Captive insurance: Avoiding the risks

Captive insurance entities offer a vehicle to self-insure that can be especially cost- and tax-effective. Although their implementation and legal structure are often poorly understood, their financial rewards can be very attractive. Some professionals recommend captive insurance as the greatest thing since sliced bread. Others are wary of getting their clients involved in creating a captive, knowing that the IRS closely scrutinizes them. This article explores what captive insurance is and why the IRS often challenges it, but also why, if created correctly, captive insurance can be a powerful tool. The article also describes how to structure and manage a captive to avoid IRS challenges.

THE ALLURE TO SELF-INSURE

Why form a captive insurance company in the first place? As a basic example, assume a doctor is paying $500,000 per year for medical malpractice insurance, an ordinary and necessary business expense. The premiums paid are fully deductible under Sec. 162. But once paid, the money is forfeited. The policy transfers the liability for claims to a third-party insurance provider, but assuming a claim-free practice, there is no recovery of the cash paid for coverage (beyond the value of a tax deduction), nor any return to the insured on the funds set aside in a reserve to pay any claims.

Contrast that to a captive insurance entity formed by the doctor to self-insure against malpractice claims. The doctor incorporates the captive insurance company, owns all its shares, and pays the premiums to his own company. His medical practice still gets the Sec. 162 tax deduction for all premiums paid, assuming the captive entity is formed properly and managed correctly. During the life of the captive entity, funds contributed to it are reserved and invested for the benefit of any potential claims. When the doctor retires, he liquidates his captive insurance company. The investments made over the years can earn substantial returns. The funds liquidated are paid out as long-term capital gain. It is obvious that, given a choice, setting up a captive insurance company appears on its face to be a no-brainer. So, what’s the problem?

The first question the doctor would likely ask you as his trusted adviser would be whether his captive insurance company could afford to actually pay any major claim should one be made. He might also question whether he has the time to deal with all the regulatory compliance needed to become an insurance company.

To answer the second question first, several companies in the United States specialize solely in setting up captive insurance companies at a moderate cost and handle all of the regulatory compliance issues for their clients.

The answer to the first question is more complicated. When a captive insurance company is set up, a portion of the premiums paid annually into the captive entity are typically then paid into a reinsurer fund that pools resources and reinsures a multitude of captives invested in the pool of funds. The reinsurance company may be collecting premiums from as many as 100 or more captive insurance companies. A reinsurer provides protection against one captive insurance company’s having to pay a large loss itself. Sometimes the setup involves an enforceable pledge agreement whereby the captive keeps the funds, subject to the reinsurer’s having the right to payment in the event of claims.

In the majority of cases, captive insurance entities pool their funds with like-kind entities and similar risk profiles so they will not face catastrophic losses, and can typically expect to receive the bulk of the reinsurance premiums back in a refund. This is the fundamental insurance concept of risk distribution. When claims are made, this pool of money collected from all of the captive insurance companies is used to defend the claim and pay it if it has merit.

THE IRS’s SKEPTICISM

The IRS has continually listed certain small captive (microcaptive) insurance arrangements on its “Dirty Dozen” list of tax-abusive transactions. The Service has taken the position that microcaptive insurance arrangements are often really a disguised device for estate planning with a large tax deduction attached to it. After all, if a doctor set up a trust and contributed money to it and, ultimately, the proceeds from the trust were liquidated to the doctor or his beneficiaries at some point in his life or at his death, there would be a tax consequence upon the liquidation but no tax deduction upon the contribution. The IRS argues that the premiums paid in captive arrangements are often not legitimate ordinary and necessary business expenses and often seeks to disallow the original tax deduction.

It should be pointed out that captive insurance companies are not exclusive to doctors or professionals. Any business can set up a captive insurance company. Any business where insurance may be a large component of expenses would generally benefit from establishing its own captive entity. In one of the first court cases challenged by the IRS, an electronics, furniture, and appliance rental company set up its own captive insurance company. The IRS in essence argued that the arrangement created an incestuous relationship between the captive and the company setting it up, a brother-sister arrangement. The Tax Court ruled in favor of the taxpayer and against the IRS (Rent-A-Center, Inc., 142 T.C. 1 (2014)). The court found that all the indicia of insurance existed. There was a shift of the risk from the rental company to its captive insurance company, and there was a distribution of that risk among all the captive insurance companies in the reinsurance pool.

