The captive insurance model has been widely accepted for over 50 years and has evolved into a helpful financing tool for business owners who want to insure their risks. Being recognized as an insurance company, a captive is subject to regulatory oversight and the potential scrutiny of the Internal Revenue Service (IRS).
As a business owner, it’s no wonder you’re concerned that the IRS will be watching your every move and tax the hell out of you if you decide to be a captive owner.
In recent years, there has been a growing perception that the IRS is not a fan of captives. Captives are a legitimate form of insuring your business. It’s always the bad players that make people look at captives negatively.
At ReNu, we believe it is important to put this perception into context. To put it plainly, not all captives have been managed appropriately, and—as with anything—once a few parties try to cheat the system, the system starts watching everyone more closely.
After reading this article, you will better understand what it takes to be compliant with the IRS as a captive owner. That way, you can see if captives are the right fit for your business.
Why is the IRS keeping an eye on captives?
Certain tax elections allow insurance companies to only pay tax on investment income and not underwriting profit. Some business owners are being pitched captives as a tax shelter using this election.
Business owners who enter a captive solely for the tax benefit raise a red flag for the IRS, which has a potential impact on all captive owners for heightened scrutiny. For a business that is vigilant in establishing and managing its captive—and in complying with all regulatory and IRS requirements—this added scrutiny just serves to continuously improve its efforts.
For a business that is trying to pull a fast one on the IRS, they’ll be held accountable and pay the price for cheating.
How is the tax deduction different with a captive?
When a business is buying insurance from a third-party carrier, that business can deduct its premium as an expense after it is paid. In contrast, when you self-insure with a “rainy day” bank account of $2 million, the business cannot deduct any amount from the fund until payments are made on claims.
However, that third-party insurance company can estimate future payments for losses and deduct their present value in the current year. So, for the example given above, the insurance company can deduct most of that anticipated $2,000,000 payment in year one.
If the business owner elects to enter a captive rather than outsourcing their insurance program, then things change. Because a captive can deduct the anticipated loss up front just like any other insurance company, the captive owner benefits from the resulting tax deduction.
While there are tax benefits, they should not be a primary motivation to join a captive insurer. Watch this video that explains potential tax benefits.
What does the IRS look for when scrutinizing captives?
If the arrangement is a sham, or if it even appears that it has been established solely for tax purposes, then the IRS will demand that the captive owner demonstrate a non-tax business purpose for establishing the captive, along with proper documentation and related actions.
The most recent tax court decisions regarding captives have required that the following criteria be met for the captive to merit consideration as a bonafide insurance company:
- an insurance risk must be involved;
- the risks must align with common notions of insurance;
- risk shifting; and
- risk distribution.
Insurance risk
The owners must demonstrate that they want to be in the insurance business (willing to assume and share insurance risk), and the captive must be operated as an insurance company, observing formalities and operating at arm's length from the insured parties.
Concerning insurance risk, the tax court wants to confirm that:
- there is a realistic (not speculative) chance that a loss will occur;
- there is a chance that a loss will not occur (allowing for some fortuity);
- the insurance risk differs from a business risk; and
- the insurance risk differs from an investment risk.
Common notions of insurance
The term “common notions of insurance” refers to the things insurance typically covers.
Atypical risks—things outside the norm—trigger greater IRS scrutiny. If challenged, will need to be justified and substantiated with documented evidence of both the safety and the captive owners’ risk management measures to mitigate the risk.
In the leading case on what constitutes insurance (not just captive insurance), the U.S. Supreme Court noted that neither the Internal Revenue Code nor the Treasury regulations define insurance. Accordingly, the Supreme Court stated that in determining if a transaction is insurance, the transaction must be insurance in its commonly accepted sense. This is sometimes worded that the transaction has common notions of insurance.
Risk shifting
“Risk shifting” refers to the situation where a person facing the possibility of an economic loss transfers some or all of the financial consequences of that loss to the insurer. After this transfer, a loss by the insured does not affect them because the insurance payment offsets it.
