the IRS has been quite successful in pursuing such cases in recent years.
Captive Insurance Tax Benefits
A captive insurance company is a legally licensed, limited-purpose property and casualty insurance company formed to insure the risks of its owners. Companies commonly form captives to insure against risks their commercial policies exclude, to add coverage above their commercial policies’ maximum limits, or simply to provide coverage at lower cost.
In addition to cost-saving and risk-management benefits, there are also some potential tax advantages that can lead companies to consider forming a captive. Under Internal Revenue Code Section 831(b), certain small property and casualty insurance (P&C) companies can qualify to be taxed solely on their investment income, not on their underwriting income.
In other words, the premiums that a qualifying P&C insurance company collects might not be taxable as income, even though those same premiums would be a deductible business expense to the company that pays them. When an insurance company and the business it insures share common ownership, this can present an opportunity for significant tax savings—but also a risk for potentially illegal tax avoidance.
To qualify for this tax treatment, a captive insurance company must meet certain conditions, including a ceiling on its premium income (hence the term “microcaptive”). For 2022, the maximum premium income for an insurer to qualify under Section 831(b) is $2.45 million.
A more importantly requirement is that a microcaptive must be operated and regulated as a licensed, legitimate insurance company. This means it must have adequate risk-shifting and risk-sharing capabilities, sufficient capital reserves, regular premium schedules, and documented claims procedures.
Recognizing a Questionable Plan
The potential tax benefits of forming a microcaptive can be attractive to many companies, but these advantages have also attracted the attention of the IRS, which regards certain types of microcaptives as potentially abusive tax shelters.
In many instances, promoters will approach a business about forming a microcaptive insurance company, offering to help the business qualify for Section 831(b) tax savings in exchange for set-up and management fees. Some such offers may be legitimate, but businesses should be alert to warning signs of a potential scam, which include:
- Coverage against risks that are highly unlikely, unrelated to the business, or already covered by other policies
- Premiums that are arbitrary, unusually high, or collected only intermittently
- Lack of clearly defined claims procedures
- Inadequate reserves to pay claims
- Lack of defined investment guidelines to maintain liquidity
Put simply, if your sole motivation for creating a microcaptive is to lower your tax bill, there’s a good chance the IRS will regard the plan as an abusive tax shelter.
The IRS Cracks Down
The IRS first listed abusive microcaptive insurance schemes on its annual “Dirty Dozen” list in 2014 and has made them a priority enforcement issue ever since. In 2016, the agency issued Notice 2016-66 (https://www.irs.gov/pub/irs-drop/n-16-66.pdf), which identifies specific microcaptive features that qualify as “transactions of interest.” It also spells out extensive disclosure and reporting requirements for companies engaged in such transactions.
In 2019, the IRS issued a broad settlement offer that allowed taxpayers being audited for questionable microcaptive transactions to settle their cases in exchange for exiting the arrangement and making other concessions. A year later, it launched 12 dedicated microcaptive examination teams to target and litigate such cases, successfully prosecuting numerous microcaptive insurance companies and their owners in US Tax Court. In June 2022, the 10th US Circuit Court of Appeals upheld the IRS’s argument in one of these convictions, further strengthening the agency’s position in future cases.
A captive insurance company can be a legitimate and valuable risk management strategy for many businesses. But before you enter into such an arrangement, it is important to have an impartial third-party underwriter, actuary, or risk management professional review premiums, coverage, and other plan details.
Above all, it is essential that you consult a qualified, objective, and trusted tax professional before agreeing to any microcaptive insurance plan. If your company is already engaged in a microcaptive plan, your tax pro can also help you explore options and alternatives.
Contact Holbrook & Manter today with any questions you may have.