Is Captive Insurance a Legitimate Tax Shelter?

Insurance coverage is one thing wanted by all companies to guard towards the danger of loss. With captive insurance coverage, a enterprise can create its personal protection to attain two targets: safety for the companies and monetary benefits for his or her homeowners. Captive insurance coverage can also be generally promoted mainly as a tax shelter, however utilizing it this fashion has its hazards.

How Captive Insurance coverage Works

Captive insurance coverage is an insurance coverage firm owned by the individuals it insures. Not like mutual insurance coverage firms, that are additionally owned by policyholders, captive insurance coverage firms are each owned and managed by policyholders. In a nutshell, captive insurance coverage is a type of self-insurance. Nonetheless, the captive insurance coverage firm is topic to state laws on insurers identical to different insurance coverage firms.

Whereas policyholders personal the captive insurer, the policyholder’s possession isn’t an funding within the true sense of the phrase. No capital or property is contributed to the corporate, apart from premium funds. And possession ceases when insurance coverage lapses, equivalent to when the proprietor now not wants protection and stops paying for it. The policyholder can’t promote, present, or bequeath something.

Captive insurance coverage firms could be arrange in a wide range of methods. “Pure captives” insure solely its homeowners. “Single-parent captives” have a single proprietor (equivalent to a Fortune 500 firm); “group captives” have a number of homeowners. For instance, firms in a single trade might type a captive insurance coverage firm (a gaggle captive) to satisfy their particular danger wants.

Captive insurers could be fashioned within the U.S. or in quite a few jurisdictions worldwide. Every nation has its personal limits on capitalization and the way a lot surplus should be retained. In response to the Nationwide Affiliation of Insurance coverage Commissioners (NAIC), there are greater than 7,000 captive insurers worldwide.

Safety for the Enterprise

Conventional insurance coverage merchandise might not meet a enterprise’s wants, not less than not at an reasonably priced worth. Captive insurance coverage can present broader protection than obtainable by way of present merchandise. This protection could be tailor-made to guard towards troublesome dangers. Skilled companies companies and building firms, for instance, might discover captive insurance coverage interesting. Commerce associations can also supply captive insurance coverage for members. The Coin Laundry Affiliation, for instance, used captive insurance coverage for a few years as a result of its members couldn’t get hold of conventional protection for his or her 24-hour companies.

However the extent of this particular kind of protection is sort of restricted. In response to the Worldwide Danger Administration Institute (IRMI), the everyday captive insurance coverage restrict is $250,000 per incidence. Losses in extra of this restrict should not protected by the captive insurance coverage. These with captive insurance coverage use reinsurance for losses in extra of the restrict.

Companies even have higher management over their price of safety. As a result of captive insurance coverage is restricted in scope, it may higher handle danger and keep away from worth hikes inherent within the industrial insurance coverage market.

Monetary Benefits for House owners

Whereas the primary cause for captive insurance coverage is danger administration, an ancillary profit for companies that use captive insurance coverage is that they stand to revenue if the corporate’s underwritings are sound. Captive insurers usually distribute dividends to homeowners.

One method to improve these returns is to scale back claims. This may be executed by higher enterprise practices geared toward security in order that claims are minimized or prevented. One other method is to have a larger assessment of claims by way of a greater understanding of occurrences than conventional insurers have.

Yet one more method that captive insurers generate earnings is by controlling bills, that are increased within the industrial market than for captive insurance coverage.

Tax Shelter?

Captive insurance coverage is a legit tax construction for small-business homeowners. Premiums paid to a captive insurer could be tax deductible if the association meets sure risk-distribution requirements. Thus, the enterprise will get a present 12 months write-off regardless that losses might by no means happen. The Inside Income Service (IRS) in Rev. Rul. 2002-89 and Rev. Rul. 2002-90, has laid out the principles underneath which captive insurance coverage constitutes insurance coverage for federal revenue tax functions in order that premiums are deductible. There are two secure harbors underneath which captive insurance coverage is considered as actual insurance coverage (i.e., premiums are deductible):

• Fifty % third celebration insurance coverage secure harbor. If the captive insurance coverage firm will get not less than 50% of its premiums from unrelated third-party insureds, there may be enough danger distribution.
• Twelve insured secure harbor. If the captive insurance coverage firm has not less than 12 insureds, every having between 5% and 15% of the entire danger, then there may be enough danger distribution, too.

Nonetheless, the IRS should still problem premium deductions the place it believes there are stopgaps that thwart danger distribution, equivalent to reinsurance or tax-shelter like preparations.

In 2016, the IRS recognized micro-captive insurance coverage transactions as a possible danger for tax avoidance or evasion however lacked the knowledge to determine potential preparations or their traits. In reality, captive insurance coverage was nonetheless one of many “abusive tax shelters” on the 2022 (the newest obtainable) IRS “soiled dozen” checklist of tax scams.

The issue arises, in response to the IRS, when micro-captive insurance coverage firms “might ‘insure’ implausible dangers, fail to match real enterprise wants or duplicate the taxpayer’s industrial coverages. The ‘premiums’ paid underneath these preparations are sometimes extreme and are used to skirt the tax regulation.”

Complete quantities of annual premiums in these so-called micro captives “typically equal the quantity of deductions enterprise entities want to scale back revenue for the 12 months; or, for a rich entity, whole premiums quantity to $1.2 million yearly to take full benefit of the [Tax] Code provision.” These captives are being focused by the IRS for audit.

The Backside Line

Captive insurance coverage can meet risk-management wants for a small firm whereas offering monetary rewards for it, however any such insurance coverage isn’t for everybody. Sometimes, preliminary premiums can run tons of of hundreds of {dollars} or into the tens of millions. And there are appreciable prices, greater than 1 / 4 of one million {dollars}, to create a captive insurance coverage firm and cowl charges to actuaries, attorneys, and an insurance coverage knowledgeable (marketing consultant or dealer).