When the IRS is reviewing a captive, the risk-shifting criteria are often met if the captive is well capitalized, the risk is shared, and no one guarantees the captive’s performance.
Risk distribution
Risk distribution requires a sharing of risks. There must be sufficient exposure units (e.g., employees, stores, vehicles, etc.), and the IRS requires that there be many insureds.
One test that is sometimes applied to confirm risk distribution is that an insured does not pay its losses. The courts have found that risk distribution exists in either of two scenarios: There is enough outside business, or it is “brother-sister” insurance.
What types of captives is the IRS cracking down on?
The IRS has been closely examining micro-captives within the last decade due to what the IRS perceives as the “potential for tax avoidance or evasion.”
A micro-captive is a small captive insurance company that may be taxed under Internal Revenue Code § 831(b), which provides that a captive qualifying to be taxed as a U.S. insurance company may pay tax on investment income only in any year that its written premium is at or below the threshold for the applicable tax year.
Micro-captives often have only one owner, making risk distribution an essential requirement for their being recognized as a legitimate insurance company.
What is Section 831(b) of the Internal Revenue Code?
Internal Revenue Code Section 831(b) was established in 1986 as part of a U.S. tax overhaul. It is a tax exemption that was initially meant to benefit small, mostly agricultural-based mutual captives, allowing for the captive’s underwriting profit to not be taxed at a federal level.
How do 831(b) micro-captives work?
A micro-captive, like other types of captives, is wholly funded and controlled by its owner(s). The micro-captive must abide by the regulations set forth by its captive domicile, that is, the state, country, or territory that licenses it. A micro-captive has some additional and unique considerations:
- it can’t be a life insurance company;
- it must elect to be taxed under IRC 831(b); and
- its annual premiums can’t exceed the established threshold for a given year.
Why is the IRS targeting 831(b) micro-captives?
A micro-captive must meet the IRS’s diversification requirements, which, among other things, specify that no policyholder can contribute more than 20% of the micro-captive’s annual premiums. In addition, if the micro-captive is defined as a “transaction of interest” by the IRS, it is subject to additional reporting requirements around such things as its assets, claims, and how premiums were set.
Since the increased scrutiny on micro-captives began in 2012, soft-warning letters have been issued to thousands of taxpayers involved in captives being taxed under 831(b), informing them of increased examination and the potential resulting penalties. And even though some groups under audit were offered settlements in 2019, the IRS established a new office in 2021 dedicated to addressing the abusive micro-captives.
How can I avoid being targeted by the IRS if I join a captive?
The IRS is being heavy-handed in its response to captives overall because a few uninformed, unprepared “bad actors” are advising business owners to make bad choices. For the most part, the people who are getting into trouble don’t have a non-tax reason for belonging to a captive. They only joined a captive for the tax deduction, making the captive a brighter spot on the IRS radar.
If you can’t back up your premium with actuarial data, you don’t have insurance. For example, you are insuring a building in Florida for an earthquake. The probability of an earthquake happening in that area is next to zero. Scammers tout the ability to insure for this risk and convince business owners that it’s viable. The IRS has a different opinion.
If people abuse the law and claim a business need for coverage that is not supported by fact, then the IRS sharpens its focus to detect any other similar abuses. And because it is more challenging with an 831(b) to substantiate coverage claims, a micro-captive has to go through more hoops if challenged.
At ReNu, we firmly believe that the best way for any captive owner to avoid (or at least minimize) the headaches of an IRS challenge is to ensure that your captive meets all the criteria of a valid insurance company. This means establishing your captive properly and for the right reasons, developing and maintaining a well-documented risk management program, and ensuring vigilant oversight of the captive over time.
The best companies are going to captives because they want to control their coverage, but even they need to be able to support that choice if challenged by the IRS.
To find out more about the financial impact of captive ownership, be sure to read our article on whether captives help with your business’s cash flow.
If you're looking at captives as an insurance strategy, you might be wondering how your business would perform. Take your captive assessment to get your results.
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