The IRS challenged the concept again in Securitas Holdings, Inc., T.C. Memo. 2014-225. Again the IRS lost. The elements of risk shifting and risk distribution were present. Since the crucial elements existed — namely, that there was a real risk of loss from claims, that risk had been shifted from the insured company to the captive, and the captive was adequately capitalized and the arrangement otherwise constituted insurance in the commonly accepted sense — the Tax Court allowed the transaction and the deductibility of the premiums.

AVRAHAMI AND LESSONS LEARNED

Despite its losses in these cases involving large captive insurance arrangements, the IRS has not given up its attack on captive insurance arrangements in general and microcaptive insurance arrangements in particular. Part of the reason for its continued unwillingness to accept captive insurance companies as a legitimate business was the potential for taxpayers to abuse the structure. A Tax Court case last year highlights this potential and why the IRS remains skeptical of these types of arrangements. The case, Avrahami, 149 T.C. No. 7 (2017), is a clear road map of what not to do in setting up a captive insurance arrangement.

In Avrahami, the taxpayers, after consulting with a lawyer who was a promoter of microcaptive insurance arrangements, created their own microcaptive insurance company pursuant to Sec. 831(b) (microcaptives are discussed later in this article). The evidence undermined the taxpayers’ claims that their microcaptive insurance company arrangement was legitimate. For example, the taxpayers’ premiums went from approximately $150,000 per year paid to independent insurance companies to almost $1.2 million per year to their own microcaptive. They did not cancel their preexisting insurance.

The taxpayers also created another real estate company that borrowed almost all of the money paid in premiums to the microcaptive. They then borrowed all the money paid to the real estate company themselves. The court observed that this appeared to be a “circular flow of funds.” In addition, the borrowing back of the funds also created a situation in which, if claims had been made against the policies, the microcaptive would have been undercapitalized.

In addition, the actuary who determined the amounts of risk to set the premiums appeared to the court to be unable to justify the premiums, and the premiums appeared to have no relation to industry standards pertaining to a relationship between premiums and risk. It probably didn’t help the court’s perception that the actuary that set the premiums for the taxpayers’ policies worked almost exclusively for the promoter who marketed the microcaptive arrangement to the taxpayers and that the premiums for the taxpayers’ company magically seemed to be just under the Sec. 831(b) $1.2 million ceiling then in effect for treatment as a small (“micro”) insurance company.

Testimony in the case indicated that, as the policies were written, there would be almost no possibility of any legitimate claims being made against them, and no claims were actually made before the IRS began its audit of the taxpayers. After the IRS informed the taxpayers of its proposed audit changes, a sudden slew of claims were made against the microcaptive, with all of them being paid, even though they were not timely under the policy and by its terms should have been turned down.

The Tax Court ruled that the captive’s election to be a Sec. 831(b) microcaptive was invalid. Because the company created was not really an insurance company, there was no risk shifting or risk distribution, and the arrangement would not meet acceptable definitions and standards of how insurance companies operate.

As Avrahami shows, this area is ripe for abuse. But that does not mean that a legitimate microcaptive insurance company that is not set up and used for tax-avoidance purposes cannot still be a valuable vehicle. Following are some of the lessons to be learned from Avrahami, as well as Notice 2016-66, in which the IRS specifically outlined what it perceives to be evidence of tax-avoidance objectives of microcaptive insurance companies and designated certain arrangements involving them as transactions of interest under Regs. Sec. 1.6011-4(b).

First, if one of the legitimate goals of setting up a captive insurance company is to combat rising premium costs, then premiums to the captive insurance company should go down compared with those of previous commercial coverage, not up. Also, the previous insurance should no longer be needed and should be canceled. If the policies written by the captive include potential additional coverages that the taxpayer did not have before or could not afford before forming its own captive, the premiums could go up somewhat, but there should be specific written documentation of why those additional coverages are necessary. If a doctor typically pays, as in the example above, $500,000 in annual premiums and upon setting up his own captive pays $2 million in premiums, is it really plausible that the doctor set up the captive with the legitimate goal of cutting his insurance costs? The IRS certainly has a stronger argument that once the captive was formed, the estate planning element became more prominent.

The IRS also focuses on how the premiums were set in the first place. If your client was paying premiums to a commercial insurer, it would determine the premium using actuarial and risk calculations. Likewise, a captive insurance company must hire legitimate actuarial and risk factoring companies to set the premium structure for it to be justifiable. This is another line of IRS attack: the legitimacy of the company setting the premiums and the allocations of the premiums to various risk factors. The actuarial company used should be able to justify the premiums it determined by comparison with industry standards.

