IRS examinations of captive insurance arrangements are on the rise. You may now wish to revisit your captive insurance arrangement.
Captive insurance is a very powerful tool in insuring against business risks. An IRC §162 deduction is available for insurance premiums paid by the insuring business, plus up to $1.2 million of the captive insurance company’s earnings may escape taxation. The IRS is aware of these powerful benefits and believes that many of these arrangements exist for the tax benefits rather than to provide valid insurance.
In examining a captive arrangement, the IRS will initially demand copies of all promotional materials. Throughout the IRS examination, the IRS has made it clear it will look for the following “red flags”:
• Materials emphasizing the income tax goals of the captive insurance arrangement; i.e. the materials emphasize premium deductions versus insurance needs.
• The realistic probability of coverage applying to the business. If the likelihood of the insurable event happening is low, the IRS believes the cost of coverage should likewise be low.
• Reverse engineering the amount of premiums to equal exactly the $1.2 million exemption
• An impermissible circular flow of funds, i.e. where the premium monies, either through loans or distributions, end up in the hands of the insured business or a closely related party).
• Lack of adequate risk distribution or risk shifting. This arises where the captive insures only the single business and simply holds the premium monies in the event of a claim.
• Failure to obtain an actuarial study supporting the premiums charged (a valid underwriting process) by the captive.
• No analysis of the cost and availability of commercial insurance in the non-captive market. Insurance rates far in excess of commercially available rates indicate a tax purpose versus insurance purpose.
• Materials emphasizing the estate planning benefits of the captive insurance structure. The IRS position is that I.R.C. §831(b) was not enacted as an estate planning tool, but to assist taxpayers who want to manage risk.
• The existence of guarantees, which is a sign of inadequate capitalization.
• Lack of claims history. No claims indicates that the insurance pool is insufficient and risk shifting may not exist.
These “red flags” do not automatically invalidate a captive arrangement. However, they are indicators that in substance the captive arrangement lacks risk shifting, risk distribution, and fails to qualify as insurance in the commonly accepted sense.