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Tax Considerations for Captives

Tax Considerations for Captive Insurance Companies

The topic of federal income taxation and captive insurance is complex and the reader is encouraged to obtain advice from qualified tax counsel. The following information is provided to give you a general idea of the many tax considerations involved and should NOT be relied upon as tax advice.  Instead, our goal is that this tax  primer gives you enough information on which to begin asking good questions of your tax advisor.

The key taxation question to ask is "Will my captive be considered an insurance company for federal income tax purposes?

By qualifying as an insurance company, premiums paid to the captive by the insured businesses will be tax deductible as a normal business expense.  And as an insurance company, the captive can take tax deductions and tax elections not available to non-insurance entities.  For example, small electing insurance companies (i.e. those writing less than $1.2 million in annual premiums) are only taxed on investment gains while underwriting profits are not taxed in the year they are earned (but are taxed when distributed as dividends to owners at the capital gains rate).  And insurance companies writing more than $1.2 million can deduct reserves on unpaid claims, unlike businesses that have self insurance programs.

The answer as to whether a captive (whether domiciled in the US or offshore) is an insurance company for federal tax purposes will depend on a number of factors, including:

• Has risk been shifted from one or more tax payors (i.e the insured businesses) to another (i.e. the captive owners)?  An in-depth understanding of captive ownership options, disregarded entities, and controlled group criteria is needed.  Just because premiums are deposited with an unrelated entity such as a rent-a-captive or protected cell company does not mean that risk has been shifted.
  
  
• Has risk been distributed within the captive (i.e. does the captive have a pool of separate risks it will insure or does it participate in one or more reinsurance pools)?
  
  
• Does the captive have a reasonable level of capital and liquidity given the coverage and limits of insurance it provides?
  
  
• Are the captive's efforts primarily in earning income from the issuance of insurance contracts
  
  
• Does the captive have practices and procedures similar to what is generally accepted within the insurance industry?
  
  
• Are premium rates reasonable?
  
  
• Does the captive operate "at arm's length" with its insureds?
  
  

US Taxation of Foreign Domiciled Captives

If a captive is domiciled outside of the US, there are additional US federal tax ramifications related to premiums paid to the captive  by US concerns (such as federal excise taxes), taxes payable by US captive owners (such as Subpart F  Passive Foreign Investment Company taxation , branch profits tax, withholding tax on interest, and related person insurance income tax), and the potential loss of tax credits (such as the loss of tax credit carryforwards for 953(d) domestic elections).   If a foreign captive is deemed not to be an insurance company by the IRS, then the IRS will treat the captive as a controlled foreign corporation subject to Subpart F income by negating the 953 domestic election (which is only available to insurance companies).

Recent IRS Publications

After decades of ambiguity in the definition of "insurance" and after losing a number of tax court cases involving captive insurance companies, the IRS issued a series of revenue rulings and publications to help taxpayers, advisors, and its own agents. Readers are encouraged to review Rev. Rul 2005-40 (Tax on Insurance Companies other than Life Insurance Companies); Notice 2003-35 (Organizations exempt under section 501(c)15); Rev. Rul. 2002-89 (Deductibility of premiums paid to captives writing more than 50% unrelated risk), Rev. Rul 2002-90 (Deductibility of premiums paid to captives with multiple insureds), Rev. Rul. 2002-91 (Group captives);  Notice 2003-34 (Offshore Entities Investing in Hedge Funds);  Notice 2002-70 (Certain Reinsurance Arrangements); and Rev. Proc. 2003-3 (Obtaining private letter rulings and determination letters).  IRS publications can be found at www.irs.gov.

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