Captives: In Theory
Assume that a business pays commercial market insurance premiums to commercial insurers to insure against various losses. These premiums are deductible in determining the business’s taxable income. As in the case of most P&C insurance, the premiums are “lost” every year as the coverage expires.
A business will sometimes “self-insure” by setting aside funds to cover its exposure to a particular loss. The setting aside of these funds, however, is not deductible by the business for tax purposes.
The Code, on the other hand, affords a “smaller” business the opportunity to establish its own “captive” insurance company. In order to facilitate the creation and operation of such a caprice, the Code provides for the deductibility of reasonable premiums paid to such a company by the business, and allows the captive may receive up to $1.2 million of annual premium payments ($2.2 million for taxable years beginning after December 31, 2016) from the business free of income tax.
In order to be respected, the captive must 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 addition, 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 Issues A Warning – And Then Another
Too often, however, taxpayers use captives for personal, nonbusiness planning. Indeed, many promoters tout the captive arrangement as a retirement, compensation, or estate planning device.
Last 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, described above. 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.”
Last month, the IRS went a step further and announced (in the “Notice”) that certain micro-captive insurance transactions would be treated as “transactions of interest” – in other words, transactions of a type that have a potential for tax avoidance or evasion. This IRS Notice alerted persons involved in such transactions to certain responsibilities and penalties that may arise from their involvement with these transactions.
A “transaction of interest” is one in which a taxpayer attempts to reduce the aggregate taxable income of the taxpayer and/or related persons using contracts that the parties treat as insurance contracts and a related company that the parties treat as a captive insurance company. The entity that the parties treat as an insured entity under the contracts claims deductions for premiums paid for insurance coverage. The related company that the parties treat as a “micro-captive” insurance company elects to be taxed only on its investment income and, therefore, excludes the “premium” payments received under the contracts from its taxable income. The manner in which many of these contracts are interpreted, administered, and applied, the IRS indicated, is inconsistent with arm’s length transactions and sound business practices.
Overview of Transactions of Interest
In a typical micro-captive transaction, Taxpayer owns an entity (“Insured”) that conducts a trade or business. Taxpayer and/or persons related to Taxpayer also own another entity (“Captive”).
Captive enters into a contract (“Contract”) with Insured. Captive and Insured treat the Contract as an insurance contract for federal income tax purposes. Captive provides insurance coverage for Insured.
Captive enters into a pooling agreement under which a portion of the risks covered under the Contract are treated as pooled with risks of other entities and Captive assumes risks from other entities.
Insured makes payments to Captive under the Contract, treats the payments as insurance premiums that Insured deducts as ordinary and necessary business expenses. Captive treats the payments received from Insured under the Contract as premiums for insurance coverage. The micro-captive transaction is structured so that Captive has no more than $1.2 million in net premiums written for each taxable year ($2.2 million for taxable years beginning after December 31, 2016) in which the transaction is in effect. Captive elects under the Code to be taxed only on taxable investment income and to exclude the premiums from taxable income.
A promoter (“Promoter”) typically markets the micro-captive transaction structure to the Taxpayer. Promoter typically provides continuing services to Captive, including:
(1) providing the forms used for the Contract;
(2) management of Captive; and
(3) administrative, accounting, or legal services, including the filing of tax forms.
The coverage provided by Captive under the Contract has one or more of the following characteristics:
(1) the coverage involves an implausible risk;
(2) the coverage does not match a business need or risk of Insured;
(3) the description of the scope of the coverage in the Contract is vague, ambiguous, or illusory; or
(4) the coverage duplicates coverage provided to Insured by an unrelated, commercial insurance company, and the policy with the commercial insurer often has a smaller premium.
The payments made by Insured to Captive under the Contract have one or more of the following characteristics:
(1) the amounts of Insured’s payments under the Contract are designed to
provide Insured with a business deduction of a particular amount;
(2) the payments are determined without an underwriting or actuarial analysis that conforms to insurance industry standards;
(3) the payments are not made consistently with the schedule in the Contract;
(4) the payments are agreed to by Insured and Captive without comparing the amounts of the payments to payments that would be made under alternative insurance arrangements providing the same or similar coverage; or
(5) the payments significantly exceed the premium prevailing for coverage offered by unrelated, commercial insurance companies for risks with similar loss profiles.
Captive, Insured, or both do one or more of the following:
(1) Captive fails to comply with some or all of the laws or regulations applicable to insurance companies in the jurisdiction in which Captive is formed, the jurisdiction(s) in which Captive is subject to regulation;
(2) Captive does not issue policies or binders in a timely manner consistent with industry standards;
(3) Captive does not have defined claims administration procedures that are consistent with insurance industry standards; or
(4) Insured does not file claims for each loss event covered by the Contract.
Captive’s capital has one or more of the following characteristics:
(1) Captive does not have capital adequate to assume the risks that the Contract transfers from Insured;
(2) Captive invests its capital in illiquid or speculative assets usually not held by insurance companies; or
(3) Captive loans or otherwise transfers its capital to Insured.
