Within the last 20 years, many small businesses have begun to insure their very own risks by way of a product called “Captive Insurance.” Small captives (also referred to as single-parent captives) are insurance companies established by the owners of closely held businesses seeking to insure risks which are either too costly or too hard to insure through the traditional insurance marketplace. Brad Barros, a specialist in the field of captive insurance, explains how “all captives are treated as corporations and must be managed in a method in line with rules established with both the IRS and the correct insurance regulator.”
According to Barros, often single parent captives are owned by way of a trust, partnership and other structure established by the premium payer or his family. When properly designed and administered, a business will make tax-deductible premium payments to their related-party insurance company. Depending on circumstances, underwriting profits, if any, can be paid out to the owners as dividends, and profits from liquidation of the company may be taxed at capital gains.
Premium payers and their captives may garner tax benefits only once the captive operates as a real insurance company. Alternatively, advisers and business owners who use captives as estate planning tools, asset protection vehicles, tax deferral and other benefits not linked to the actual business intent behind an insurance company may face grave regulatory and tax consequences.
Many captive insurance companies are often formed by US businesses in jurisdictions outside the United States. The cause of that is that foreign jurisdictions offer lower costs and greater flexibility than their US counterparts. As a rule, US businesses may use foreign-based insurance companies so long as the jurisdiction meets the insurance regulatory standards required by the Internal Revenue Service (IRS).
There are many notable foreign jurisdictions whose insurance regulations are recognized as safe and effective. These include Bermuda and St. Lucia. Bermuda, while more costly than other jurisdictions, is home to most of the largest insurance companies in the world. St. Lucia, a more inexpensive position for smaller captives, is noteworthy for statutes which are both progressive and compliant. St. Lucia is also acclaimed for recently passing “Incorporated Cell” legislation, modeled after similar statutes in Washington, DC.
Meeting the high standards imposed by the IRS and local insurance regulators could be a complex and expensive proposition and should only be finished with the assistance of competent and experienced counsel. The ramifications of failing to be an insurance company can be devastating and may include the next penalties:
In general, the tax consequences may be more than 100% of the premiums paid to the captive. In addition, attorneys, CPA’s wealth advisors and their clients may be treated as tax shelter promoters by the IRS, causing fines as great as $100,000 or maybe more per transaction.
Clearly, establishing a captive insurance company is not a thing that should be taken lightly. It is important that businesses seeking to begin a captive work with competent attorneys and accountants who’ve the requisite knowledge and experience necessary to avoid the pitfalls related to abusive or poorly designed insurance structures. A broad guideline is that the captive insurance product needs to have a legal opinion covering the fundamental aspects of the program. It is well recognized that the opinion should be given by an independent, regional or national law firm.
Risk Shifting and Risk Distribution Abuses; Two key aspects of insurance are those of shifting risk from the insured party to others (risk shifting) and subsequently allocating risk amongst a large pool of insured’s (risk distribution). After many years of litigation, in 2005 the IRS released a Revenue Ruling (2005-40) describing the fundamental elements required to be able to meet risk shifting and distribution requirements.
For individuals who are self-insured, the use of the captive structure approved in Rev. Ruling 2005-40 has two advantages. First, the parent does not have to share risks with every other parties. In Ruling 2005-40, the IRS announced that the risks can be shared within exactly the same economic family as long as the separate subsidiary companies ( no less than 7 are required) are formed for non-tax business reasons, and that the separateness of these subsidiaries also has a business reason. Furthermore, “risk distribution” is afforded so long as no insured subsidiary has provided significantly more than 15% or significantly less than 5% of the premiums held by the captive. Second, the special provisions of insurance law allowing captives to take a current deduction for an estimate of future losses, and in some circumstances shelter the income earned on the investment of the reserves, reduces the cash flow needed seriously to fund future claims from about 25% to nearly 50%. Put simply, a well-designed captive that fits the requirements of 2005-40 brings about a price savings of 25% or more.
Though some businesses can meet the requirements of 2005-40 within their very own pool of related entities, most privately held companies cannot. Therefore, it’s common for captives to buy “alternative party risk” from other insurance companies, often spending 4% to 8% each year on the amount of coverage necessary to meet the IRS requirements.
