In the past 20 years, many small businesses have started to insure their own risks through a product called “Captive Insurance”. Small captives (also known as single-parent captives) are insurance companies founded by owners of companies that are close to each other and who want to insure risks that are either too expensive or too difficult to insure through the traditional insurance market. Brad Barros, an expert in captive insurance, explains how “all captives are treated as companies and should be managed using a method that complies with the rules established by both the IRS and the appropriate insurance regulator.”
According to Barros, single parental prisoners are often owned by a trust, partnership, or other structure set up by the contributor or his family. When a business is well designed and managed, it can make tax-deductible premium payments to their affiliated insurance company. Depending on the circumstances, any underwriting gains may be distributed as dividends to owners and profits from liquidation of the company may be taxed against capital gains.
Premium payers and their captives can only get tax breaks if the captive operates like a real insurance company. Alternatively, advisers and business owners using captives as estate planning tools, asset protection vehicles, tax deferrals, or other benefits unrelated to an insurance company’s real business purpose may experience serious regulatory and tax consequences.
Many captive insurance companies are often formed by U.S. companies located in jurisdictions outside the United States. This is because foreign jurisdictions offer lower costs and more flexibility than their US counterparts. As a rule, U.S. companies may use foreign-based insurance companies, as long as the jurisdiction meets the insurance standards required by the Internal Revenue Service (IRS).
There are several notable foreign jurisdictions whose insurance rules are recognized as safe and effective. These included Bermuda and St. Lucia. Bermuda, while more expensive than other jurisdictions, is home to many of the largest insurance companies in the world. A cheaper location for smaller prisoners, St. Lucia is notable for statutes that are both progressive and compliant. St. Lucia is also lauded for recently adopting “Incorporated Cell” legislation modeled on similar statutes in Washington, DC.
Common violations of captive insurance; While prisoners remain highly beneficial to many companies, some industry professionals have started improperly marketing and misusing these structures for purposes other than those intended by Congress. The abuses include the following:
- Improper risk shift and risk diversification, also known as “Bogus Risk Pools”
- High deductibles in captive bundled schemes; Captive reinsurance through private placement of variable life insurance
- Incorrect marketing
- Inappropriate integration of life insurance
Meeting the high standards of the IRS and local insurance regulators can be a complex and expensive affair and should only be done with the help of a skilled and experienced counsel. The consequences of not being an insurance company can be devastating and can include the following sanctions:
- Loss of all deductions from premiums received by the insurance company
- Loss of all deductions from the premium payer
- Forced distribution or liquidation of all insurance company assets that impose additional taxes on capital gains or dividends
- Possible Adverse Tax Treatment as a Controlled Foreign Company
- Possible Adverse Tax Treatment as a Personal Foreign Holding Company (PFHC)
- Potential regulatory sanctions imposed by the insured jurisdiction
- Potential penalties and interest imposed by the IRS.
All in all, the tax consequences can exceed 100% of the premiums paid to the captive. In addition, attorneys, CPA wealth advisers and their clients can be treated as tax shelter promoters by the IRS, which can result in fines of $ 100,000 or more per transaction.
Clearly, setting up your own insurance company is not something to be taken lightly. It is critical that companies seeking to set up an internal work environment with skilled lawyers and accountants who have the necessary knowledge and experience to avoid the pitfalls associated with misuse or poorly designed insurance structures. A general rule of thumb is that an internal insurance product must have legal advice on the essential components of the program. It is well known that the advice should be given by an independent, regional or national law firm.
Shifting risks and misuse of risk distribution; Two important elements of insurance are shifting the risk from the insured to others (shifting the risk) and then assigning the risk to a large pool of policyholders (risk distribution). After many years of litigation, the IRS released a Revenue Ruling (2005-40) in 2005 that describes the essential elements necessary to meet risk change and distribution requirements.
For those who are confident, using the in Rev. Ruling 2005-40 approved captive structure two advantages. First, the parent does not have to share risks with other parties. In Ruling 2005-40, the IRS announced that risks can be shared within the same economic family as long as the separate subsidiaries (minimum 7 required) are formed for non-tax business reasons, and that the separation of these subsidiaries also has a business reason. In addition, “risk distribution” is provided as long as no insured subsidiary has provided more than 15% or less than 5% of the captive’s premiums. Second, the special provisions of insurance law that allow prisoners to take a current deduction for an estimate of future losses, and in some circumstances to protect the income earned from the investment of the reserves, reduce cash flow needed to fund future claims from about 25% to almost 50%. In other words, a well-designed prisoner who meets the requirements of 2005-40 can save 25% or more.
