Today, many companies, large and small, are facing the challenge of controlling costs associated with managing risk and higher tax rates. One solution that large businesses have utilized for some time and is now being considered more and more by small to mid-size businesses is the formation of their own “captive” insurance companies. By addressing what have historically been uninsured risks through deductible premiums paid to a privately-owned insurance company, the business/family may be able to accomplish multiple goals.
Section 831(b) of the Internal Revenue Code was enacted to provide small to mid-size companies and closely-held businesses a way to establish their own captive insurance companies. This technique may allow them to better control the costs associated with deductibles and co-insurance on their traditional coverages as well as those for typically uninsured risks in a tax-favored manner. This provision allows for deductions of up to $1,200,000 per year for premiums to insure these risks. These premiums are not reportable as income by the captive insurance company. This is due to the reality that the captive may have to pay claims against the policies it has issued to the operating company. If these risks are properly priced and appropriately managed, the captive may be able to accumulate significant reserves over time as well as make tax-favored distributions to its shareholders.
Aside from risk management and income tax advantages, captives may also provide attractive estate benefits. As a matter of generational wealth planning, a captive insurance company formed to service the needs of a family-owned operating company may be owned by a trust for the benefit of the family’s future generations as a means to accomplish certain estate planning goals. As a well-run captive’s assets grow, the stock becomes more valuable and the company may pay out qualified dividends as well. This may result in both favorable income tax treatment as well as a means of shifting value to future generations with lower estate tax.
As with any significant business decision, managers, boards and owners should take pains to ensure a captive is suitable for their company. While U.S. companies have utilized captive insurance to address legitimate risks and realize potential tax benefits for many years, the IRS has begun to take a very hard look at them. In their February 3rd, 2015 memo, the IRS suggested that “unscrupulous promoters” have encouraged and assisted a great many closely-held companies in creating both onshore and offshore captives, then ‘selling’ to the entities often times poorly drafted ‘insurance’ binders and policies to cover ordinary business risks or esoteric, implausible risks for exorbitant ‘premiums’.
We’ve found the old saying of “you get what you pay for” to be pretty consistent. Considering this very direct statement by the IRS, it seems even more important to align your business with an experienced firm who will conduct an unbiased feasibility study of the uninsured risks the company is exposed to as well as the costs and benefits of insuring the risks through a captive. If you choose to proceed, they should also be able to assist you in the drafting of the captive’s organizational documents, choice of domicile, capitalization, actuarial pricing of premiums to insure specific risks, and your investment policy statement. Finally, you should have reasonable confidence that they will be able to help you effectively defend your choice to establish and utilize your captive. In the end, it is not just the “form” but also the “substance” of the transaction that must pass muster. The fact that the state or nationality in which your captive is domiciled approved the formation of the captive and the investments it makes doesn’t mean the IRS will accept the tax-deductions taken at the operating company level.
The take-away to us is that this potentially attractive structure is not one to be implemented without careful diligence and forethought. Forming a small captive is not a trivial endeavor and the costs and benefits need to be carefully evaluated beforehand. Companies considering captives are wise to seek counsel from financial advisors, accountants, and attorneys that practice in this area. Done well, this somewhat esoteric planning technique may provide big benefits. Done poorly, you may become a captive of the IRS.
Matt Curtis, Cravens & Company Advisors