In recent posts, including my December 2017 article on OVDP Withdrawals and Rejections, I have described several of the issue-specific “compliance campaigns” launched by the Large Business and International (LB&I) division of the IRS in 2017. One of those campaigns focuses on abuse of the rules governing the creation of captive insurance companies.
What Are Captive Insurance Companies and Why Do They Exist?
Some corporations face risks for which it is difficult to find coverage within traditional insurance markets. Historically, such companies often found themselves having to essentially insure themselves. While some chose to simply put funds aside in vaguely defined risk reserves, others opted to create wholly owned subsidiaries, known as “captive” insurance companies, to meet their insurance needs.
The IRS created special tax rules for captives in the 1950s. Under section 831(b) of the U.S. Tax Code, certain captive insurance companies may elect to pay tax only on their investment income and not on income derived from premiums.
Since insured parties can deduct premiums paid to captives on their tax forms, and since both insured and insurer exist under the same parent corporation umbrella, there can be significant tax benefits associated with the use of a captive insurance company. Perhaps inevitably, some corporations have succumbed to the temptation to form bogus captives that serve exclusively as tax shelters. The LB&I has taken notice. Whereas legitimate insurance companies help to manage risk, illegitimate captive insurance companies now put corporations at greater risk of a visit from IRS enforcement agents.
Captive Insurance Transaction Red Flags: The IRS Is Watching
As I pointed out in a previous article on Valuing Artwork for Charitable Contributions, the IRS looks askance at any transaction that appears to have been conducted for the sole purpose of gaining a tax benefit. In scrutinizing business-to-business contracts—including those between different subsidiaries of the same parent corporation—the IRS relies on the arm’s length standard, which holds that any legitimately negotiated contract will serve the self-interest of both entities.
Fundamentally, the arm’s length standard requires a captive insurer to operate as a legitimate insurance company. Key attributes of a legitimate insurance company include:
1. Insurable Risk
In broad terms, in order to constitute an insurable risk, a scenario must be unlikely but not ridiculously unlikely. A scenario that is probable is not a risk, but rather an expected business expense. Insuring against such a scenario would not serve an insurance company’s interests.
On the other hand, a policy covering an absurdly unlikely scenario would offer no actual insurance benefit for the policyholder. If a company located in Wyoming paid premiums to a captive to cover damage associated with a rabid platypus attack, the LB&I would see a tax dodge, not an insurance contract.
2. Reasonable Premiums
Insurance premiums are set based on extensive actuarial review of existing claims data. No legitimate insurance company can survive by charging premiums that massively exceed industry averages. Paying such exorbitant premiums to a captive can quickly land your company on the LB&I’s radar.
3. Risk Distribution
Because insurable risks relate to unlikely circumstances, most clients of an insurance company will not file claims during the course of any particular year. The premiums paid in by those clients enable the insurer to cover the costs of whatever claims are filed by the unlucky few and still make a profit. This principle is known as risk distribution, and it is the cornerstone of all legitimate insurance arrangements.
One of the clearest indicators of true risk distribution is regular payment of reasonable claims. If the entities insured by a captive either neglect to file claims when events would justify doing so or willingly accept underpayment of claims, the principle of risk distribution is violated and the legitimacy of the insurance company immediately comes into question.
If a captive insurance company does not collect premiums from enough clients to cover reasonably anticipated claims, then there is no risk distribution at all. Captives are therefore allowed to sell policies to outside companies in order to generate a sufficiently large policyholder pool.
Determining whether an insurance arrangement provides adequate risk distribution is a complicated process. If you are unsure whether your captive insurer meets the LB&I’s requirements, consult a qualified tax professional.
4. No Circular Money Flow
The LB&I is particularly on the lookout for transactions in which a captive insurance company makes payments to clients in a manner that does not qualify as taxable income for the insured, such as issuance of loans. Such arrangements take on the look of a circular capital flow, from the insured to the captive and back to the insured. If an aging Han Solo worked for the IRS, he would tell you, “That’s not how insurance works!”
Conclusion: Insuring Legitimately Ensures Compliance
With regard to the LB&I’s micro-captive insurance campaign, the simplest guiding rule is one that children hear daily: Use it for what it’s there for. The IRS has repeatedly affirmed that it will honor the 831(b) elections of legitimately functioning captive insurance companies. If the insurance is legitimate, the tax benefits will be as well.