Claimed Tax Treatment and Benefits
Insured and Captive treat the Contract as an insurance contract for federal income tax purposes. Insured claims a deduction for the premiums paid. Captive excludes the premium income from its taxable income and is taxed only on its investment income.
Captive uses the premium income for purposes other than administering and paying claims under the Contract, generally benefitting Insured or a party related to Insured. For instance, Captive may use premium income to provide a loan to Insured.
However, if the transaction does not constitute insurance, Insured is not entitled to deduct the amount of that payment as an insurance premium. In addition, if Captive does not provide insurance, Captive does not qualify as an insurance company and Captive’s election to be taxed only on its investment income is invalid.
According to the Notice, the IRS recognizes that related parties may use captive insurance companies for risk management purposes that do not involve tax avoidance, but it also believes that there are cases in which the use of such arrangements to claim the tax benefits of treating the Contract as an insurance contract is improper.
However, according to the IRS, it lacks sufficient information to identify which micro-captive arrangements should be identified as tax avoidance transactions, and it also lacks sufficient information to define the characteristics that distinguish the tax avoidance transactions from other micro-captive transactions.
Therefore, the IRS Notice identified certain transactions as transactions of interest that would trigger certain reporting requirements under the Code.
Transactions To Be Reported
The following transaction is identified as a transaction of interest under the Notice:
(a) Taxpayer owns an interest in an entity (“Insured”) conducting a trade or business;
(b) An entity owned by Taxpayer, Insured, (“Captive”) enters into a contract (the “Contract”) with Insured that Captive and Insured treat as insurance;
(c) Captive elects under the Code to be taxed only on taxable investment income;
(d) Taxpayer, Insured, or one or more persons “related” to Taxpayer or Insured own at least 20 percent of the voting power or value of the outstanding stock of Captive; and
(e) One or both of the following apply:
(1) the amount of the liabilities incurred by Captive for insured losses and claim administration expenses during the Computation Period is less than 70 percent of the following:
(A) premiums earned by Captive during the Computation Period, less
(B) policyholder dividends paid by Captive during the Computation Period; or
(2) Captive has at any time during the Computation Period made available as financing or otherwise conveyed or agreed to make available or convey to Taxpayer, Insured, or a person related to Taxpayer or Insured (collectively, the “Recipient”) in a transaction that did not result in taxable income or gain to Recipient, any portion of the payments under the Contract, such as through a guarantee, a loan, or other transfer of Captive’s capital.
The Computation Period is (a) the most recent five taxable years of Captive, or (b) if Captive has been in existence for less than five taxable years, the entire period of Captive’s existence.
Any transaction that is substantially similar to the above-described transactions is identified as a “transactions of interest,” and any person entering into such a transaction on or after November 2, 1016 must report the transaction to the IRS. The required disclosure, on Form 8886, Reportable Transaction Disclosure Statement, must identify and describe the transaction in sufficient detail for the IRS to be able to understand the tax structure of the transaction and the identity of all parties involved in the transaction. For example, the Captive must disclose:
(1) whether it has, at any time during the Computation Period, made available as financing or otherwise conveyed or agreed to make available or convey any portion of the payments under the Contract to Taxpayer, Insured, or a person related to either of them, through a separate transaction, such as a guarantee, a loan, or other transfer;
(2) A description of all the type(s) of coverage provided by Captive;
(3) A description of how the amounts treated as premiums for coverage provided by Captive were determined, including the name and contact information of any actuary or underwriter who assisted in these determinations;
(4) A description of any claims paid by Captive, and of the amount of, and reason for, any reserves reported by Captive on the annual statement; and
(5) A description of the assets held by Captive; that is, the use Captive has made of its premium and investment income, including but not limited to, securities, loans, real estate, or partnerships or other joint ventures, and an identification of the related parties involved in any transactions with respect to those assets.
Persons required to disclose these transactions who fail to do so may be subject to severe penalties under the Code.
According to the Notice, once the IRS has gathered enough information regarding potentially abusive arrangements, it may remove a transaction from the “transactions of interest” category or it may designate a transaction as a listed transaction.
In the interim, the IRS may challenge a position, taken as part of a transaction that is substantially similar to the transactions of interest described in the Notice, under other provisions of the Code or judicial doctrines such as sham transaction, substance over form, or economic substance.
What is a taxpayer to do during this interim period? It depends. If the taxpayer already has a micro-captive arrangement in place, the taxpayer needs to determine whether it falls within the “transactions of interests” category described in the Notice. If it does, then the taxpayer has to very careful and very thorough in disclosing the requested information. If a taxpayer has not yet created a captive, but is considering one for bona fide business reasons, I would nevertheless advise patience. Although tax avoidance or the improper use of the insurance arrangement may be the farthest thing from the taxpayer’s mind, it would behoove the taxpayer to wait for whatever guidance the IRS eventually issues based on the information that will be gathered pursuant to the Notice.