The IRS recently considered whether an arrangement between members of a corporate group and its affiliated insurance company, involving foreign currency fluctuations, constituted insurance for Federal tax purposes. For reasons that we will describe, the IRS concluded that the arrangement did not constitute insurance. captive

Before getting into the details of the IRS’s holding, however, a brief description of captive insurance, and of the IRS’s scrutiny of such arrangements, may be in order.

What is it? How does it work?

Assume that Acme Co. pays commercial market insurance premiums to commercial insurers to insure against various losses. These premiums are deductible in determining Acme’s taxable income. As in the case of most P&C insurance, the premiums are “lost” every year as the coverage expires.

Businesses will sometimes “self-insure” by setting aside funds to cover their exposure to a particular loss. Self-insurance, however, is not deductible.

The Code, on the other hand, affords “smaller” businesses the opportunity to establish their own captive insurance company—indeed, it encourages them to do so —and provides for the deductibility of reasonable premiums paid to such companies by the businesses.

Additionally, the captive may receive up to $1.2 million of annual premium payments from the business free of income tax. Of course, the business cannot simply choose to pay $1.2 million of premium to the captive; the amount paid must be reasonable for the loss being insured.

The captive, which is created as a C corporation, will set aside appropriate reserves and will invest the balance of the premiums received. Any investment income and gains recognized by the captive will be taxable to the captive.

Captive As True Insurance Company

From a tax perspective, the key is that the captive actually operate as a bona fide insurance company. It must insure bona fide risks. It must not be a risk that is certain of occurring; there must be an element of “fortuity” in order to be insurable.

In order to be respected as insurance, there must be “risk-shifting” and “risk distribution.” Risk shifting is the actual transfer of the risk from the business to the captive. Risk distribution is the exposure of the captive to third-party risk (as in the case of traditional insurance). The IRS has issued several rulings over the years regarding these requirements.

To achieve the status of real insurance (from a tax perspective), the captive pools its premiums with other captives (not necessarily from the same type of business).

These pools are managed by a captive management company for a fee. The management company will conduct annual actuarial reviews to set the premium, manage claims, take care of regulatory compliance, etc. This pool will pay on claims as they arise.

The captive should lead to a reduction of the commercial premiums being paid by the business; for example, by covering a larger deductible. Down the road, however, the captive may serve some other important business functions. For example, it may be possible to borrow from the captive to fund a business project.

Proceed With Caution

Too often, taxpayers use captives for personal, nonbusiness planning. Indeed, many promoters tout the captive arrangement as an ultimate retirement, compensation or estate planning device.

Earlier this year, the IRS released its list of “dirty dozen” tax scams. Among the abusive tax structures highlighted was a variation on the so-called “micro” captive insurance company, discussed herein. The IRS characterized the scam version as an arrangement with “poorly drafted ‘insurance’ binders and policies to cover ordinary business risks or esoteric, implausible risks for exorbitant ‘premiums.’ ” According to the IRS, promoters in such scams received large fees for managing the captive insurance company while assisting unsophisticated taxpayers “to continue the charade.” [Link?]

On the other hand, stay tuned for tomorrow’s discussion of a Tax Court ruling from early last year in which the Court decided that payments made by a subsidiary corporation to the captive formed by its parent corporation were properly deductible as insurance premiums (ordinary and necessary expenses incurred in carrying on a trade or business).