Is Captive Insurance a Legitimate Tax Shelter?

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Is Captive Insurance a Legitimate Tax Shelter?

All companies need insurance to safeguard themselves against the danger of loss. With captive insurance, a company may design its own coverage to meet two goals: protection for the company and financial benefits for the owners. Captive insurance is occasionally sold primarily as a tax shelter, although doing so entails risks.

How Captive Insurance Works

A captive insurance firm is one that is owned by the individuals it covers. Policyholders own and control captive insurance firms, as opposed to mutual insurance companies, which are also owned by policyholders. Captive insurance, in a nutshell, is a kind of self-insurance. However, the captive insurance firm, like other insurers, is subject to state insurance rules.

While policyholders own the captive insurer, their ownership is not an investment in the traditional sense. Other than premium payments, no cash or property is donated to the organization. And ownership ends when insurance expires, such as when the owner no longer requires coverage and ceases to pay for it. Nothing may be sold, gifted, or bequeathed by the insured.

Captive insurance firms may be formed in many ways. “Pure hostages” solely guarantee their owners. “Single-parent captives” are owned by a single entity (such as a Fortune 500 corporation); “group captives” are owned by numerous entities. Companies in a single sector, for example, may create a captive insurance business (a group captive) to suit their unique risk requirements.

Captive insurers may be founded in the United States or in a variety of other countries throughout the globe. Each nation has its own capitalization restrictions and surplus retention requirements. There are around 7,000 captive insurers globally, according to the National Association of Insurance Commissioners (NAIC).

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Protection for the Business

Traditional insurance policies may not suit the demands of a company, at least not at a reasonable price. Captive insurance may give more comprehensive coverage than conventional policies. This coverage may be customized to protect against certain hazards. Captive insurance may be attractive to professional services and construction organizations, for example. Members of trade groups may also be offered captive insurance. For many years, the Coin Laundry Association, for example, employed captive insurance since its members couldn’t get regular coverage for their 24-hour companies.

However, the scope of this specialized coverage is rather restricted. The standard captive insurance limit, according to the International Risk Management Institute (IRMI), is $250,000 per event. Losses in excess of this threshold are not covered by captive insurance. Those that have captive insurance employ reinsurance to cover losses that exceed the limit.

Businesses may also better regulate their security costs. Because captive insurance is restricted in scope, it may better control risk and prevent the price increases that are common in the commercial insurance market.

Financial Advantages for Owners

While the primary rationale for captive insurance is risk management, organizations that employ captive insurance may earn provided the company’s underwritings are good. Dividends are often paid to captive insurers’ owners.

Reducing claims is one method to boost these returns. This may be accomplished by improved business procedures targeted at reducing or eliminating claims. Another approach is to do a more thorough evaluation of claims by having a better grasp of events than conventional insurers.

Another way captive insurers make money is by managing expenditures, which are greater in the commercial market than in the captive market.

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Tax Shelter?

For small-business owners, captive insurance is an acceptable tax arrangement. If the arrangement fulfills certain risk-distribution rules, premiums paid to a captive insurer may be tax deductible. As a result, even if losses may never arise, the company receives a current-year write-off. The Internal Revenue Service (IRS) has established the standards under which captive insurance qualifies as insurance for federal income tax purposes and premiums are deductible in Rev. Rul. 2002-89 and Rev. Rul. 2002-90. There are two safe harbors that allow captive insurance to be treated as actual insurance (i.e., premiums are deductible):

  • Fifty percent third-party insurance protection. There is adequate risk dispersion if the captive insurance firm receives at least 50% of its premiums from unrelated third-party insureds.
  • Twelve guaranteed safe refuge. There is adequate risk dispersion if the captive insurance firm has at least 12 insureds, each with between 5% and 15% of the total risk.

However, the IRS may still contest premium deductions if it feels there are gaps in risk distribution, such as reinsurance or tax-shelter agreements.

The IRS recognized micro-captive insurance transactions as a possible risk for tax avoidance or evasion in 2016, but did not have enough information to identify prospective arrangements or their features. In reality, captive insurance was still included as a “abusive tax shelter” on the IRS’s “dirty dozen” list of tax schemes in 2022 (the most recent accessible).

According to the IRS, the issue occurs when micro-captive insurance businesses are formed “may ‘insure’ implausible risks, fail to meet legitimate business requirements, or duplicate the taxpayer’s commercial coverages The ‘premiums’ paid under these agreements are often exorbitant and are used to avoid taxation.”

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Total yearly premiums in these so-called micro captives “frequently match the amount of deductions required by corporate organizations to lower revenue for the year; alternatively, for a rich company, total premiums amount to $1.2 million annually to fully benefit from the [Tax] Code provision.” The IRS has selected these prisoners for audit.

The Bottom Line

Captive insurance may suit a small business’s risk-management requirements while also giving financial advantages, but it is not for everyone. Initial premiums may often range from hundreds of thousands to millions of dollars. There are also significant expenditures, more than a quarter-million dollars, to establish a captive insurance firm and pay actuaries, lawyers, and an insurance specialist (consultant or broker).

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