The IRS is challenging the arrangement by a doctor, in Goel, T.C. No. 028013-14, petition filed Nov. 24, 2014, for a large percentage of the allocation of the premiums paid to his captive attributed to a potential terrorist attack. However, the doctor is arguing that if his patients’ records were subject to being lost in a cyberattack, their lives could be at stake. Besides, the premium was set by a legitimate actuarial company and not by him. This case (in which the author of this article is petitioner’s counsel) is currently pending trial in the Tax Court. Unlike Avrahami, the doctor in Goel is arguing that he had legitimate concerns regarding computer hacking and ransomware of patient records, falling under the umbrella of terrorist threats.

MICROCAPTIVES AND NOTICE 2016-66

Under Sec. 831(b), a small non-life insurance company can elect to be taxed only on taxable investment income. This provision was designed to allow a small, self-owned (microcaptive) insurance company to avoid taxation on premium income. To qualify to elect this alternative tax treatment, the insurance company’s net written premiums (or, if greater, direct written premiums) can’t exceed $2.2 million per year, adjusted for inflation after 2016 ($1.2 million for tax years before 2016), and must meet certain diversification requirements.

In Notice 2016-66, the IRS laid out the various factors that indicate that a microcaptive insurance arrangement has tax-avoidance or tax-evasion purposes. If the IRS finds that this is the case, it will disallow the Sec. 162 ordinary and necessary business expense for the payment of the premium to the captive insurance company. Negligence penalties could also apply.

Contract coverage

In Section 1.02(c) of Notice 2016-66, the IRS identified traits of abusive microcaptive contract coverage. The first is that the coverage involves an implausible risk. In its Dirty Dozen news releases IR-2015-19 and IR-2016-25, the IRS referred to these as “esoteric, implausible risks.” While it is a question of fact whether a risk is implausible, the IRS, unsurprisingly, takes a narrow view of what risks are plausible. This is demonstrated in Goel, where despite the increasing prevalence of cyberattacks by terrorist organizations, the IRS is arguing that the risk of such an attack against a doctor’s medical practice is an implausible risk. Taxpayers must be prepared to offer credible evidence that an unusual covered risk is not an implausible risk for their business.

Insuring against a cyberattack as part of the cost of premiums, however, is not far-fetched. Today, such attacks and malware that include ransomware are becoming part of the lexicon. Businesses can be wiped out if their computer networks are attacked. An attack such as this subjects a company not only to potential lawsuits from customers but also to a drop in future revenue, as fear of providing sensitive information to the company results in a loss of ongoing business opportunities. To combat the IRS perception, companies need to document the financially catastrophic consequences of a cyberattack. This would include a report to the insurer documenting potential damage to the insured’s business if its data were breached, if its confidential information were stolen, or if its computer network were shut down.

The second listed feature of abusive coverage is that which does not match a business need or risk of the insured. A butcher paying $5,000 in annual insurance premiums would likely insure against a customer’s getting some type of food poisoning. It is unlikely, however, that an additional premium of $10,000 per year to a captive insurance company for keeping the butcher’s computers from being hacked would pass IRS muster. This is because there is no real logical basis that such a business would be significantly and irrevocably damaged should its computers go down; its relationship with meat vendors would not be damaged, and even though it might accept customers’ credit cards, it wouldn’t keep them on its database. There should be a correlation between the potential risk and the calculation of the premium.

On the other hand, a health care organization with confidential patient information could be required to maintain tremendous risk insurance coverage to defray the cost of a loss that would almost certainly arise if its records were compromised. Again, the solution would be for professionals representing the insured to prepare a detailed report of the risks and the potentially catastrophic effect of the consequences. This should be provided to the insurance company and its actuarial component to document the reasonable relationship between the setting of the premium and the actual risks being insured.

The third IRS objection listed in the notice is that the description of the scope of the coverage in the contract appears vague, ambiguous, or illusory. The IRS perceives this abuse when it audits a captive insurance company and finds the insurance contract so poorly written that the actual coverage is not spelled out. Insurance companies, captives included, should be very specific as to what they are covering. The rule of thumb should be if a major commercial insurer wouldn’t structure the insurance in a certain way, the captive insurance company shouldn’t, either.

