Captive insurance companies (CICs) face increased scrutiny by the IRS, due to what the government views as a high risk of illegal tax avoidance or evasion. As a result, promoters, managers, and entities are shying away from forming captives, even when they have a good reason to do so.
Not all captives are created equal. When formed for the right reasons, managed conservatively, and within the constraints of the ever-evolving law related to micro-captives, they can offer many benefits and advantages. When considering a captive insurance transaction, the only reason to consider a CIC is to provide for insurances that can be proven as prohibitively expensive or difficult to obtain.
CICs formed for any purpose other than a demonstrable insurance need should be regarded with the utmost caution.
Understanding the Reasons for Captive Insurance Companies
The U.S. government implemented laws to encourage the development of small, closely-held, for-profit insurers as a way to stimulate economic growth. Forming a CIC allows businesses to obtain the insurance coverage they might not be able to find in the commercial marketplace and to keep insurance premium costs as low as possible.
It is important to remember that the overarching purpose of any captive is to provide insurance. The CIC can eventually make a profit and provide tax advantages to investors, but ultimately, it should serve the insurance needs of a parent company that has uninsured, uninsurable, or underinsured risk.
The Still Existing Advantages of a Captive
By providing businesses with a way to control their insurance coverage, CICs are a highly effective means for transferring risk and protecting business assets from unexpected losses. Businesses may save money on premiums and can tailor policies to cover exactly the risks they face. Captive coverages can fill in the gaps and carveouts in commercial policies, or in some cases, replace them. Throughout the entire formation process, the business owner should work with their commercial insurance agent to ensure coverages are maintained and that the insurance purpose is followed.
While the law provides that CICs are allowed to pass profits along to investors when the company is profitable (i.e., paid premium revenue exceeds claims liability), CICs should never operate as a piggy bank or investment vehicle or “alternative financing” entity. It is critical that a CIC be managed just like you would expect a commercial insurance company would operate. Meaning, coverages are tailored to need, premiums match up with reality, and there is a strictly adhered to claims process—among other important operational requirements.
The Imperatives of Captive Compliance
Many captive promoters and managers have been targeted by IRS promoter audits recently for advocating CIC transactions primarily as a tool for minimizing the investor’s tax liability and protecting assets. As a result, the IRS has—as they have with every other tax-motivated transaction—begun to impose more scrutiny as well as substantial penalties on captive insurance company owners. As we have reported in our other articles, investors who unfortunately found themselves in hot water have begun to file class-action lawsuits against promotors.
Captives are currently in hot water with the IRS over the repeated refrain that the promoter knows best how to structure the transaction. Business owners are required to understand the complex transactions they enter into. Consider that—if you were to invest in any other company in any other industry—and you were told “don’t worry” and “set it up like this so you never make a claim” or “loan your own money back to you”—you would never agree to something that sounds like a sham. In a similar manner, do not agree to a CIC transaction that does not pass the smell test.
Creating a captive that is — and remains — compliant is critical. However, as the rules and regulations governing CICs are in a constant state of flux, this requires input from a tax attorney who is highly knowledgeable in this complex field.
Cantley Dietrich is recognized as one of the world’s foremost experts in captive insurance compliance matters. If you have questions regarding the operations of your captive insurance company, are a concerned advisor, or have concerns about any other transaction you have entered into, we assist our clients in ensuring they’re operating well within the constraints of governing laws. Contact us today to learn more or to schedule a consultation.