Authored by: Brent Wagner
Many may remember the early 2000s when Producer Owned Reinsurance Companies (PORCs) were a hot button with the IRS. Recently the IRS has regained focus on captive insurance companies through issuance of Notice 2016-66 alerting taxpayers that certain “Micro-Captive” arrangements were “transactions of interest.” Beginning in 2016, captive insurance arrangements were required to be reported by not only the captive but also its owners and affiliated companies. Failure to report such structures opened taxpayers up to significant penalties including $100,000 per reporting failure. As can be imagined, this created pressure during the recent filing season to ensure all such arrangements were identified and properly reported. With this renewed focus, it is important for auto dealers to understand the purpose and risks associated with captive insurance arrangements.
The IRS defines Micro-Captives of interest in section 2.01 of the Notice as follows:
- A person (“A”) directly or indirectly owns an interest in an entity (or entities) conducting a trade or business and the business entity is the “Insured”;
- An entity or entities (“Captive”) directly or indirectly owned by A, Insured, or persons related to A or Insured, enters into a contract (or contracts) (the “Contracts”) with Insured that Captive and Insured treat as insurance, or reinsures risks that Insured has initially insured with an intermediary (“Company C”);
- Captive elects under IRC section 831(b) to be taxed only on taxable investment income (the net premium written threshold for the election is $1.2 million through 2016 and increases to $2.2 million beginning in 2017);
- A, Insured, or one or more persons related (within the meaning of IRC section 267(b) or 707(b)) to A or Insured, directly or indirectly own at least 20 percent of the voting power or value of the outstanding stock of Captive; AND
- One or both of the following apply:
- The amount of liabilities incurred by Captive for insured losses and claim administration expenses during (in general) Captive’s most recent five taxable years is less than 70 percent of Captive’s premiums earned, less policyholder dividends paid during that period; OR
- Captive has at any time during (in general) its most recent five taxable years directly or indirectly made financing available or otherwise “conveyed or agreed to make available or convey to A, Insured, or a person related (within the meaning of IRC section 267(b) or 707(b)) to A or Insured (collectively, the “Recipient”) in a transaction that did not result in taxable income or gain to the Recipient, any portion of the payments [premiums] under the Contract, such as through a guarantee, a loan, or other transfer of Captive’s capital.”
How do captive insurance companies work?
Captive insurance arrangements have been in use by auto dealers for many years. Commonly this arrangement is used to share the risk of service contracts that are sold through the dealership. Instead of the risk being fully offloaded to a separate insurance company, the dealer sets up a corporation that he or she owns and remits funds to the corporation from the sale of the service contract. Funds or reserves are held by the corporation to cover claims remitted by the customer. Any excess reserves after the service contracts expire are paid to the dealer in the form of a dividend.
Why would dealers want to go through the hassle of setting up a separate company and taking on additional risk? Other than the obvious bet that insurance premiums will outpace claims over time, there are also some significant tax advantages. While the dealership lowers its taxable income by paying deductible insurance premiums to the reinsurance company, an election can be made by the captive under IRC section 831(b)(1) to be taxed only on investment income, excluding premiums up to the IRC section 831 premium threshold ($2.2 million for 2017). As noted above, after the service contracts expire, excess reserves are then issued to the owner(s) via a qualified dividend currently taxed at the capital gain rate.
Risk of abuse
However, these types of arrangements can create a pathway for abuse, explaining increased scrutiny from the IRS. Recently, the IRS gained traction in its efforts to thwart such structures when it prevailed in Avrahami v. Commissioner, 149 T.C. No. 7 (Aug. 21, 2017). The Avrahami case is an example of the taxpayer establishing a micro-captive to ensure against their typical business risks, but also with added terrorism coverage. During the two years in question, the Avrahamis deducted $1.1 million and $1.3 million in insurance expenses through their business (up from $150,000 previously). These funds were diverted to their reinsurance company and ultimately found their way back to the owners as no claims occurred.
While the Avrahami v. Commissioner case may seem like an extreme example, understanding the facts of the case provides clarity as to why these arrangements have hit the IRS’s radar. It also provides some key considerations when examining micro-captive arrangements to ensure they are supportable as legitimate business transactions. Taxpayers should:
- Ensure their micro-captive arrangement involves risk-shifting, risk-distribution, an insurable risk, and meets commonly accepted notions of insurance
- Consider whether the company is organized and operated as an insurance company, including whether the premiums are reasonable and the company is properly capitalized to cover future claims
If you have questions or concerns whether your micro-captive arrangement is poorly structured or not operating according to the guidelines noted above, please contact your Baker Tilly advisor for a review.
For more information on this topic, or to learn how Baker Tilly specialists can help, contact our team.
The information provided here is of a general nature and is not intended to address the specific circumstances of any individual or entity. In specific circumstances, the services of a professional should be sought. Tax information, if any, contained in this communication was not intended or written to be used by any person for the purpose of avoiding penalties, nor should such information be construed as an opinion upon which any person may rely. The intended recipients of this communication and any attachments are not subject to any limitation on the disclosure of the tax treatment or tax structure of any transaction or matter that is the subject of this communication and any attachments.