Most actuarial companies specifically break down the origin of how they compute the premium. The total premium is made up of subpremiums for all the risks that it covers. Without a doubt, that delineation should be clearly spelled out in the insurance contract. Each subpremium should be consistent and justified by an industry standard. This was one of the problems in Avrahami; the premiums had no basis in any industry standard, and the court surmised that the premiums were set more to meet the small-insurer ceiling of Sec. 831(b) than to cover any particular risk.

The IRS’s fourth objection is to coverage that duplicates coverage provided to the insured by an unrelated, commercial insurance company, where the policy with the commercial insurer has a far smaller premium. An example of this perceived abuse occurs when the insured is paying a commercial insurer a set premium, then sets up a captive insurance company, pays it higher premiums, and doesn’t cancel its existing insurance. The motivation of the insured is put into question if the total premiums rise substantially and the original insurance is still maintained. In such cases, the IRS may contend these new premiums to the captive are not ordinary or necessary. To avoid this problem, taxpayers need to be instructed that a captive’s premiums should be consistent with those for insurance on the open marketplace, and that there is no need to keep existing insurance in place.

Amounts paid to, management of, and capitalization of a captive

The IRS also highlights in Notice 2016-66 arrangements in which the amounts paid to the captive might indicate an abusive microcaptive arrangement. These include, as discussed above, when the premiums significantly exceed those for coverage offered by other unrelated commercial insurance companies, when the premiums are not made consistently, or when there is no actuarial analysis in setting the premiums. The management of the captive may also raise questions, and the IRS will also examine whether the captive complies with the laws of the jurisdiction where it is incorporated, issues policies or binders in a timely manner, has clear claims procedures consistent with insurance industry standards, and the insured files claims for loss events.

The IRS also scrutinizes the company’s capital, including, for example, whether it has sufficient capital to assume the risk of claims, whether the capital consists of illiquid assets not usually held by insurance companies, and whether the company has made loans or transferred the capital back to the insured (as occurred in Avrahami, described above). In an attempt to quantify undercapitalization of a microcaptive, the IRS states in Section 2.01 of the notice that if the taxpayers or related persons own at least 20% of the microcaptive, and claims made against the captive are less than 70% of the premiums paid in, or less than 70% of the dividends paid to the owners, or the captive has made some financing arrangement with the owners that didn’t result in taxable income (e.g., a loan to an owner), then this is a “transaction of interest.”

Standard industry practice

Some of the other issues that the IRS points to in Notice 2016-66 can be characterized as standard industry practice for insurance in general. For example, forming captives that do not have legitimate underwriting or actuarial analysis, that collect premiums in a haphazard manner and do not enforce collection when the insured fails to pay, or that show no relationship between the premiums and what could be obtained in the open marketplace clearly indicates that the real purpose of forming the captive is estate planning or investment. To overcome these perceived faults, captives should set premiums that are reasonable, competitive, and, of course, based on real actuarial and underwriting standards. Then the insured should actually pay them regularly.

REWARDS FOR CORRECT FORMATION AND OPERATION

When advising clients about setting up a captive insurance company, a trusted adviser should stress that if a captive is set up correctly, it is possible for the insured to lower premiums and, ultimately, upon the dissolution of the business, get back most of the amounts paid to the captive — a great incentive that doesn’t happen with the purchase of commercial insurance. Also, the amounts paid into a captive can be invested in conservative, delineated investments that are regulated under insurance industry requirements. Absent payment of claims, the amounts contributed as premiums have an opportunity to grow. Plus, if an election is made under Sec. 831(b), the microinsurance company won’t have to pay tax on the premiums, just on the investment income.

However, it should also be stressed that owning a captive insurance company is not a license to treat it as a personal piggy bank. The company will use a significant amount of the premiums paid to reinsure in an insurance pool to cover risks, the company must be adequately capitalized, and the premiums must be set to conform with industry standards for the risk being insured. The taxpayers should not borrow the premiums back from the captive, they should cancel their existing insurance, and they should turn over management of the captive to experienced professionals who manage captives, much as pension plan administrators do for Sec. 401(k) plans and IRAs. If they comply with these logical rules, taxpayers get the benefit of both a present tax deduction and, potentially, a future return of their premiums as well as any growth.

About the author

Philip Garrett Panitz, Esq., LL.M., (pgp@pktaxlaw.com) is the senior tax partner at the law firm Panitz & Kossoff LLP in Westlake Village, Calif.

To comment on this article or to suggest an idea for another article, contact Paul Bonner, a JofA senior editor, at ­Paul.Bonner@aicpa-cima.com or 919-402-4434.

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