September 3, 2019
The high cost of insurance is an issue for most companies. A strategy used by 90 percent of the Fortune 500 companies to help control the cost of insurance is to form a captive insurance company (captive). This is an insurer wholly owned by a parent company which provides insurance to its parent and related companies. Captives are generally used to augment existing commercial policies and provide insurance for risks not covered by traditional insurance.
Captives can cover everything from general and umbrella liability to workers compensation, regulatory changes, and legal defense. Some companies use captives to fund employee benefit programs like life and disability insurance, retirement, and healthcare benefits. Other types of insurance captives offer include employment practice liability, contractor liability, director/officer/employee liability, contractual liability, property damage and business interruption, fiduciary liability, equipment, and protection against pollution, mold and other environmental claims.
Generally, any type of definable and measurable risk can be covered by a captive provided the state or country in which it is domiciled (i.e. incorporated, licensed, managed and operated) allows the line of business to be underwritten. Contractors can custom tailor insurance policies to cover their specific needs. Captives can also be used to decrease the cost of commercial policies. Contractors can elect to reduce premiums by increasing deductibles and then have the deductible paid through the captive.
In order to qualify as an insurance company for tax purposes, the captive must have adequate risk shifting and sharing and operate and be regulated like an "actual" insurance company with enough capital to allow it to take risk. The company must be a U.S. taxpayer, either domiciled in the United States or offshore. The captive must also elect and qualify under Section 953(d) to be taxed as a U.S. insurer. The gross premium income for the tax year in question must be $2.3 million (for taxable years beginning in 2018) or less with the premium cap subject to inflation adjustments. This premium threshold applies to all insurers included in a single consolidated tax filing.
In the past, captives only made sense for companies with at least $100,000 in insurance premiums and more than $10 million in revenue. Today, it is possible for smaller contractors to form their own captives due to declining capital requirements and operating costs. Ideal candidates are businesses with $500,000 or more in profits, multiple entities, risk currently uninsured or underinsured, and interest in protecting its assets while possibly minimizing its tax obligation. A properly structured captive offers both added insurance coverage and numerous tax planning opportunities, including but not limited to tax deductions on insurance premiums paid to the captive, lower income taxes, and possible tax saving on shareholder dividends.
Smaller or “micro-captives” may qualify to be exempt from federal income tax on operating income. Under Internal Revenue Code section 831(b), a captive with a gross premium income of $2.3 million or less that makes an election under that section is not taxed on premium income but is taxed on investment income. In other words, if the captive is established according to IRS guidelines, it may qualify to receive up to $2.3 million in premiums tax free from its parent company. The parent or affiliate company can then take a deduction for the amount paid to the captive as a legitimate business expense.
The captive can make a profit if claims are less than the premium paid by the company. A portion of the profits can then be reinvested to avoid ordinary income taxation. Or, the funds could be disbursed to the company’s shareholders as a qualified dividend which would be taxed at a lower rate. Even so, there is always the risk that claims against the company could be higher resulting in a loss. Therefore, it is important to consider what risks to insure under the captive instead of a commercial policy.
Many contractors join a group captive where a number of businesses come together to form their own insurance company or an association captive which is established by a trade group for the benefit of its members. Participating in a group or association captive allows its members to share, in some degree, the collective risks, as well as the benefits such as potential investment earnings and profits from premiums paid in excess of claims. Since group members make a commitment to minimize risks, participation also serves as a risk management tool.
It should be noted that the IRS has included “micro-captives” on its "Dirty Dozen" list of tax scams to avoid for many years. According to the IRS, insurers that qualify as small insurance companies can elect to be treated as exempt organizations or to exclude limited amounts of annual net premiums from income so that the captive insurer pays tax only on its investment income. In certain “micro-captive” structures, owners of closely held entities are encouraged to participate in schemes that do not qualify as insurance.
As with any business strategy a contractor should consult with legal counsel, as well as accounting, insurance, and other professionals before establishing a captive. Contractors need to be fully aware of compliance and funding requirements, as well as IRS regulations. It is important to carefully consider all the costs, risks, and benefits to ensure that a establishing a captive is a viable strategy for a business.
Martin C. McCarthy, CPA, CCIFP
McCarthy & Company, PC
Disclaimer: This alert is for informational purposes only and does not constitute professional advice. Information contained in this communication is not intended or written to be used as tax advice, and cannot be used by the recipient to avoid penalties that may be imposed under the Internal Revenue Code. We strongly advise you to seek professional assistance with respect to your specific issue(s).