There still seem to be a number of people who have not yet received the news that the 501(c)(15) captive is effectively no more. While Congress did not abolish 501(c)(15) insurance companies, they instead created a $600,000 maximum limit for gross receipts of both the insurance company and other companies held by the same control group. Which means, if both the insurance company’s income and the income of the owners exceeds $600,000 in a year, then the 501(c)(15) limit has been busted and the exception no longer applies. Since no business would even consider a captive that would have less than $600,000 in income by itself, the effect of Congress’ change is to have effectively eliminated 501(c)(15) in all but the rarest of circumstances.
Yet some tax professionals ignore the news about this change and continue to advise their clients that the 501(c)(15) is a great investment. Even worse, some of these professionals have misconstrued the Determination Letter provided by the IRS to allow in some way an “exception” to the gross receipts test, which is absolutely not true. To the contrary, such letters say that the captive is exempt only so long as it complies with 501(c)(15), which is no longer practically feasible. These clients are about to wake up to a horrific tax nightmare.
Another common captive insurance error is when the person setting up the insurance company only uses it to underwrite the risks of his own company. Being that there is no risk-spreading, there is little to no chance that the IRS will consider the insurance company’s activities to be that of insurance, and no chance that the IRS will consider the insurance company to be an insurance company for tax purposes.
The problem begins when people have received bad advice from their Property-Casualty broker, and set up a captive insurance to underwrite their business needs. By thinking that due to the fact that they have 11 or more single-member LLCs as subsidiaries, they meet the test for risk-sharing. But the IRS recently announced in Rev.Ruling 2005-40 that the IRS simply disregards the single-member LLCs and so there is just one policyholder and no risk-sharing.
There is a major Property-Casualty insurance broker who has been advising his clients to set up these arrangements and I would not be surprised to see significant litigation against this broker and his advisors who thought they understood the federal tax treatment of insurance companies.
A captive insurance strategy being sold to doctors, where they act like they are making payments of medical malpractice premiums or disability income premiums to an offshore segregated-cell insurance company. After some time, that insurance company ends up paying out those premiums as profits to an offshore trust or a similar arrangement that is directly or indirectly controlled by the doctor himself. These arrangements are designed to appear as offshore deferred compensation arrangements.
What happens is the same in all these cases. The doctor makes his premium payment to the segregated-cell captive, takes a deduction for it, and then gets his money back tax-free offshore. This is a criminal tax evasion, and the doctor who doesn’t fess up before being caught by the IRS will definitely spend time at a federal prison. In addition to prison time, the doctor will have to pay huge fines and penalties and back taxes and interest.
Captive insurance company taxation is complex and constantly changing. It is too easy to mess up leading to the entire captive arrangement to be disregarded. While captive insurance is a powerful tool, it must be overseen by a quality tax advisor and counsel. If an arrangement sounds too good to be true, it probably is.