Expert Commentary

Defending the Need for Captives to the IRS

When a captive is considered and formed, there is usually some form of insurance coverage need. Most of the time, per known statistics, the coverage needed is for workers compensation. Increasingly, captive formation folks are seeking coverage for exposures that the traditional market won't, or don't yet, cover. For example, such a move may turn out not to be tax deductible, which can be a big, not necessarily happy, surprise.


Captives
January 2014

While one never forms a captive for tax reasons, or shouldn't put them first, many businesses today operate in fields of endeavor that are new and different from that in which previous businesses operated. This is increasingly true of cyber risk exposures, among others. These exposures develop so quickly that it is difficult for the traditional market to develop actuarial studies, market and underwriting protocols, and all of the accompanying disciplines to offer coverage. See the ramifications of the recent Target stores' fiasco.

This is where captives step in. This is one reason captives were developed and remain creative and exciting and useful to the business community. Coverage is often desired when it cannot be found. Skilled practitioners are able to develop actuarial rates and coverage to meet the needs.

Coverage in the captive provides discipline to the operations, some comfort to the financial folks, and many benefits to the owners. Tax advantages may be among those benefits.

Other examples would be a pipe manufacturer (whose proprietary product reacts to subsoil moisture and stresses entirely differently than other pipe) that cannot get a traditional market to rate and underwrite its product differently. Or a manufacturer of wire products that must assemble its wire into specific bundles to satisfy major customers that cannot get the traditional insurers to treat its product differently. And yet, the traditional market won't adjust claims or manage risk differently.

Traditional insurers, in order to offer admitted, rated coverage, must develop actuarial bases, underwriting procedures, marketing programs, and many other formalized efforts within their structures. These steps can take months or even years to be in effect and helpful in the market. In the interim period, the exposure remains and builds potential uncovered losses.

A captive can move more quickly. With a sophisticated actuary, a willing regulator, and a competent manager, a policy with wording can be developed and put in place quickly.

IRS Objections

These are situations in which a captive is the obvious solution. But, because they are not done in the traditional marketplace, it is usual for the Internal Revenue Service (IRS) to take the position that the coverage is not legitimate insurance. How can this be?

The federal government does not have extensive experience with or knowledge of captives. This is not generally an issue, as captives are regulated by the states, where there is more and better knowledge of captives. This is where there will be understanding of the need for captive coverage. That's all to the good until one applies for the expected federal tax deduction under ordinary business expenses.

There are existing cases where the IRS has denied the tax deduction for the business cost of the insurance premium because no such coverage exists in the traditional market. This is quite a surprise at tax time. What can be done to prevent this?

The IRS position is often, "If the coverage is not offered in the traditional marketplace, it must not be real insurance; therefore, the deduction is disallowed."

Document Case for Captive

Realistically, one must begin at the beginning. It is not necessary to obtain a tax ruling in advance, but it is prudent to conduct and document a thorough analysis of the new exposure. This admonition applies always, but when we are talking allowable, expected tax deductions, the advice becomes more pointed.

It is important for your actuary to document the needed coverage as to the actual exposure and the logic for the rating structure. If it is possible for them to link it in any way to some existing coverage, that would help the argument.

This is a very good moment for the captive manager, working with the actuary and the attorney, to build the case for the necessity of the coverage and how it would apply to the exposure. Why does the traditional market choose not to cover this critical piece yet? Cite cases of losses that were not covered and caused financial losses to the insured.

More importantly, one should obtain a written confirmation from a traditional market, or several, acknowledging the lack of coverage for the subject exposure. If obtainable, a letter from a traditional insurer stating the lack of existing coverage, its efforts to develop same, and the need in the marketplace to offer such coverage would be extremely useful. It affirms to the IRS the reality of the situation.

Conclusion

This is a situation that is likely to grow with the rapid changes in the business world. As new exposures are created and the traditional market lags behind, a captive is the obvious solution. Now the chore is to get the IRS on board with reality. This will not be an easy task.


Opinions expressed in Expert Commentary articles are those of the author and are not necessarily held by the author's employer or IRMI. Expert Commentary articles and other IRMI Online content do not purport to provide legal, accounting, or other professional advice or opinion. If such advice is needed, consult with your attorney, accountant, or other qualified adviser.

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