Among the essential aspects of the purchased risk is that there’s a reasonable likelihood of loss. As a result of this exposure, some promoters have attempted to circumvent the intention of Revenue Ruling 2005-40 by directing their clients into “bogus risk pools.” Levens verzekeringen In this somewhat common scenario, an attorney and other promoter could have 10 or maybe more of their clients’ captives enter right into a collective risk-sharing agreement. Within the agreement is a published or unwritten agreement not to produce claims on the pool. The clients like this arrangement since they get every one of the tax great things about running a captive insurance company without the danger related to insurance. Unfortunately for these businesses, the IRS views these types of arrangements as something other than insurance.
Risk sharing agreements such as for instance these are considered without merit and should be avoided at all costs. They add up to simply a glorified pretax savings account. If it could be shown that the risk pool is bogus, the protective tax status of the captive can be denied and the severe tax ramifications described above is likely to be enforced.
It is well known that the IRS looks at arrangements between owners of captives with great suspicion. The gold standard in the market is to buy alternative party risk from an insurance company. Anything less opens the entranceway to potentially catastrophic consequences.
Abusively High Deductibles; Some promoters sell captives, and then have their captives participate in a large risk pool with a high deductible. Most losses fall within the deductible and are paid by the captive, not the danger pool.
These promoters may advise their clients that since the deductible is really high, there is no real likelihood of alternative party claims. The problem with this type of arrangement is that the deductible is really high that the captive fails to meet the standards set forth by the IRS. The captive looks more just like a sophisticated pre tax savings account: no insurance company.
A different concern is that the clients may be advised they can deduct all their premiums paid into the danger pool. In the case where the danger pool has few or no claims (compared to the losses retained by the participating captives using a high deductible), the premiums allocated to the danger pool are simply just too high. If claims don’t occur, then premiums should be reduced. In this scenario, if challenged, the IRS will disallow the deduction produced by the captive for unnecessary premiums ceded to the danger pool. The IRS might also treat the captive as something other than an insurance company because it did not meet with the standards set forth in 2005-40 and previous related rulings.
Private Placement Variable Life Reinsurance Schemes; Over the years promoters have attempted to generate captive solutions designed to offer abusive tax free benefits or “exit strategies” from captives. Among the popular schemes is in which a business establishes or works together a captive insurance company, and then remits to a Reinsurance Company that part of the premium commensurate with the part of the danger re-insured.
Typically, the Reinsurance Company is wholly-owned by way of a foreign life insurance company. The legal owner of the reinsurance cell is a foreign property and casualty insurance company that’s not susceptible to U.S. income taxation. Practically, ownership of the Reinsurance Company can be traced to the cash value of a life insurance plan a foreign life insurance company issued to the principal owner of the Business, or even a related party, and which insures the principle owner or even a related party.
Investor Control; The IRS has reiterated in its published revenue rulings, its private letter rulings, and its other administrative pronouncements, that who owns a life insurance plan is likely to be considered the income tax owner of the assets legally owned by the life insurance plan if the policy owner possesses “incidents of ownership” in those assets. Generally, to ensure that the life insurance company to be viewed who owns the assets in a separate account, control over individual investment decisions mustn’t maintain the hands of the policy owner.
The IRS prohibits the policy owner, or even a party linked to the policy holder, from having any right, either directly or indirectly, to require the insurance company, or the separate account, to obtain any particular asset with the funds in the separate account. In effect, the policy owner cannot tell the life insurance company what particular assets to invest in. And, the IRS has announced that there can’t be any prearranged plan or oral understanding in regards to what specific assets can be dedicated to by the separate account (commonly called “indirect investor control”). And, in an ongoing number of private letter rulings, the IRS consistently applies a look-through approach with respect to investments produced by separate accounts of life insurance policies to locate indirect investor control. Recently, the IRS issued published guidelines on once the investor control restriction is violated. This guidance discusses reasonable and unreasonable quantities of policy owner participation, thereby establishing safe harbors and impermissible quantities of investor control.