Managing risk and insurance is already enough of a pain, especially when there’s more money taken from your business. Understandably, you would look for alternatives and figure out financial strategies.
Many business owners think captive insurance markets are a safe tax shelter. Let’s get this out of the way now: if you’re looking into captives as a tax shelter, you need to reconsider the reason you would be a captive owner. It’s a bad idea–unless you enjoy the IRS breathing down your neck.
At ReNu Insurance Group, we’ve helped over 130 businesses become captive owners by following the rules by the book. We’ve also turned away our fair share of businesses that wanted to be captive owners for tax purposes. We understand the implications of what can happen when businesses join captives for the wrong reasons.
In this article, you’ll learn about the purposes of captives, why businesses see captives as a tax shelter, legal risks with the IRS, and the primary reason businesses become captive owners. That way, you’ll understand why going into captives with them being a tax shelter is a bad idea.
How does captive insurance work?
A captive insurance company is a type of insurance company owned and controlled by its insureds. It is primarily set up to insure the risk of its owners. Like any other insurance company, captives are expected to follow the regulations of their domicile, offshore or onshore.
There are different types of captives, such as single-parent, group, and cell captive insurers.
Why some business owners look at captives as a tax shelter
Some business owners are tempted to use captives for tax advantages, believing they can deduct insurance premiums and avoid taxes on income until funds are withdrawn from the captive.
In reality, captives offer legitimate benefits such as risk management, cost savings, and improved control over insurance. Remember: captive insurers are primarily a long-term insurance strategy. The last thing you want is the IRS all over you and your business.
Regardless of the benefits, you might still be curious about how your business would do when you are part of a captive. Take this assessment before continuing to see how captives can benefit your business.
What are the legal risks with captives and the IRS?
First and foremost, the IRS wants to be sure your captive is a legitimate insurance company. There are stringent rules for what qualifies a legitimate insurance company. Your captive needs to be recognized as a bonafide insurance entity with these three criteria:
- Risk Transfer - The captive must transfer risk to a third party.
- Risk Distribution - The captive must pool risks from various unrelated entities.
- Insurance Characteristics - The insurance must cover genuine insurable risks. Not investment risks or business risks. For example, the IRS won’t be cool with you insuring your building in Montana for hurricane risks.
If a captive doesn’t meet these requirements, the IRS can disallow the tax deductions for premiums paid. This can lead to penalties and back taxes. If the IRS hears you say, “I want to go into captives for tax purposes,” they will grab their camera and look closely at your actions like L.B. Jefferies from Alfred Hitchcock’s Rear Window.
The IRS has been actively auditing captives, especially those formed under section 831(b) elections. They allow small insurance companies to be taxed only on investment income. In the past, this has led to some businesses misusing this election. Business owners can find themselves facing legal challenges and significant fines.
There have been various cases where business owners faced severe consequences for improperly using captives. For example, some have insured highly unlikely events like tornado insurance in San Diego at exorbitant premiums above market rates. When these practices were audited, the IRS ruthlessly went after these businesses like the hammer of Thor, implementing hefty fines and disallowing deductions.
Watch this video that covers the relationship between captives and the IRS:
Misconceptions of using captives for tax purposes
One common misconception is that captives can be used to shelter money and avoid taxes. That’s just not the case. Funds in your captive are subject to taxation, even when distributed.
The costs and complexity of maintaining a captive can outweigh tax benefits. Businesses already require an initial investment, ongoing administrative costs, regulatory compliance, and actuarial services.
How businesses should use captive insurers
Again, if you plan to be a captive owner primarily for tax purposes, rethink your decision. You’re asking for the IRS breathing down your neck. Captives are an insurance strategy.
Captive insurance is a tool for businesses that focus on risk management and safety for their insurance needs. They provide control and lower costs over time (assuming you keep claims to a minimum). Businesses can use captives to self-insure against specific risks that are not adequately covered by the traditional insurance markets.
Look at captives as a long-term insurance strategy
It’s been said once and will be mentioned again: Don’t be a captive owner primarily for tax purposes. They’re a long-term insurance strategy focused on safety and risk management. Going in primarily for tax purposes is a way to get the IRS to put all their focus on you but in the same way as a toxic relationship. And things won’t work out for you in the end.
However, being a captive owner primarily for insurance purposes has its benefits. That’s why you need to read our article Is Captive Insurance Right For My Business? See if it is the right fit for you. And also, check out our article How Do I Profit in a Captive?
If you have any questions about captive insurance, schedule a call with one of our insurance advisors at ReNu Insurance Group!
