What is Captive Insurance?
Captive Insurance Programs
Captive Insurance Benefits
Captive Tax Benefits
WMS Captive Services
Captive Feasibility Study
Captive Risk Pools
Captive Policies & Limits
Captive Insurance Costs
Estate Planning Benefits
Asset Protection Benefits
IRS Captive Tax Rulings
IRS Letter Rulings
Captive Tax Scams
Captive Tax Articles
IRC Section 831
IRC Section 953(d)
IRC Section 1563
Copyright 2004 American
Institute of Certified Public Accountants
July 1, 2004
SECTION: Vol. 35, No. 7; Pg. 419; ISSN: 0039-9957; CODEN: TAADDJ
LENGTH: 1250 words
HEADLINE: Using Captives to Manage Risk
BYLINE: Smith, Annette B
insurance arrangement is an alternative risk management mechanism that has
become popular in today's business environment for managing certain risks as
part of a company's overall risk management program. Captives typically have
been used to fund property and casualty insurance coverage, such as general
liability, products liability and workers' compensation. Depending on the
business reason for using captives, their tax implications vary. Increasingly,
non insurance businesses are using captives to manage certain risks as part of
their overall risk management programs. In knowing the non tax advantages and
disadvantages associated with captives, tax practitioners will be able to
articulate the basic domestic tax benefits and to discuss the significant issues
that IRS agents might pursue in an examination.
A captive insurance arrangement is an alternative risk management
mechanism that has become popular in today's business environment for managing
certain risks as part of a company's (or group of companies') overall risk
management program. Captives typically have been used to fund property and
casualty insurance coverage, such as general liability, products liability and
workers' compensation. Depending on the business reason for using captives,
their tax implications vary.
Domestic Tax Benefits
Premium deductions: Insurance premiums (which qualify as "insurance" for Federal
tax purposes) paid by policyholders to a captive are deductible as ordinary and
necessary business expenses under Sec. 162(a). In contrast, reserves set aside
for self-insuring certain risks are not deductible; see Spring Canyon Coal Co.,
13 BTA 189 (1928), afF'd, 43 F2d 78 (10th Cir. 1930), and Pan-American Hide Co.,
1 BTA 1249 (1925).
Insurance company tax rules: Captives (which qualify as "insurance" companies
for Federal tax purposes) are taxed as insurance companies. Thus, they can take
advantage of certain Code provisions specifically targeted to insurance
companies. Examples include the captive's being able to:
* Recognize premium income as it is earned, rather than when paid, under Sec.
* Deduct accrued losses in a manner unavailable to other taxpayers (due to the
Sec. 461 (h) "all events" test), by deducting currently an estimate of losses
incurred and future expenditures needed to settle such losses, under Sec.
832(b)(5) (rather than deducting when paid);
* Elect to be taxed only on investment income under Sec. 831 (b), if net
written premiums (or if greater, direct written premiums) for the tax year do
not exceed $1.2 million (as revised by the Pension Funding Equity Act of 2004 (PFEA));
* Qualify for tax-exempt status under Sec. 501(c)(15) if gross receipts for the
tax year do not exceed $600,000, more than 50% of which are derived from
premiums (rather than investment income); see PFEA Section 206.
State taxes: Captives generally are not subject to state income taxes. This may
result in permanent tax savings on income-producing assets held within the
To take advantage of these tax benefits, a captive must satisfy two primary
requirements: (1) a valid insurance arrangement must exist between the captive
and its policy-holders (2) and the captive must be an insurance company for
Federal tax purposes.
Over the years, courts have examined a number of factors that, when present,
should help support the second requirement, including:
* A valid business purpose (non tax) exists for forming the captive;
* "Insurance" risk is present, not merely investment risk;
* The contractual arrangement involves "risk shifting";
* The captive insures sufficient independent risks to support the "risk
* The absence of any parental guarantees or hold-harmless agreements;
* The captive meets statutory capital surplus requirements in its jurisdiction
* The captive is subject to regulation and licensure;
* The captive is adequately capitalized;
* The captive deals with its policy-holders on an arms-length and standard
commercial basis; and
* The policies are insurance contracts as commonly understood in the industry.
Besides having a valid insurance arrangement, the captive must be an insurance
company for Federal tax purposes. The term "insurance company," as defined by
PFEA Section 206(c), means any company more than 50% of the business of which
during the tax year is the issuing of insurance or annuity contracts or the
reinsuring of risks underwritten by insurance companies.
Issues and Recent Guidance
According to the IRS, two principal issues found in captive insurance
cases are the deductibility of (1) premiums paid by a parent to a captive
subsidiary and (2) payments paid by one subsidiary to a captive within the
group; see Internal Revenue Manual 220.127.116.11.7. To help reduce the uncertainties
associated with using a captive, the Service has issued general safe harbor
rulings and provided the possibility of advance rulings for those taxpayers that
cannot meet those safe harbors (Rev. Proc. 2002-75).
In Rev. Rul. 2002-89, the IRS held that an insurance arrangement between a
parent and its wholly owned subsidiary captive will be treated as insurance if
more than 50% of the risks the captive insures are those of persons unrelated to
the parent and captive, and if more than 50% of the total premiums (on both a
gross and net basis) are attributable to such unrelated persons. However, when
only 10% of the risks insured by the captive are those of persons unrelated to
the parent and captive, the arrangement will not constitute insurance (Rev. Rul.
In Rev. Rul. 2002-90, the Service held that a brother-sister captive would be
treated as insurance, despite the absence of risks of unrelated parties being
insured by the captive. It found that each of the 1.2 subsidiaries' risks, which
represented a significant amount of independent risks, was sufficiently
distributed, as the liability to any one of the subsidiaries accounted for no
more than 15%, and no less than 5%, of the total risks. Accordingly, premiums
the subsidiaries paid to the captive would be deductible.
Finally, in Letter Ruling (TAM) 200323026, the IRS held that certain captives
were not insurance companies, as a result of the (1) captive's inadequate
capitalization, (2) informality between the contracting parties, (3) presence of
parental guarantees and (4) lack of risk distribution and concentration of risk.
Increasingly, non insurance businesses are using captives to manage certain
risks as part of their overall risk management programs. In knowing the non tax
advantages and disadvantages associated with captives, tax practitioners will be
able to articulate the basic domestic tax benefits and to discuss the
significant issues that IRS agents might pursue in an examination.
The intent of this item was to introduce tax advisers to the domestic tax
benefits of using a captive. However, it did not address many important tax and
nontax issues. In particular, practitioners would need to analyze choice of
captive domicile, a feasibility analysis, captive development and
implementation, and disclosure requirements and international taxation, before
rendering advice to a particular company on its prospects for successfully
implementing a captive.
FROM CLINTON N. MCGRATH, JR., CPA, J.D., LL.M., WASHINGTON, DC
LOAD-DATE: September 8, 2004