A Captive Insurance Company is a privately owned, legally formed insurance company created to insure the risks of one or more companies owned by the Captive's founder. The Captive's objective is to generate a profit by insuring specific risks not typically covered under existing insurance coverage. The founder may be able to substantially reduce property and casualty insurance costs, control premiums and provide an excess cash flow. A Captive Insurance Company can have significant tax effects. The increased propularity and use of Captives has caused greater IRS scrutiny regarding the use, misuse or abuse of Capitive Insurance Companies.
A pure Captive is owned and controlled by one entity and insures that entity and/or its subsidiaries. A "group" captive is an insurance company owned and controlled by two (2) or more unaffiliated organizations, which is formed to provide insurance to its group or association of owners. The owners are usually companies from a related business field.
The Captive can earn investment income on the premiums paid. This investment will allow more funds to be available to pay claims and/or increased profits. The Captive will reduce the administrative costs such as agent commissions, compliance with federal and state regulations, office overhead and salaries otherwise inherent in commercial insurance premiums.
Captive Insurance Companies may be formed within the United States or off shore. Several states now have captive insurance including Nevada, Hawaii, Montana, Utah, Delaware, Washington and Vermont. Vermont is the largest Captive domicile in the United States.
In 2002, the IRS issued three revenue rulings providing "safe harbors" for captives: Revenue Ruling 2002-89 (Third Party Risk), Revenue Ruling 2002-90 (12 Entity) and Revenue Ruling 2002-91 which deals with a group captive arrangement.
The Internal Revenue Code provides property and casualty insurance companies certain deductions against taxable income not allowed for ordinary businesses. In addition to these unique deductions, Internal Revenue Code Section 831(b) provides that up to 1.2 million dollars in premiums may be received annually without income tax.
Captive insurance is a very powerful tool in insuring against business risks. In a successful captive scenario, an IRC §162 deduction is available for insurance premiums paid by the insuring business and 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 numerous abusive arrangements exist that do not, in fact, offer valid insurance.
In examining a captive arrangement, the IRS will initially demand copies of all promotional materials. Throughout the IRS examination, the IRS will look for the following "red flags":
- Materials emphasizing the income tax goals of the captive insurance arrangement. The IRS will evaluate whether such materials emphasize premium deductions as opposed to 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. To illustrate, there would be little need for hurricane coverage in a land locked area or earthquake coverage where there is no fault line within hundreds of miles.
- Reverse engineering the amount of premiums to equal exactly the $1.2 million exemption amount to the penny. The IRS believes certain taxpayers are exploiting this advantage by signing up for premiums exactly at the $1.2 million level.
- An impermissible circular flow of funds where the premium monies, either through loans or distributions, ultimately end up in the hands of the business or a closely related party. The IRS has a history of suspicion over the "circular flow" of funds.
- Lack of adequate risk distribution to be considered an insurance company for tax purposes. This arises where the captive insures only the single business and simply holds the premium monies in the event of a claim. The IRS is very focused on a perceived lack of risk distribution and risk shifting in certain captive arrangements.
- Failure to obtain an actuarial study supporting the premiums charged by the captive for the insurance. The IRS will examine the underwriting process.
- Lack of an analysis of the cost and availability of commercial insurance in the non-captive market. The IRS believes that insurance rates far in excess of commercially available rates defy common sense.
- Materials emphasizing the estate planning benefits of the captive insurance structure. For instance, the IRS will scrutinize a captive insurance company owned by a family limited partnership or irrevocable trusts that benefits the business owners' family members. The IRS takes the position 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. The IRS believes that guarantees may be an indication of inadequate capitalization.
- Lack of claims history. The IRS believes that no claims may indicate that the insurance pool is insufficient and risk shifting may not exist.
