Taxes and Insurance Captives

October 2008

There is a growing movement to convince those considering captives to form them for the perceived tax benefits. While it has long been axiomatic that one does not form a captive solely for tax reasons, that axiom is being tested more frequently than ever.

by Michael R. Mead
M.R. Mead & Company, LLC

To be clear, I am not qualified to offer advice about taxes, nor am I doing so. That said, I attend many meetings where the subject is discussed and will share some observations about what I have learned.

Tax Code Exceptions

Insurance premiums paid as a business expense are usually deductible when paid to an unrelated third party which is qualified as an insurance company. There are many nuances to that statement when the third party insurer is a captive. These nuances can make or break the deal.

The ownership of the captive, in general, cannot be the same as the ownership of the insured and have the premium pass as deductible.

There are some notable exceptions to that statement and they have been provided by the Internal Revenue Service (IRS). In days long ago, to encourage the formation of insurance companies for small businesses and businesses and individuals located away from commercial centers, two exceptions to the Internal Revenue Code were created known as 501(c)(XV) and 831(b). Both of these sections, in slightly different ways, excepted small premiums and the investment income derived thereon from taxes.

Probably to no one's surprise, people began to use these sections for purposes not originally intended. The 501(c)(XV)s were particularly attractive as both premiums under $1.2 million and investment income on capital were excluded from taxation. This favorable situation culminated in a well-known case in which the owner had over $100 million in capital supporting premiums of $1 million. His tax deductions finally drew the attention of the IRS, not in a good way, and the exception was modified sufficiently to rein in new formations of these entities. He did not fare well in the resultant actions.

Not to be deterred in the quest for tax angles, the attention of many is now turning to 831(b)s. The premium level is higher, at $1.2 million, and the tax exception is only on underwriting income, but it is an existing exception. Many tax, investment, and captive advisers have made the formation of these entities the centerpiece of their Web sites and their sales activity.

Cautionary Notes

Granted that using a legitimate tax code section to reduce one's tax bill is smart business, a few cautionary notes should be considered. First of all, the exception to payment of tax must be applied for and granted by the Treasury Department. The exception is perpetual, and only the Secretary of the Treasury can end it. This element adds to the business planning the necessity to keep annual premiums below $1.2 million. That may not always be possible, or it may even be overlooked. It is possible that such a development could not only endanger the tax position of the captive and captive owner but also present business insurance challenges if the captive cannot be used as intended because it would raise the premium.

Second, should this growing promotion draw the unwanted attention of Congress, it is likely that the law would be changed unfavorably. That is always a concern in the captive business, but in today's situation—where there is widespread promotion of this exception—it is far more likely to draw interest from the IRS and Congress.

A variation of this current promotion of 831(b)s is to avoid the $1.2 million dollar annual premium restriction by forming serial captives all applying for the exception. It would seem that this approach would also draw attention as egregious action, and it would certainly increase the frictional cost of the captives. Each entity would still have to be audited, licensed, managed, taxed, and operated. Perhaps the tax benefits would outweigh this increase in frictional costs, but it would need careful analysis.

Conclusion

I would continue to maintain that the purpose of forming a captive is to control one's own risk and risk dollars. Any tax benefits derived are advantageous but can also be temporary and even painful if not handled with care.

There as many approaches to captive management and tax planning as there are advisers, so one must always be cautious, particularly when considering whether or not to "push the envelope" with the IRS. There certainly are techniques for tax deductibility in which the facts and circumstances have been approved by the IRS, and keeping close to those decisions would seem to be the wiser choice.

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