A captive insurance company manages its parent company’s business risks while providing it with substantial benefits. However, abuse of the tax benefits of captives – particularly small ones – has resulted in an IRS crackdown.
Captive insurance companies cover risks either too expensive to insure or which are otherwise not readily available through commercial insurance. These companies are perfectly legitimate, so long as they meet the qualifications and operate in accordance with the law.
Captive abuse under attack
Captive abuse has been on the IRS radar for quite some time, with small captives under particular scrutiny. While the 2015 Appropriation Bill made significant modifications to IRC §831(b) that were favorable for legitimate captives (increasing the premium limits from $1.2 to $2.2 million), it also took aim at captive abuses, adding a 20% diversification requirement and an alternative diversification requirement that makes it difficult for owners to misuse captives as a wealth-transfer vehicle.
Then the Tax Cuts and Jobs Act of 2017 (TCJA) reduced many captive insurance tax benefits such as increasing the tax rate for small captives to 21% and making changes to actual loss reserve discounting. This has made captives less attractive to taxpayers who might be thinking about using them for tax rather than insurance purposes.
Captive insurance audit triggers
Here are some actions taken by captive insurance companies that have triggered IRS audits:
- Poorly drafted binders from captive managers without experience or credentials.
- No real insurance – coverage of implausible risks that are rarely if ever paid out.
- Exorbitant premiums, particularly those that are paid at the end of the year and appear to use reverse engineering to reach the maximum deduction.
- Other circumstances in which it appears that the captive is being used to artificially generate deduction and/ or to transfer money to heirs rather than to serve a valid business insurance purpose.
If the IRS determines that a taxpayer has abused a captive insurance arrangement, it is likely to disregard it entirely and to disregard all deductions associated with it. The IRS may also prosecute the taxpayer.
Qualified captive insurance tax and legal advice
Tax and captive insurance professionals have repeatedly stated that the tax benefits should not be the main reason for establishing a captive insurance company. There are a great many factors to consider when establishing and maintaining captive insurance, and this should be done only after consultation with a qualified tax and legal professional. Contact the San Francisco tax attorneys at Moskowitz, LLP to see if a captive is right for you.