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Increased IRS Scrutiny for Captive Insurance Companies

By Attorney Shad M. Brown

I know many of you are thinking the same thing: "What is a captive insurance company?" In a nutshell, a captive insurance company is an insurance company which has common ownership with the entity it insures. Recently, numerous news agencies have reported that it appears the IRS is increasing scrutiny of these captive insurance arrangements. However, before one can understand why the IRS would increase scrutiny, it is important to understand the benefit to such an entity.

All businesses attempt to manage the various risks that can negatively affect them. Typically, the most significant risks are managed through insurance. There are numerous commercial insurance products which help businesses manage risks associated with property and casualty loss, professional malpractice, tort liability and the like. When businesses pay the premiums for these insurance policies, they are allowed to deduct the payments as ordinary and necessary expense of the business. This reduces the amount of business income that is subject to taxation.

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    However, every business is also subject to additional risks that they cannot purchase insurance for because they cannot afford it or because commercial insurance policies do not exist for these risks. These risks may include loss of a key client, loss of a key employee, and losses associated with negative government regulation. Without an insurance option, companies will often self-insure these risks by retaining earnings to create reserves that can be used if such risks come to fruition. The downfall to this approach is that the company does not get a deduction for the money it sets aside in a reserve account. This in turn increases the business income subject to taxation, which ultimately increases the amount of taxes paid by the business.

    Captive insurance companies are a solution to this gap in coverage

    Under a captive insurance arrangement, a business will form a separate insurance company. This insurance company will have common ownership with the insured business and will underwrite the insurance policies the business is unable to obtain elsewhere. In return, the business will pay premiums to the insurance company, which are deductible as a business expense. This deduction provides an immediate tax benefit for the insured business. Generally, this benefit is offset by the fact that the captive insurance company recognizes the premiums it receives as income. Thus, under a general captive insurance arrangement, the tax savings are minimal. However, the Internal Revenue Code provides a much more favorable tax treatment for some captive insurance companies, often referred to as "microcaptives."

    Microcaptives are defined as captive insurance companies that do not receive annual premiums in excess of $1.2 million. Unlike most insurance companies, these microcaptives do not treat the premiums received as income. Instead, a microcaptive is taxed only on the investment income earned as it invests the premiums it receives. This provides a great opportunity for tax arbitrage. However, where there is an opportunity for arbitrage, there is also an opportunity for abuse, and it is these potential abuses that concern the IRS. To combat this potential, the IRS has issued several publications which attempt to offer safe-harbor directions for companies that want to establish and operate microcaptives. Despite these publications, ambiguity and the potential for abuse remain.

    When making the decision to establish a microcaptive, it is important to consult with a qualified professional who understands the benefits and risks to such an arrangement. The trusted tax attorneys of Brown & Jensen have advised clients on the formation and continued operation of captive insurance arrangements. We have also guided clients through IRS audits which are the direct result of increased IRS scrutiny. When contemplating any tax planning strategies or defense against the IRS, we are your trusted tax advisor.

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