Captive insurance companies are becoming more and more popular among small business owners. The Internal Revenue Service has noticed this rise in popularity and has included them on its annual “Dirty Dozen” list of tax scams.
Why all the fuss?
First, captive insurance companies are nothing new as they have been around since the 1950’s; however, back then only large U.S. companies formed them. It has only been recently that they have gained popularity among small business owners. Captive insurance companies are formed mainly for three reasons. First, some companies are unable to get insurance coverage for various reasons. Second, some companies seek to obtain cheaper insurance. And third, some companies seek to gain more control over their current insurance program.
The mechanics of a captive insurance company
A business owner forms a captive insurance company to cover the risks of loss, and pays premiums to the captive that it would ordinarily pay to an insurance carrier. The business owner can name the company, themselves or family members as owners of the captive. As with payments to the insurance carrier, the premium payments are deductible as an ordinary business expense. A small insurance company is offered an advantage in Internal Revenue Code section 831(b), which allows insurance companies with less than $1.2 million in premiums to be taxed on their investment earnings rather than their gross income. This means that while your company gets an ordinary deduction of up to $1.2 million of premium payments, the captive only gets taxed on any investment earnings it has on invested reserves. Assuming the captive has normal operating expenses and claims payouts, it can accumulate a sizable amount of reserves. Furthermore, the captive can then pay out its reserves as dividends to its owners who are taxed at the current lower capital gains dividend rates. Please note that the $1.2 million premium limit is being raised to $2.2 million starting January 1, 2017.
What is the Internal Revenue Service (IRS) looking for?
As noted above, the ordinary business expense deduction combined with the reduced capital gains dividends rate for payouts to the captive business owners has a “too good to be true” ring to it. As such, the Internal Revenue Services is making sure that these captive insurance companies are legitimate. Some things being looked at by the IRS are whether the risks being insured by the company are real risks that the company would typically insure against. For example, anti-terrorism insurance is one risk that some captives insure and whether this is a valid risk to your company depends on what type of business you are in. The IRS also looks to see if the captive insurance companies are paying out claims. Again, if a company is not filing claims then why would they continue to insure against a loss that is remote. Finally, the IRS is looking to see if the premiums paid to the captive insurance companies are reasonable given the coverage.
What can you do to stay out of the IRS scrutiny?
To best way to stay out of the IRS’s scrutiny is to use a qualified advisor that has experience setting up and running a captive insurance company. This means the captive insurance company needs to be a bona fide business with all the proper legal documentation, licensing and registrations. Claims filed with the company need to be legitimate, documented and processed accordingly. In short, a captive insurance company needs to be set up and run like an insurance company.
Please contact us if you would like to discuss whether a captive insurance company is right for you.