Captive Insurance Companies Must Be Structured Properly or Face Severe Tax Consequences
By Patrick Mullin, Director, Tax & Business Services
A 2018 tax court case has renewed concerns about possible tax exposures related to captive insurance arrangements and their participants and owners. These tax concerns are not limited to U.S. taxes when the captive has been organized in a foreign jurisdiction. To better understand how and why these issues can arise, it is important to understand a few basics about a captive insurance arrangement.
Captive insurance companies are set up to insure a number of related-party operating companies. The ownership of the captive insurance company usually mirrors the ownership of the operating companies that it insures. The captive insurance company is usually domiciled in a foreign jurisdiction due to a less burdensome regulatory environment and reduced capitalization requirements compared to most U.S. jurisdictions.
A foreign captive usually makes an election to be taxed as a U.S. company, thereby removing all foreign tax considerations. The captive also makes an election to be taxed as a “small” captive. This election under IRC 831(b) allows a “small” captive to be taxed only on its investment income. This means that all premium and related underwriting income is exempt from U.S. taxation. The current premium limit for a small captive is $2.2 million. As you can imagine, this can provide substantial tax savings.
The business reasons behind the formation of a captive and the way it’s organized and run are critical to defending the arrangement if examined and questioned by the IRS. With such a big tax benefit to be realized, many promoters have put together programs that won’t meet the requirements to be recognized as a captive insurer upon exam, or they put organizations into a captive program when they clearly do not have the correct fact pattern to participate in a captive arrangement.
Potential Tax Consequences
If the captive is examined and the IRS concludes that the arrangement is not a valid insurance arrangement, a number of tax issues arise. The U.S. and international tax issues are as follows:
U.S. Tax Issues:
- The captive will not be considered an insurance company and as a result, it was not eligible to make an election to be taxed as a “small” captive. As a result, all previous underwriting profit is now subject to tax, penalties and interest and the substantial underpayment penalty provisions may apply.
- What this case does not make clear is whether the IRS challenged the operating company’s deductions for the insurance payments made to the captive. If the IRS were to challenge the deductions, the operating companies may be denied deductions for the premium payments made to the captive because the arrangement is not insurance and the payments were not ordinary and necessary payments. If the IRS was successful, tax, penalties and interest will be applicable and the substantial underpayment penalty provisions may apply.
Foreign Tax Issues:
- Because the captive is not considered to be an insurance company, it is ineligible to make an election to be treated as a U.S. insurance company. As a result, the operating companies making payments to a foreign corporation should have withheld a 30% tax attributable to fixed or determinable annual or periodic Income. This withholding is on top of the U.S. taxes mentioned above.
- The foreign corporation did not file Form 1120-F – U.S. income tax return of a foreign corporation and was penalized for failure to file these returns. The corporation was operating under the assumption that it was a U.S. corporation for tax purposes since it made the election to be taxed as a U.S. corporation.
These retroactive issues of tax, penalty and interest related to prior periods is another one of the risks associated with a captive arrangement that gets challenged and loses via audit or through a challenge in court.
Captives are a great tool to better manage risk and insurance needs while obtaining significant tax benefits, but if not set up for the right business reasons and run properly, the tax consequences can be extremely harsh. In some cases, the total tax, penalty and interest can be more than twice the actual premium involved. For these reasons, it makes sense to review all current captive arrangements in light of this recent case to ensure there are no exposures or to correct any potential exposures before an audit occurs.
Do you have questions about captive insurance arrangements, or other international tax issues? Please contact Patrick Mullin, Director, Tax & Business Services.