While some companies may meet the 2005-40 requirements within their own pool of affiliated entities, most unlisted companies cannot. Therefore, it is common for captives to buy “third-party risk” from other insurance companies, often spending 4% to 8% per year on the coverage needed to meet IRS requirements.
One of the essential elements of the purchased risk is that there is a reasonable chance of loss. Because of this exposure, some promoters have attempted to circumvent the intent of Revenue Ruling 2005-40 by directing their customers to “fake risk pools”. In this somewhat common scenario, a lawyer or other promoter has 10 or more of his clients’ prisoners enter into a collective risk-sharing agreement. Included in the agreement is a written or unwritten agreement not to make claims on the pool. Customers like this arrangement because they get all the tax benefits of owning their own insurance company without the risk associated with the insurance. Unfortunately for these companies, the IRS considers such schemes to be different from insurance.
Such risk-sharing agreements are considered unfounded and should be avoided at all costs. They are nothing more than a glorified pre-tax savings account. If it can be shown that a risk pool is fake, the prisoner’s protective tax status can be denied and the severe tax consequences described above maintained.
The IRS is known to look at agreements between prisoner owners with great suspicion. The gold standard in the industry is buying risk from third parties from an insurance company. Anything less opens the door to potentially disastrous consequences.
Insultingly high deductibles; Some promoters sell captives and then have their captives participate in a large risk pool with a high deductible. Most losses are deductible and are paid by the captive, not the risk pool.
These promoters can advise their clients that since the deductible is so high, there is no real chance of third party claims. The problem with this type of scheme is that the deductible is so high that the prisoner does not meet the standards set by the IRS. The prisoner is more like an advanced tax savings account: not an insurance company.
A separate concern is that customers are told that they can deduct all their premiums in the risk pool. In the event that the risk pool has few or no claims (compared to the losses retained by the participating captives with a high deductible), the premiums allocated to the risk pool are simply too high. If no claims are made, premiums should be reduced. In this scenario, the IRS, if disputed, will not allow the captive’s deduction for unnecessary premiums transferred to the risk pool. The IRS can also treat the prisoner as anything other than an insurance company because it did not meet the standards set forth in 2005-40 and previous related rulings.
Variable private placement life insurance plans; Over the years, promoters have tried to create captive solutions designed to take advantage of tax-exempt benefits or captives’ “exit strategies”. One of the more popular schemes is when a company creates an internal insurance business or works with an internal insurance company and then reimburses to a reinsurance company that portion of the premium that matches the portion of the reinsured risk.
Typically, the reinsurance company is wholly owned by a foreign life insurance company. The legal owner of the reinsurance cell is a foreign real estate and casualty insurance company that is not subject to U.S. income tax. In practice, the reinsurance company’s ownership can be traced to the present value of a life insurance policy that a foreign life insurance company has issued to the principal owner of the company or a related party, and which insures the main owner or a related party.
- The IRS may apply the doctrine for sham transactions.
- The IRS may challenge the use of a reinsurance agreement as an inappropriate attempt to divert income from a taxable entity into a tax exempt entity and will reassign the income.
- The life insurance policy issued to the Company may not qualify as life insurance for US federal income tax purposes because it violates the restrictions on investor control.
Investor control; The IRS has reiterated in its published income plans, private letter statements, and other administrative statements that the owner of a life insurance policy is considered the owner of the income tax on the assets legally owned by the life insurance policy if the policyholder owns “incidents of ownership “in those assets. In order for the life insurance company to be considered the owner of the assets in a separate account, control of individual investment decisions should generally not be in the hands of the policyholder.
The IRS prohibits the policyholder or any policyholder-related party from having the right, directly or indirectly, to oblige the insurance company or individual account to acquire a particular asset with the funds in the separate account. In fact, the policyholder cannot tell the life insurance company in which specific assets to invest. And the IRS has announced that there can be no pre-agreed plan or verbal understanding of which specific assets can be invested through the separate account (commonly referred to as “indirect investor control”). And in an ongoing series of private letter statements, the IRS consistently applies a look-through approach to investments made through separate life insurance accounts to find indirect investor control. Recently, the IRS has published guidelines on when the investor control violation is violated. This guidance discusses reasonable and unreasonable levels of policy owner participation, identifying safe havens and unacceptable levels of investor control.
