Large companies have been forming captive insurance companies (captives) to self-insure their risks since the 1950’s. In general, these captives were formed to lower insurance costs, provide access to the reinsurance market, and cover exposures where there are gaps in the commercial market. When congress enacted section 831(b) of the Internal Revenue code in 1986, it was intended to extend the benefits of self-insurance, from large publicly traded companies to smaller middle market closely held business entities.
Section 831(b), provides a tax advantage to small property and casualty insurance companies. Under section 831(b), a company can elect to be taxed solely on its net investment income when gross annual premium is $1.2 million or less. The 831(b) captive can also provide tax benefits for its owner in the form of deductible premiums paid to the captive as ordinary business expenses.
IRS scrutiny of tax benefits
The number of tax benefits available to small captive owners has made the IRS wary that some of these 831(b) captives are being marketed for abusive purposes. So much so, the IRS added captive insurance to its annual “dirty dozen” list of tax scams for the 2015 filing season. In late 2014, the IRS began to take a more active look at the use of captive insurance companies and specifically, 831(b) captives. In September 2014, Artex Risk Solutions Inc., a subsidiary of Arthur J. Gallagher Inc, and one of the largest captive managers, announced that they were subject to an IRS investigation related to the formation of captives under section 831(b).
Captives for estate planning
One of the more common abusive practices the IRS is asserting is the formation of 831(b) captives for estate planning purposes. There are two principle areas where the IRS is alleging abuse in connection with the use of 831(b) captives and estate planning. One, the captive is owned by an irrevocable trust outside of the estate of the insured business owner. In certain circumstances, this structure could enable a business owner to transfer wealth in the form of insurance company profit, in a transaction that avoids estate tax. Two, the assets of the captive are used to purchase life insurance on the owner of the insured business. Because the premium paid to the 831(b) captive is deductible by the insured business and taxed in the captive, a business owner could use this technique to indirectly purchase life insurance with pre-tax dollars.
The Treasury and the Joint Committee on taxation have also raised concerns over the use of the 831(b) captive for estate planning tax arbitrage. Congress has taken a renewed interest in the use of small captives and 831(b) and the Senate Finance committee introduced a bill to tighten up tax abuses related to the use of 831(b) captives. In the initial form, the bill provided for the increase of the tax-exempt premium threshold from $1.2 million to $2.2 million with an index for inflation which is viewed favorably by the captive insurance industry, but only permitted 20% of the premium from a related party. In that form, the bill would have severely limited the use of captives for self-insurance purposes. The bill has since been modified and interested parties from the captive industry are working with congressional staff to present alternatives that will eliminate abusive estate tax shelters and preserve the 831(b) captive for risk management purposes.
Anticipated future state of 831(b) captives
The increase to the premium threshold is expected to increase the number of organizations that can use the 831(b) captive structure for risk management purposes. Organizations using a high deductible excess insurance program with premiums in excess of $1.2 million will now have an opportunity to use the 831(b) captive and take advantage of the tax benefits. However, the proposed legislative restrictions on the use of a captive for estate planning purposes will probably slow down the growth of the 831(b) captive industry has a whole.
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