In a recent opinion involving captives, a majority of the U.S. Tax Court in Rent-A-Center, Inc. v. Commissioner held that payments by a parent company's wholly-owned subsidiaries to a wholly-owned captive insurance company were fully deductible under section 162 of the Internal Revenue Code of 1986, as amended, as insurance expenses. The decision reverses the Tax Court's prior analysis regarding the deductibility of premiums paid by affiliated subsidiaries to a captive (referred to as a brother-sister captive insurance arrangement) and agrees with the Sixth Circuit that there can be sufficient shifting of risk in such an arrangement for insurance to exist and premiums paid to the captive to constitute deductible insurance expenses. This opinion is favorable for taxpayers because it demonstrates that captive insurance companies can be legitimate business arrangements entitled to special tax treatment if structured and managed properly.
There is no statutory definition of the term "insurance." The issue of whether arrangements involving captive insurance companies qualify as "insurance" for Federal tax purposes has been a source of considerable contention between the Internal Revenue Service and taxpayers. The U.S. Supreme Court, however, has established two necessary criteria for an arrangement to be considered insurance: risk shifting and risk distribution. Also, the arrangement must involve insurance risk and meet commonly accepted notions of insurance.
In Rent-A-Center, Inc., Rent-A-Center ("RAC") became increasingly concerned about its growing risk management costs following a period of rapid expansion from 1993 to 2002. Aon Risk Consultants, Inc. analyzed RAC's insurance program and advised the company to create a wholly-owned insurance subsidiary (i.e., a captive). RAC incorporated its captive, Legacy Insurance Co. Ltd. ("Legacy"), in Bermuda in 2002. Legacy wrote insurance policies that covered RAC's workers' compensation, automobile, and general liability claims. The annual premiums Legacy charged were allocated to each RAC subsidiary. Beginning in January, 2008, the IRS sent RAC notices of deficiencies for tax years 2003 through 2007, determining that the subsidiaries' payments to Legacy were not deductible insurance expenses. The IRS had argued that RAC's captive was a sham entity created primarily to generate Federal income tax savings.
In deciding whether the subsidiaries' payments were deductible, the Tax Court first determined whether Legacy was a bona fide insurance company. Although Federal income tax consequences were considered during the formation of Legacy, the court ruled that the formation of Legacy was not a tax-driven transaction. Specifically, the court concluded that Legacy was not a sham because RAC created the captive for significant and legitimate nontax considerations, including increasing the accountability and transparency of RAC's insurance operations, accessing new insurance markets, and reducing risk management costs. Further supporting the court's holding were its findings that Legacy entered into arm's-length insurance contracts for workers' compensation, automobile, and general liability claims; charged actuarially determined premiums; was subject to regulatory control; paid claims from its separately maintained account; and was adequately capitalized. In the Kilpatrick Townsend Tax Team's experience defending captives, the IRS focuses on the types of coverage the captive insures and the extent to which the captive operates as a business with maintenance of books and records, a claim processing procedure, and other operational systems a business would employ. The fact that Legacy covered workers compensation and other common business risks of loss weighed in Legacy's favor and should have deterred the IRS from litigating the case.
Turning to the issue of whether the payments to Legacy were deductible insurance expenses, the court analyzed the four criteria mentioned above: risk shifting, risk distribution, whether the captive arrangement involved insurance risk, and whether the arrangement met commonly accepted notions of insurance. The Tax Court held that all four requirements were satisfied. In its analysis, the court focused on risk shifting; in particular, whether the insurance policies at issue shifted risk between RAC's subsidiaries, as the insured entities, and Legacy. In doing so, the court examined the arrangement's economic impact on RAC's subsidiaries to determine if the subsidiaries had, in fact, shifted the risk. It concluded that the policies shifted risk, acknowledging the Sixth Circuit's ruling in Humana v. Commissioner that brother-sister captive insurance arrangements may shift risk. Based on the specific facts presented to the court, it found that Legacy was a separate, independent, and viable entity; was financially capable of meeting its obligations; and reimbursed RAC's subsidiaries when they suffered an insurable loss. Moreover, a payment from Legacy to RAC's subsidiaries did not reduce the net worth of the subsidiaries.
As noted, Rent-A-Center, Inc. is a favorable opinion for companies that have captive insurance companies or are considering establishing them. A captive insurance company may be a very economical way to handle insurance costs and provide additional protection from a wide range of busines risks.