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US tax consequences of
captive insurance
Charles Lavelle analyses how the Internal
Revenue Service affects captive thinking.
April 2007
One should only establish and operate a
captive insurance company for valid nontax
business purposes. Once the decision
is made to establish a captive, one should
structure it in a tax-efficient manner. Even
though the IRS and courts have established
safe harbours and guidelines, determining
whether a captive arrangement is
“insurance” for US tax purposes is more
art than science. This article outlines
the current status and issues of captive
insurance taxation.
In 1977, the IRS announced that captive insurance arrangements
“insuring” related parties would not be respected for US Federal income
tax consequences, no matter how they were arranged. The IRS won
several early court cases because the captive was poorly capitalised,
or the parent or insureds guaranteed the captive’s performance or
solvency. Subsequently, taxpayers with well-capitalised captives won
several court cases generally on one of two theories: the captive
insured enough affiliates that owned no stock in the captive (i.e.
‘brother-sister’) or the captive insured a sufficient amount of unrelated
business (i.e. third-party business).
In 2001, the IRS reversed its 24-year policy and announced that it
would generally respect captive insurance arrangements for Federal
income tax purposes; however, it stated that it would challenge certain
captive arrangements based on their “facts and circumstances”.
During the last six years, the IRS has further defined its views on
when captive arrangements should not be respected.
What are the benefits if a captive arrangement meets the definition
of “insurance”? Generally, a self-insured operating company cannot
deduct reserves for property or casualty losses (e.g. liability, workers’
compensation, etc.); however, an insurance company may deduct
such reserves and may include an estimate of losses even though a
claim has not been filed.
Similarly, an operating company that buys insurance from a
commercial carrier may deduct the premiums, but it cannot deduct
an equivalent amount set aside for self-insurance, even if that money
were placed in an escrow account restricted to paying claims. The
question is whether paying premiums to a captive insurance company
that the insured owns is more like paying premiums to a commercial
carrier (and thus deductible), or more like self-insurance (and thus
not deductible).
Because the captive insurance company is generally taxable on the
premium income, the net tax benefit to the entire group is normally
the discounted present value of the deduction of the loss reserves by
the insurance company.
In 1941, the United States Supreme Court stated: “historically and
commonly insurance involves risk-shifting and risk-distributing”.
This case did not involve captives, but its requirements of “riskshifting”
and “risk distribution” have been adopted in the captive
cases. Subsequent cases have introduced other requirements.
a. Risk-shifting: Risk-shifting requires that the risk involved must
be transferred from the insured to the captive. Several taxpayers
have lost their cases where the parent or insured guaranteed
the obligations of the captive, agreed to capitalise the captive if
losses occurred, or otherwise undercut the purported transfer of
the risk to the captive.
b. Risk distribution: Risk distribution has generated the most
controversy recently. To have risk distribution, enough premiums
must be pooled from enough risks that the law of large numbers
(law of averages) will result in actual losses approximating
projected losses. The IRS also believes that no matter how many
exposure units there are, there must be many different insured
entities. The IRS’ position is that there can never be insurance if
there is only one insured (nor if there are two insureds, where one
insured has 90 percent of the risks). Generally, if there are enough
operating subsidiaries (of a parent), then the premiums paid to
the captive subsidiary (of the same parent) by those ‘brothersister’
subsidiaries are insurance, but the parent’s premiums are
not deductible. The IRS will treat the arrangement as insurance if
there are at least 12 subsidiaries, each of which pays between 5
and 15 percent of the captive’s premiums; but one court case is
not that restrictive. The IRS does not count a disregarded single
member LLC as an insured, but many tax advisors believe the
IRS is wrong. The IRS has not taken a position on whether multimember
If there is enough unrelated business, the parent’s premiums
are insurance. The IRS’ official position is that insurance exists
where there is more than 50 percent unrelated business, but
not where there is 10 percent unrelated business; the most
favourable case for the taxpayer found insurance to exist where
there was 29 percent unrelated business. The IRS has formally
asked taxpayers whether the unrelated risks need to be the same
as the related risks; the industry does not think so.
c. Insurance risk: Courts require that the risk involved be an
insurance risk. Risks such as fire, windstorm, accident, etc. are
obvious insurance risks. Risks that can produce a gain, rather
than only a loss or neutral result, are investment risks rather than
insurance risks.
The IRS has twice ruled that retroactive insurance was not
insurance under the facts involved, although tax advisors
generally think that retroactive insurance can be insurance under
the right circumstances.
The IRS has privately ruled that an imbedded express limited
warranty is not an insurance risk, but rather is a business risk. It has
also privately ruled that a separately priced extended warranty that
can be declined by the customer is an insurance risk.
d. Commonly accepted as insurance: The arrangement should have
the ‘look and feel’ of insurance. For instance, there should be
reasonable capitalisation; reasonable premiums; standard policy
forms; reasonable reserves; standard investments; corporate
formalities maintained; independent operation; and reasonable
regulation.
e. No sham: The courts sometimes use some of the above
factors to state that the transaction is not a sham. The captive
arrangement should be established and operated for a non-tax
business purpose.
Some operating companies seek to borrow funds from the captive.
The IRS has asked for comments on what effect, if any, loans from the
captive to its affiliates have on whether an arrangement is insurance.
In response, two industry associations said that the standard should
be whether the loan is enforceable and permitted, and should depend
on the liquidity of the borrower and insurance company. Many in the
industry measure loan-backs in terms of the percentage of investable
assets loaned by the captive. The government is apparently concerned
whether the insured is paying its claims with its own money (no riskshifting)
and that a commercial carrier cannot normally loan more
than a few percent of its assets to any debtor.
There is a special tax benefit for insurance companies with less
than $1.2 million of annual premiums. These companies (referred
to as section 831(b) companies) are only taxed on their investment
income and not their underwriting income (but they may not offset
an underwriting loss against investment income). Many closely held
businesses have found this to be a very favourable provision. There is
complete exemption from income tax for an insurance company that,
together with its affiliates, has no more than $600,000 of annual gross
receipts, but the requirements are very hard to meet.
If a foreign insurance company does business in the US, it is subject
to regular US income tax and an additional “branch profits” tax; most
companies avoid this at all costs. Because they try to conduct their
activities (signing policies, receiving payment, investing assets, etc.)
outside the US, many foreign insurance companies view themselves
as not doing business in the US, even though they write insurance
on risks in the US. A foreign insurance company that does not do
business in the US is not subject to US tax, unless it elects to be;
however, US shareholders of such a company may be taxed on the
insurance company’s income under two circumstances.
Because of the above, foreign insurance companies with US
shareholders generally elect to be taxed as US insurance companies under section 953(d) (or on related party insurance income (RPII)
under section 953(c)), except in select circumstances. If the foreign
insurance company does not do business in the US or elect to be taxed
(or have its RPII taxed) as if it were US, then a four percent excise tax
is imposed on direct property, casualty or indemnity premiums; a one
percent tax is imposed on all reinsurance premiums, and direct life,
health and annuity premiums.
A tax-exempt owner of a captive has very different considerations and
often does not want the arrangement to be considered “insurance” for
tax purposes. The tax-exempt parent does not need the tax deduction
for the premiums; the captive does not want the income to be taxable
to it; and the tax-exempt entity does not want unrelated business
taxable income.
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