Case law impacting business owners who created captive insurance companies began in the early 1900s. This long-standing history of court decisions provides us with a road map to allow successful implementation of a captive insurance company, with predictable tax results.
Captives generally pay income tax on net earnings annually. If the captive meets certain qualification requirements, it may elect favorable taxation under Internal Revenue Code 831(b), which provides significant tax advantages for small captive insurance companies. Captive insurance companies may be taxed only on their investment income, and do not pay taxes on the premiums they collect, providing premiums to the captive do not exceed $2.45M annually. Further, the captive may retain surplus from underwriting profits free of income tax. Investment income is taxable to the captive insurance company at graduated corporate rates, while dividends paid out of a captive, if any, should be taxed at long-term capital gains rates as a qualifying dividend.
In order to be eligible for the favorable taxation noted above, it is crucial that the captive insurance company conforms with Internal Revenue Code Section 7701(o) regarding economic substance, and be structured and managed as an insurance company, providing true risk, for appropriate premium levels. The Service has frequently stated that an insurance contract must fall within the “commonly accepted sense of insurance” based upon a number of factual determinations. A captive insurance company must be organized and operated for bona fide business purpose and demonstrate both risk shifting and risk distribution in order for the arrangement to meet the requirements to qualify as insurance in the commonly accepted sense.
In Technical Advice Memorandum 200816029 (April 18, 2008), the Service has stated that cases involving “captive insurance” arrangements have distilled the concept on “insurance” for federal income tax purposes to three elements, applied consistently with principles of federal taxation:
- Involvement of an insurance risk
- Shifting and distribution of that risk
- Insurance in its commonly accepted sense
Fortunately there is a long history of case law to guide the captive implementation and regulatory team throughout the process, enabling the experts to design a compliant captive insurance company. Better yet, through the application of “safe harbor” Revenue Rulings, the business owner has a clear path for captive design with predictable tax results. Oxford Insurance Company LLC has obtained an independent tax opinion from one of the most respected law firms in the country, providing analysis of its captive insurance structure – confirming that Oxford’s arrangement should constitute insurance for federal income tax purposes and that amounts paid as premiums are deductible as insurance premiums under Section 162 of the Code. Our independent tax opinion has been updated on October 12, 2013. You should consult with your independent tax counsel to determine the tax treatment for premiums paid by your operating company to your captive.
Investment Plans for captive insurance companies are typically structured in a manner which will reduce exposure to taxation from investment income. It is not uncommon for the captive investment manager to incorporate tax-free municipal bonds and other asset classes generating annual dividend income. The Dividends-Received Deduction under U.S. federal income tax law provides that the captive can exclude 50% of the dividends it receives from taxable income.
The Protecting Americans from Tax Hikes (PATH) Act of 2015 passed both the House and Senate and has been signed into law December 18, 2015.
The new legislation affecting eligibility for 831(b) election for captives is effective for taxable years beginning after December 31, 2016. Premiums allowed under section 831(b) are increased from $1.2m to $2.2M annually, with indexing for inflation. The first index adjustment increased the limit to $2.3M annually effective tax year 2018. The legislation also included new restrictions on the ability to qualify for section 831(b) treatment and addressed concerns over abusive arrangements. It is essential that captive owners seek guidance to update their arrangements to comply with one of the new qualification tests contained in the new legislation.
These new provisions help to clarify congressional intent providing ongoing support for small captives which comply with responsible risk management objectives. It is widely believed that the new legislation will result in minimal impact on, and is welcome news for, compliant captive structures.
Notice 2016-66 was issued on November 1, 2016 to provide guidance on reporting requirements for 831(b) Captive Insurance Companies and details how to submit that data and who is required to file.
The information requested in Notice 2016-66 is expected to assist the IRS in gaining knowledge on what structures are out there and conclude if additional scrutiny is warranted. Much of the information is data that the insurance regulators already receive as part of their initial and ongoing review of captives in their jurisdiction (at least for domiciles that Oxford operates in.) The reporting requirements are also extended to advisors who may be deemed to be material to the transaction. Form 8918 will be required to be submitted for those advisors that meet those thresholds or wish to make a “Protective Filing”.
At a surface level, the Service acknowledges (not surprisingly to those that are active in this space) that 831(b) Captives are “Transactions of Interest” and have the potential for tax avoidance, but also acknowledges that 831(b) Captives can be set up for valid risk management purposes. The Oxford message since inception has always been to follow the rules, have solid business purpose and documentation of economic substance, utilize a compliant risk distribution structure, invest like an insurance company and file claims when losses occur where Captive coverage is in place. When these criteria are met, additional information reporting should not be of concern for any existing or prospective Oxford client, nor their advisors.
Notice 2017-08 was issued on December 29, 2016 extending until May 1, 2017, the time for filing participant and material adviser disclosure statements regarding micro-captive deals and substantially similar transactions that were identified in Notice 2016-66 as transactions of interest. It is critical that participants and material advisors required to make filings provide their tax advisors and captive manager the necessary information to allow them to prepare these complicated filings on a timely basis.
The IRS issued a news release IR-2019-157 on September 16, 2019 announcing a global settlement of abusive 831(b) captive insurance plans. The offer was extended to a limited group of captives providing captive owners limited deductibility and potential waiver of penalties as part of the offer.
The IRS issued news release IR-2020-26 on January 31, 2020 announcing the formation of new examination teams to audit additional plans it believes to be abusive. It also reminded taxpayers and advisors that disclosure of participation in micro-captive insurance transactions is required under Notice 2016-66.
IRS releases form letter – Micro-Captive Insurance – on March 20, 2020. This form letter was mailed to taxpayers participating in certain captive insurance arrangements. The letters are titled “Micro-Captive Insurance” and remind everyone that plans similar to those addressed in recent Tax Court decisions may not be eligible for claimed Federal tax benefits. The industry is well-aware of the deficiencies noted in the referenced Tax Court decisions, which provide a detailed road map for how not to operate a captive insurance program. There is no new information to be learned from the apparently mass-produced form letters, which appear to merely confirm the January 31, 2020 announcement of increased focus on non-compliant plans. We are confident that the Tax Court will have an opportunity to rule on a compliant captive program in the future, providing additional needed guidance for the IRS and our industry. Until such guidance is provided by the Tax Court, we expect that we will continue to see the IRS increase efforts to disrupt the captive insurance industry.
The IRS released IR-2020-160 on July 16, 2020 announcing annual “Dirty Dozen” list, which unveils tax scams for 2020; as Americans are urged to be vigilant to these threats. Micro-captive insurance arrangements are not included in this list.
The IRS released IR-2021-82 urging participants of abusive micro-captive insurance arrangements to exit those transactions. Taxpayers are urged to consult an independent tax advisor and consider exiting transactions which are abusive.
April 16, 2021 – SIIA Advocates Balanced IRS Approach to Captive Insurance, U.S. Business Needs. The IRS recently issued IR 2021-82, in which it urges participants in abusive micro-captives to exit such structures. The announcement comes as the U.S. Tax Court ruled against the taxpayer in the Caylor Land case. To date, the IRS has been successful in limiting cases tried to those whose facts favor the Service and are not reflective of the industry. Thus, creating a negative bias at the examination level of the IRS. The Self-Insurance Institute of America, Inc. (SIIA) continues to be supportive of curbing abusive practices within the industry and urges participants within potentially abusive transactions to heed the IRS’ advice. At the same time, it is important to note that the vast majority of captive participants are utilizing the structure to protect themselves against appropriate risks, as the tax code intended.