The final factual determination is simple. Each court will ask whether it has been agreed, whether orally or tacitly, that the separate account of the life insurance policy will invest its funds in a reinsurance company that has provided reinsurance for a property and accident policy that covers the risks of a business where the owner of the life insurance policy and the person who is insured under the life insurance policy are affiliated with or the same person as the owner of the business, less the payment of the property and accident insurance premiums?
If this can be answered in the affirmative, the IRS should be able to successfully convince the tax judge that the investor control restriction has been violated. It follows that the income earned by the life insurance policy is taxed to the life insurance owner as it is earned.
The investor control restriction is violated in the structure described above, as these arrangements generally provide that the reinsurance company will be owned by the segregated account of a life insurance policy that ensures the life of the owner of the business of a person associated with the owner of the Company. Drawing a circle may not allow all premiums paid by the Company to become available to unrelated third parties. Therefore, any court looking at this structure can easily conclude that every step in the structure has been pre-agreed and that the investor control restriction has been violated.
Suffice it to say that the IRS announced in Notice 2002-70, 2002-2 CB 765 that it would apply both sham transaction doctrine and §§ 482 or 845 to allocate income from a non-taxable entity to a taxable entity. situations involving reinsurance contracts for goods and accidents that are similar to the reinsurance structure described.
Even if real estate and accident premiums are reasonable and meet the risk-sharing and risk-sharing requirements, so that the payment of these premiums is fully deductible for U.S. income tax, the Company is currently able to deduct its premium payments from its U.S. earnings. completely unrelated to whether the life insurance qualifies as life insurance for U.S. income tax purposes.
Inappropriate marketing; One of the ways captives are sold is through aggressive marketing designed to emphasize benefits other than the real business purpose. Prisoners are companies. As such, they can provide shareholders with valuable planning opportunities. However, any benefits, including wealth protection, wealth planning, tax-efficient investing, etc., should be secondary to the real business purpose of the insurance company.
Recently, a major regional bank has begun to offer “business and estate planning captives” to clients of their trust department. Again, a rule of thumb for prisoners is to operate as real insurance companies. Real insurance companies sell insurance, not “estate planning” benefits. The IRS may use offensive promoter sales promotion material to deny compliance and subsequent deductions related to a prisoner. Given the significant risks associated with improper promotion, it is a safe bet to only work with corporate promoters whose sales materials focus on captive insurance company ownership; no estate, asset protection and investment planning benefits. Better still, a promoter would have a large and independent regional or national law firm review its materials for compliance and confirm in writing that the materials meet the standards set by the IRS.
The IRS can look back on offensive material for a number of years, and then suspecting that a promoter is marketing an abusive tax shelter, begin a costly and potentially damning investigation of the policyholders and marketers.
Claims settlements for life insurance; A recent concern is the inclusion of small prisoners in life insurance. Small prisoners treated under Article 831 (b) do not have legal authority to deduct life allowances. Even if a small captive uses life insurance as an investment, the present value of the life insurance may be taxable to the captive and then taxable again when it is paid out to the ultimate beneficiary. As a result of this double taxation, the life insurance business is destroyed and the liability of any accountant who recommends the plan is seriously extended or even signs the tax return of the company that pays premiums to the captive.
The IRS is aware that several large insurance companies promote their life insurance policies as investments with small captives. The outcome looks eerily similar to the thousands of 419 and 412 (I) plans currently under review.
All in all, Captive insurance plans can be hugely beneficial. Unlike in the past, there are now clear rules and case histories that define what a well-designed, marketed and managed insurance company is. Unfortunately, some promoters take advantage of the rules, bend and twist to sell more prisoners. Often the entrepreneur who buys a captive is not aware of the enormous risk he or she faces because the promoter has acted incorrectly. Unfortunately, it is the prisoner’s insured and ultimate beneficiary who face painful consequences when their insurance company is considered abusive or nonconforming. The captive industry has skilled professionals who provide compliant services. It is better to use an expert backed by a large law firm than a slick promoter who sells something that sounds too good to be true.