On Dec. 18, 2015, Congress passed the Protecting Americans from Tax Hikes Act of 2015 (the PATH Act), which provides some new rules for Captive Insurance Companies (“Captives”). In 2017, Captives will be able to receive $2.2 million in premiums tax free. This also provides the potential for a $2.2 million deduction from ordinary income for the appropriate client seeking greater liability protection. This amount is an increase from $1.2 million in 2016. Congress also added two new hurdles to qualify for the Internal Revenue Code Section 831(b) election for a Captive Insurance Company effective in 2017. Note that there’s no grandfather provision so existing Captives must comply with one of these two new requirements.
- No more than 20 percent of the premiums can come from one policyholder. The definition of a “single” policyholder includes family attribution rules such as that other family members are included in the definition of a “single shareholder” or,
- The insured company may not be wholly owned by one person with the Captive owned by his heirs. The difference in ownership is limited to 2 percent. For example, if the insured company is owned 100 percent by the parents, the children could only own 2 percent of the Captive.
Many business owners using an existing Captive have named their children as owners directly or indirectly as part of their estate plan. A Captive has a unique ability to accumulate wealth quickly from the tax deductible premium payments. Often dynasty trusts own the Captive to minimize estate tax. The ownership structure must be reexamined for qualification under IRC Section 831(b) in 2017.
Captive ownership and its business structure must be reviewed to ensure compliance with the new rules, which take effect Jan. 1, 2017.
Features of Captives
A Captive is a privately owned, legally formed insurance company created to insure the risks of one or more companies owned by the Captive’s founder. The Captive’s objective is to generate a profit by insuring specific risks not typically covered under existing insurance coverage. The founder may be able to substantially reduce property and casualty insurance costs, control premiums and provide an excess cash flow. A Captive can have significant tax effects. The increased popularity and use of Captives has caused greater Internal Revenue Service scrutiny regarding the use, misuse or abuse of Captives.
A pure Captive is owned and controlled by one entity and insures that entity and/or its subsidiaries. A group Captive is an insurance company owned and controlled by two or more unaffiliated organizations, which is formed to provide insurance to its group or association of owners. The owners are usually companies from a related business field.
The Captive can earn investment income on the premiums paid. This investment will allow more funds to be available to pay claims and/or increased profits. The Captive will reduce the administrative costs such as agent commissions, compliance with federal and state regulations, office overhead and salaries otherwise inherent in commercial insurance premiums.
Captives may be formed within the United States or offshore. Several states now have Captive insurance, including Delaware, Hawaii, Montana, Nevada, Utah, Vermont and Washington.
New Form Required
The legislature recognized and approved of the legitimate needs for a Captive by increasing the available amount that can be received tax-free to $2.2 million in 2017. Despite this legislative approval and recognition, the IRS remains concerned that some Captive arrangements are abusive, formed with an eye to tax benefits and not to provide actual insurance coverage or protection.
To better monitor Captives and identify potentially abusive arrangements, the IRS identified certain Captive arrangements using “micro-Captive transactions” as “Transactions of Interest.” Those Captives must file IRS Form 8886 “Reportable Transaction Disclosure Statement” or Form 8918 “Material Advisor Disclosure Statement.” Companies or taxpayers involved in existing Captive arrangements should consult their tax advisor to better ensure timely compliance with this new requirement.
An IRS audit can generally arise in one of two ways. First, a random audit of an individual or business may occur as a result of a computer model selecting returns based on predetermined criteria. Experienced auditors typically review and select those returns. Second, an audit may arise at the Captive level when the IRS obtains participant or customer lists for audit.
Avrahami v. Commissioner (Docket No. 17594-13), which is pending before the U.S. Tax Court, provides some insight into the IRS’s position. The following items may be “red flags” that the IRS believes may be indicative of potential abuse:
- Lack of adequate risk distribution to be considered an insurance company for tax purposes. This arises when the Captive insures only the single business and simply holds the premium monies in the event of a claim. The IRS appears to be very focused on a perceived lack of risk distribution and risk shifting in certain Captive arrangements.
- Failure to obtain an actuarial study supporting the premiums charged by the Captive for the insurance. The IRS will examine the underwriting process.
- Lack of an analysis of the cost and the availability of commercial insurance in the non-Captive market. The IRS believes that insurance rates far in excess of commercially available rates defy common sense.
- Materials emphasizing the estate-planning benefits of the Captive insurance structure. For instance, the IRS will scrutinize a Captive owned by a family limited partnership or irrevocable trust that benefits the business owners’ family members. The IRS takes the position that Section 831(b) wasn’t enacted as an estate-planning tool, but to assist taxpayers who want to manage risk.
- Lack of claims history. This may be indicative of risks that can’t or won’t occur. The IRS believes that no claims may indicate that the insurance pool is insufficient and risk shifting may not exist. On the other hand, many of us have flood insurance, earthquake insurance or other liability insurance that’s needed, but we’ve never filed a claim.
The presence of any of these “red flags” isn’t determinative of the tax consequences. The key seems to be that a legitimate Captive is formed to provide substantial and meaningful insurance coverage and protection that may not be available elsewhere.