Captive Insurance Companies

Insurance does two things: First, it shifts a risk from an insured to the insurance company. Second, it distributes the risk taken on by the insurance company among a pool of like risks with a predictable number of risks that will materialize. In other words, from the insured’s perspective, insurance shifts risks; and from the insurer’s perspective, insurance distributes risk.

This is the view of insurance from a tax perspective and helps explain why historically, the IRS challenged "captive" insurance companies, or insurance companies owned by the insured. The IRS argued that true risk shifting and distribution could never occur within the same "economic family" and that as such, deductible premiums by the insured were really non-deductible contributions to a reserve fund.

Beginning with the case of Humana v. Commissioner, 88 T.C. 197 (1987), which was discussed at length in the recent case of Rent-A-Center, Inc. v. Commissioner, 142 T.C. No. 1 (2014), the IRS started consistently losing this argument. Eventually, in Rev. Rul. 77-316, the IRS announced that it would no longer rely on its economic family argument. Currently, there are a few safe harbors that taxpayers can rely upon to obtain the expected tax treatment of their captive insurance companies and payments made thereto. However, as Rent-A-Center makes clear, the IRS can still litigate based on facts and circumstances of individual scenarios.

Rev. Rul. 2002–89 and Rev. Rul. 2002-90 stand for the following two safe harbors: If a captive insurance company either (1) receives at least 50% of its income from a non-parent or (2) provides insurance for at least twelve subsidiaries, with no subsidiary accounting for less than 5% or more than 15% of the total risk underwritten, the IRS will normally concede that adequate risk shifting and distribution has occurred and not challenge the captive arrangement. 11 Mertens Law of Fed. Income Tax'n § 44:24.

Firms who market and help clients establish captive insurance companies can help clients pool with third parties in order to meet these requirements. The viability of this strategy assumes that the captive is operated as a bona fide insurance company in every respect.

While captive insurance companies provide clear asset protection benefits, the tax benefits are substantial as well. If the captive qualifies and elects to be taxed as a "small company" under section 831(b) of the Internal Revenue Code, it will be taxed only on taxable investment income, not underwriting income. A captive insurance company can receive up to $1.2 million in annual premiums and still qualify under section 831(b). Effectively, this means that by establishing a captive insurance company, a taxpayer can reduce taxable income by deducting premiums of $1.2 million, while recognizing no taxable income to the captive. Assuming a good claims history, the premiums accumulate tax-deferred and are available to be withdrawn later as dividends or long term capital gains.