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 roadmap to allow successful implementation of a captive insurance company, with predictable tax results.
Internal Revenue Code 831(b) 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 $1.2m annually. The PATH Act of 2015 increases the maximum premium amount to $2.2m and indexes this amount for inflation. These provisions are effective for taxable years beginning after December 31, 2016. 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 70% of the dividends it receives from taxable income.