Expert Commentary

Year-End Captive Advice

As we move into the rush of applications for the end of the tax year, there are some key points to keep in the front of your mind as noted below.

October 2012

There continues to be a large swell of interest in and applications for tax advantaged structures. This year, 2012, presents the possibility of being the final year of several significant tax positions, and advisers are rushing to complete new captives while the gates are open.

As these captives are being formed, it behooves the alert captive prospective owner to be reminded of some issues that may well draw your captive into unwanted scrutiny.

Actuarial Feasibility Study

The first issue perhaps is the necessity of an actuarial feasibility study to accompany the application. I have encountered advisers who believe that this step is satisfied by the domicile's own actuarial review of the captive applicant's actuarial report. These are not the same thing. One will not satisfy the requirement of the other. By not getting your own actuarial study, you will delay the application for many weeks, probably missing the tax opportunity.

Having an actuarial feasibility study not only satisfies the regulators that an independent outsider has analyzed the numbers, but it also gives comfort to the captive's owners/investors/directors that there is an outside professional view available. The domicile's actuarial review is a simpler review done by another firm to assure the regulator of the reasonableness of the captive's assumptions. They are two very different reviews indeed.

831(b) Tax Exception

Another issue is the ever-present challenge of the 831(b) tax exception. Doubtless, many applications being considered are planning to take advantage of the 831(b) exception. Enough has been said about these, but be reminded that there is heightened interest in this exception by the Internal Revenue Service. In addition to the scrutiny of the actuarial study is the increased interest in the risk pools. In order to be in compliance with the 831(b) exception, the captive must reinsure 50 percent plus or minus of its premiums. This is often done by the promoters' own offshore entity. That's okay. But if there are no claims in the pool, its legitimacy as an insurance company, and thus the legitimacy of the deduction, are in question.

As a captive owner, you may not be concerned about the ownership goals of the risk pool; you should be. The owner may well not wish to pay claims, even with your money, thus jeopardizing your own captive.

New Domicile Options

For those owners/advisers not seeking the 831(b) exception, now is the time to also pay close attention to the ever-shifting domicile landscape. We recently have seen the highly promoted openings of Connecticut, Oregon, Florida, and perhaps Ohio as new captive domiciles. There will be more. They will each promote their advantages in terms of taxes—or lack thereof—and the efficiency of their processes. This may well be true, but at bottom is the motivation of their ability to tax captives whose insureds are domiciled within the captive domicile. This is the result of the Nonadmitted and Reinsurance Reform Act portion of the Dodd-Frank Act.

The tax motivation may well override the new domicile's ability to provide comprehensive legislation and knowledgeable regulators. In fact, a close reading of the actual legislation of some of the newest domiciles raises the suspicion that the language was provided by promoters with very specific goals. These goals, not known to you, may not be in accord with your goals.

Much has been written and spoken about the paucity of qualified regulators; starting new domiciles won't address that problem. Nothing would more benefit the industry than to grow more regulators with thorough and useful knowledge of captives. If you are considering an application to a new domicile, closely review not only the laws and regulations but also the resumes of the regulators. As they will wish to interview you, remember that it should be a two-way interview. How will they work to help you make your captive successful?

Independent Directors

And finally, it is important to note the rise in the use of outside, independent directors. To some, this may seem a contradictory position in a closely held captive, but the requirements and vagaries of today's world are calling for more, not less, outside review. Each new captive being formed should consider the use of one or two independent outside directors. If well chosen, they can provide an independent view, additional knowledge and experience, and assurance to regulators and other outsiders. An ounce of prevention is indeed worth a pound of cure.

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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