Captive Insurance Issues and Trends 2017
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A microcaptive is a captive insurance company operating with annual written premium of less than $1.2 million. In the United States, such captives are taxed under Internal Revenue Code § 831(b), which provides that a captive qualifying to be taxed as a U.S. insurance company will pay tax only on investment income.
Section 831(b) of the Internal Revenue Code
Section 831(b) of the U.S. tax code stipulates special income tax rules that apply to any type of small insurance company, not just captives. These rules can be used by all types of captives, whether single owner, group owned, or rented, provided that the captive meets the following qualifications:
- The captive insurance company or the captive cell must qualify as an insurance company for tax purposes. Very briefly, this means it must have adequate risk shifting and sharing and operate and be regulated like a "real" insurance company, e.g., with adequate capital to allow it to take risk.
- The company must be a U.S. taxpayer, either domiciled in the United States or domiciled offshore but having elected and qualified under tax code section 953(d) to be taxed as a U.S. insurer.
- The gross premium income for the tax year in question must be less than $1.2 million. This premium threshold applies to all insurers included in a single consolidated tax filing.
Microcaptives became popular because, if a captive is taxed under 831(b) of the tax code, it does not pay tax on its underwriting income. It pays income tax only on its investment income. The benefit of this is clear for captives that write risks that have a quick reporting and loss payout profile, such as property insurance. If a captive with more than $1.2 million in annual premium issues a high-deductible property policy and has no property losses, the premium paid to a larger captive, less any expenses, will be taxed, as well as tax being paid on any investment income. But, if the gross premium is less than $1.2 million, only the investment income is taxed. The underwriting profit can either be returned as a shareholder dividend or remain in the captive as surplus.
Three points must be remembered:
- An insurance company qualifies to be taxed under the provisions of 831(b) annually. So, a group captive that is just getting started may have less than $1.2 million in premium in its first year of operation but, in the second year, may have grown to the point where it is no longer eligible.
- The premium threshold is calculated on a gross, not a net, basis. A captive insurance company might, for example, write $5 million in premium and cede $4 million to reinsurers, giving it a net written premium of $1 million. It would not qualify to be taxed under 831(b) due to the gross premium stipulation. On the other hand, if the insureds in a fronted captive (single owner or group) pay $5 million in premium to their issuing insurer, which then cedes $1 million to the captive, the captive's assumed premium meets the qualification of 831(b). The gross premium can be either direct written or assumed.
- A captive owner could not split its risks into two or more captives and claim that each one qualifies under 831(b). All captives owned or controlled by a single tax-paying entity will be treated as one combined entity when determining eligibility for the 831(b) rules.
One problem with 831(b) captives arises from the false
premise that all that one has to do is to meet the mathematical test of
premiums less than $1.2 million. It's not that simple. The company must qualify
as an insurance company and must have a business purpose—not merely a tax-reducing purpose—as the primary motivator for both the formation and the
continued operation of the captive.
A second issue with 831(b) captives is that they have attracted attention through a marketing blitz touting tax deductions, wealth transfer tax advantages, and tax-deductible funding for life insurance. Promoters are pushing tax reasons for forming a captive, and they are very convincing: avoiding the taxation of wealth transfer, the tax advantages of using them, in estate planning, the purchase of tax-deductible life insurance, and even asset protection.
Captives are regulated financial institutions. They should be treated with utmost care and professionalism both in the formation and annual management and operations. Buyers need to take the time necessary with experienced professionals to make sure the ideas and proposals of captive promoters will stand up under Internal Revenue Service (IRS) or regulatory scrutiny. Promoting captive formation for purely tax avoidance purposes is bad for captive owners and will prove to be bad for the promoters, too.
The IRS has demonstrated a distaste for captives, and having a microcaptive that stretches the boundaries of reasonableness will be like putting an “audit here” sign in the front lawn.
To learn more about the 831(b) election, read "The Basics of the 831(b) Election for Captives" or view our educational videos on the taxation of 831(b) Microcaptives.
This article is
based on information in "Microcaptives 101," by Kathryn A. Westover (Innovative Captive Strategies), The Risk Report, Volume XXXV, No. 2, October 2012, and “Strong Headwinds for 831(b) Captives,” Captive Insurance Company Reports, July 2012. Both are published by International Risk Management Institute, Inc., Dallas, TX.
2014 International Risk Management Institute, Inc.