Captive Insurance

Herol Graham has turned defensive boxing into a poetic art. Trouble is, nobody ever got knocked out by a poem. — Eddie Shaw

Every accountant knows that increased cash flow and cost savings are critical for businesses in 2009. What is uncertain is the best path to recommend to garner these benefits.

     Over the past decade business owners have been overwhelmed by a plethora of choices designed to reduce the cost of providing employee benefits while increasing their own retirement savings. The solutions range from traditional pension and profit sharing plans to more advanced strategies.

     Some strategies, such as IRS section 419 and 412(i) plans, used life insurance as vehicles to bring about benefits. Unfortunately, the high life insurance commissions (often 90 percent of the contribution, or more) fostered an environment that led to aggressive and noncompliant plans.

     The result has been thousands of audits and an IRS task force seeking out tax shelter promotion. For unknowing clients, the tax consequences are enormous. For their accountant advisors, the liability may be equally extreme.

     Recently, there has been an explosion in the marketing of a financial product called Captive Insurance. Small companies have been copying a method to control insurance costs and reduce taxes that used to be the domain of large businesses: setting up their own insurance companies to provide coverage when they think that outside insurers are charging too much. A captive insurance company would be an insurance subsidiary that is owned by its parent business(es). There are now nearly 5,000 captive insurers worldwide. More than 80 percent of Fortune 500 companies take advantage of some sort of captive insurance company arrangement. Now small companies can, too.

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The use of captive insurance companies have been used to manage costs and risks and realize tax benefits has been legitimate for years. The IRS has recently focused audit resources on small and mid-market companies that are forming small captive insurance companies. These companies seek to benefit from Section 831(b) of the tax code, which allows insurance companies with less than $1.2 million in premiums to be taxed on their investment earnings rather than on their gross income.

We are seeing this first-hand while we are representing small and medium size companies who have captive insurance companies in audit with the IRS. At its core, the main concern for the IRS is that some of these small and medium companies forming captive insurance companies are not engaged in true insurance. In response to this situation, the IRS recently added captive insurance to its annual “Dirty Dozen” list of tax scams for the 2015 filing season. This means that the IRS is taking a hard look at captive insurance companies and the people who manage these companies. The language from the IRS announcement is: “In the abusive structure, unscrupulous promoters persuade closely held entities to participate in this scheme by assisting entities to create captive insurance companies onshore or offshore, drafting organizational documents and preparing initial filings to state insurance authorities and the IRS. The promoters assist with creating and ‘selling’ to the entities oftentimes poorly drafted ‘insurance’ binders and policies to cover ordinary business risks or esoteric, implausible risks for exorbitant ‘premiums,’ while maintaining their economical commercial coverage with traditional insurers.”

Based on our experience, we have learned that the IRS repeatedly focuses on these main questions:

1. Why was the captive insurance company created?
2. How did the captive insurance manager market his product to the captive owner?
3. Do annual premiums vary in tandem with the business’s taxable income for the year, or conversely, do premiums hover at or near the $1.2 million mark year in and year out?
4. Were there any claims made against these policies?
5. Were there claims made against the risk pool that is often a part of the small captive setup?
6. Do coverages appear warranted and do premiums appear correctly calculated?
7. Do the premiums vary by reason of underwriting on an annual basis?
8. Who owns the captive?
9. Is the captive insurance held in trust for the benefit of others or future generations?
10. What kinds of investments are present?
11. Has life insurance been purchased?

Note: The fact that the captive insurance company may have been Ok’d by the state insurance commissioner will get you halfway with the IRS. It is important for CPAs to understand these two things:

1. While the IRS may first contact your client in the context of a promoter audit, you need to treat the contact with the IRS with utmost seriousness, even if it was initially just a third-party contact.
2. Even if your client is doing things properly, if the client is part of a larger risk pool of insured—and if one of the other members of that pool is not squared away—the entire pool is potentially in jeopardy, including your client. Bear in mind that the stakes are high. If the IRS finds that the captive insurance company doesn’t pass muster, it means losing not only the premium deduction, but also incurring a 20 percent penalty, along with interest on top of that. The IRS is also considering imposing economic substance penalties and the 20% goes up to 40%.

The best practice for CPA firms with clients who own captive insurance companies is to have a review conducted to ensure that the captive is conforming to tax law requirements both in form and substance with a deep look at the insurance provided and the overall insurance pool. This is best done before the IRS comes knocking at your door. The risks of adverse IRS action can be managed if done proactively on a voluntary basis. If your client has already heard from the IRS, be aware that this is a highly technical area of tax law which involves a detailed understanding and knowledge of insurance questions from a tax law perspective.

The mere fact that captive insurance is on the “Dirty Dozen” list means you can anticipate a thorough audit that is closely managed by technicians and senior officials at the IRS.

Lance Wallach’s success with his clients has come from having a good understanding of the IRS’s concerns and priorities and also from what he has experienced with his clients in past cases. The key is knowing what the IRS is willing to accept, when the IRS is willing to let the taxpayer correct and what it takes to resolve an examination or an audit. CPAs do play a vital role as the most trusted financial advisor for most small and medium companies. For those CPAs who do have clients with captive insurance companies, now is the time to explain to them that they are in trouble and assist them in safely getting out of this mess.