It pays to plan ahead (Captive Review)

THE RISK management aspects of form­ing a captive insurance company, which often take precedent over other considera­tions, can veil the tax planning opportu­nities such a venture facilitates. Wealth transfer, estate planning, and the ability to deduct losses that are 'incurred but not reported' (IBNR) are all examples of the advantages a mindful tax procedure offers.

Along with these benefits there are dangers, but these can be mitigated or avoided by proper tax planning dur­ing the formation of the captive. As this article demonstrates, a considered review of taxation could not only help a captive operation avoid tax-based pitfalls but also allow a captive to ultimately reap a host of untapped rewards.

Tax benefits of a captive

Deduction of loss reserves

If recognised as an insurance company for federal income tax purposes, a tax benefit that all captive insurance companies (other than Internal Revenue Code (IRC) 501(c) (15) and those electing to be taxed under IRC 831(b)) receive is the ability to deduct their IBNR under IRC 832(b)(5). The ability to deduct loss reserves is a distinct advantage over self-insurance. This unique section of the IRC allows companies to deduct their loss reserves, immediately realising a tax benefit that allows them to set aside tax dollars for when actual claims are reported and ultimately paid.

IRC 831(b) companies

IRC 831(b) allows for a considerable ben­efit for qualifying small insurance compa­nies. In general, if the company receives less than US$1.2m in net written premi­ums or direct written premiums (whichever is greater) they may elect to be taxed only on its investment income less direct and indirect investment expenses. Once the election is made, it cannot be revoked without the consent of the Secretary of the Treasury. This does not affect the premium deduction for the insured and allows the captive to accumulate a surplus with lim­ited taxation.

Estate and gift planning

Structuring the ownership of the captive to include the business owner's children and grandchildren, or trusts for the benefit of the children or grandchildren, may allow the business owner to shift assets outside of the taxable estate and avoid generation-skipping tax. Also, if the business owner utilises multiple companies, which elect IRC 831(b) treatment, he may be able to incorporate estate and gift planning into the overall risk management strategy.

Other benefits

Other benefits of a captive insurance company may include succession planning, control over claims, underwriting and investment income, competitive advantage, asset protection and retirement benefits. It is important to note that most of the tax benefits of a captive insurance company only apply if it is recognised as an insur­ance company for federal income tax purposes.

Captive insurance: IRS perspective

What is an insurance company?

Insurance companies (other than life insur­ance companies) are taxed under subchap­ter L of the IRC. An insurance company as defined by IRC 831(c) is any company, more than half of whose business during the tax year is the issuing of insurance or annuity contracts, or the reinsuring of risks underwritten by insurance companies. An important distinction here is that while the term 'insurance company' is defined, the terms 'insurance' and 'insurance contract' are not. Thus, the crux of the issue is not whether or not a captive is licensed in your respective domicile or adequately capitalised, or if premiums are actuarially determined (though these are all factors), but rather whether or not the IRS consid­ers the contracts 'insurance'.

Insurance: three-prong test

Over the years the courts have developed an informal test that is characterised as a 'facts-and-circumstances' approach with three prongs, each of which must be satis­fied: (1) the arrangement must involve the existence of an insurance risk; (2) there must be both risk shifting and risk distribu­tion; and (3) the arrangement must be for insurance in its commonly accepted sense.

While each of the three prongs must be satisfied, the issue that has generated the most recent revenue rulings is that of risk shifting and risk distribution. Revenue Rul­ing 2002-90 described these characteristics of an insurance contract:

Risk shifting occurs if a person facing the possibility of an economic loss transfers some or all of the financial consequences of the potential loss to the insurer, such that a loss by the insured does not affect the insured because the loss is offset by the insurance payment. Risk distribution incorporates the statistical phenomenon known as the law of large numbers. Dis­tributing risk allows the insurer to reduce the possibility that a single costly claim will exceed the amount taken in as premiums and set aside for the payment of such a claim. By assuming numerous relatively small, independent risks that occur ran­domly over time, the insurer smooths out losses to match more closely its receipt of premiums.

The result of a failure to meet one of the three prongs would result in not only a loss of tax benefits afforded to the captive but may also deny a tax deduction for the premiums paid.

If it is not insurance, what is it?

The nature of the arrangement will be determined based on the facts and circum­stances of the contract. In Revenue Ruling 2005-40, the IRS attempts to outline the end result for a captive that lacks the re­quired risk distribution:

Thus, an arrangement that purports to be an insurance contract but lacks the requisite risk distribution may instead be characterised as a deposit arrangement, a loan, a contribution to capital (to the extent of net value, if any), an indem­nity arrangement that is not an insur­ance contract, or otherwise, based on the substance of the arrangement between the parties. The proper characterisation of the arrangement may determine whether the issuer qualifies as an insurance company and whether amounts paid under the ar­rangement may be deductible.

Pitfalls

Good intentions

The best of intentions can go awry if income tax planning is not considered during the formation stages of the cap­tive. The formation stage of a captive is a lengthy and expensive process that could encompass over two years worth of work by actuaries, attorneys, consultants and professional management companies.

If a tax professional is not consulted dur­ing the formation stage, a captive exposes itself to critical vulnerabilities. For instance, without a tax professional's advice during formation there is no guarantee that the three-prong test will be applied before operations commence. Potentially, errors in this regard will not be caught until the initial financial statement audit or prepara­tion of the first federal income tax return, which might not occur until as much as 18 months after operations commence. The amount of time that passes between the formation stages and the initial audit or federal income tax return compounds early missteps and causes them to be difficult, if not impossible, to unwind after the fact.

Deduction for insurance premiums paid

Of great benefit to the insured is the ability to deduct the premiums paid to their cap­tive. If the premium is no longer consid­ered an "ordinary and necessary business expense" under IRC 162 then taxes from the benefit derived from the deduction could be assessed as well as penalties and interest on the presumed deficit.

Gift tax

If premiums that are paid to a captive owned by the business owner's children and grandchildren or trusts for the benefit of the children or grandchildren are disal­lowed as deductions under IRC 162, it is possible that the IRS would reclassify these payments as gifts. If that is the case, said gifts would then be subject to gift tax and generation-skipping tax.

Tax planning during formation

The importance of proper tax planning in the formation stages of a captive insurance company cannot be overstated. Captives are unique, complex tools that have the potential to affect several tax situations and plans perhaps already in place -wealth transfer plans, estate plans, gifting arrangements, tax returns of the insured (1120, 1120S, 1065, 1040) being prime examples. In order to fully realise the investment you make in your captive insur­ance company the tax implications cannot be ignored.

Ben Glenn is a senior tax consultant with Bauknight Pietras & Stromer, P. A. His practice is focused on providing tax compliance and planning services for captive insurance companies.