Many businesses use captive insurance companies to meet their risk management needs, control costs and reduce taxes. Recent developments have created new opportunities to take advantage of captives. At the same time, new restrictions designed to curb perceived abuses of micro-captives may require some companies to modify their captives' ownership structures.
Captives can be structured in many ways, but essentially, they are insurance companies owned and controlled by those they insure. Benefits include stable premiums, lower administrative costs, the ability to cover risks that are unavailable commercially and participation in the captive's underwriting profits and investment income. income.
Captives also offer significant tax advantages. For example, unlike self-insurance reserves, premiums paid to a captive are deductible. As an insurance company, the captive can deduct most of its loss reserves. Micro-captives—those with annual premiums of $1.2 million or less—enjoy even greater tax advantages. They may elect to exclude premiums from their income and pay taxes only on their net investment income, although they will lose certain deductions.
A captive can also be a powerful estate planning tool. By placing ownership of a captive in the hands of family members, business owners can transfer wealth to their heirs free of gift and estate taxes.
To provide these benefits, a captive must qualify as an insurance company for federal income tax purposes. Among other things, this means that premiums must be priced based on actuarial and underwriting considerations and the arrangement must involve sufficient distribution of risk.
There is no bright-line test for risk distribution, but the IRS has ruled that it exists when a wholly-owned captive:
- Insures the parent's operating subsidiaries, none of which pay more than 15% of the premiums; or
- Receives more than 50% of its premiums from unrelated third parties.
According to the IRS, a captive that insures only the risks of its parent does not distribute risk.
Several recent Tax Court cases may create fresh opportunities for companies to establish captives. In the court's view, risk distribution exists when there is a large enough pool of unrelated risks, regardless of the number of entities involved. In other words, a captive achieves risk distribution if coverage is spread over a sufficient number of employees, facilities, vehicles, products or services, even if they are all part of the same entity. However, it is not certain how the IRS will react to such arrangements.
Last year's Protecting Americans from Tax Hikes (PATH) Act had a big impact on micro-captives. Beginning in 2017, the premium limit went from $1.2 million to $2.2 million, making this vehicle available to more companies. But, at the same time, this act also establishes a diversification requirement that will be monitored through annual information returns. To qualify, a captive must meet one of these two tests:
- No more than 20% of premiums come from any one insured; or
- Ownership of the captive mirrors (within a 2% margin) ownership of the insured business.
The first test may be difficult for smaller captives to meet. The second test essentially prohibits the use of a micro-captive as an estate planning tool.
Review Your Insurance Arrangements
The recent developments described above may open up captive insurance to more businesses. If you have ever considered establishing a captive, now is a good time to revisit this strategy. Generally, it takes several months to set up the captive properly and get all of the actuarial studies completed.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.