2020 Year-End Tax Guide

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THE MARCUM 2020 YEAR-END TAX GUIDE

Captive Insurance Companies: A 2020 Year-End Update

Insurance is a contract whereby an individual or entity (the “insured”) pays a fee to a second party in return for nancial protection against losses. An insurance company issues multiple contracts to multiple insureds with the goal of making a pro t from a net gain between claims paid for losses and cumulative premiums received along with earnings from investment of those premiums. A captive insurance company (“captive”) is an insurance company owned and controlled by the insureds. In the U.S., a small “captive” has tax benefits as outlined by Internal Revenue Code Section 831(b), which allows small captive insurers to pay federal taxes only on investment income, not on underwriting income. The maximum allowable premium for an 831(b) captive is $2.2 million annually. During the early 2010s, the IRS started investigating captives for abusive transactions. In 2016, the IRS published Notice 2016-66 in which the agency advised that micro-captive insurance transactions have the potential for tax avoidance or evasion. The IRS filed suit against companies paying premiums to captives and won three major lawsuits starting in 2017. The Tax Court articulated four factors that indicate an arrangement constituting insurance:

In these three cases, the Tax Court concluded that contracts between the captives and defendant companies had not passed the risk. In 2019, the IRS offered settlements to companies paying premiums to captives, which the IRS reported were accepted by 80% of the companies receiving such notice. Related Captives – The type of captive that was the focus of the IRS investigations and lawsuits. The lawsuits were not because of the relationship between the captive and the operating company. The lawsuits were based on the failure of the captives to meet the four factors above. Group Captives –Owned by a number of different companies generally in the same industry. The goal is for the operating company owners to have a lower cost of insurance. Premiums on a commercial insurance policy need to cover losses from well-run companies with less insurable incidents as well as losses from companies with greater insurable incidents. Generally, owners of the group captive are better risks than the general population because the owners make the decision to admit better risk companies as owners and insureds. Group captives are generally managed by an insurance professional who also places reinsurance policies for excess losses. X Association Captives –Similar to a group captive except that it is affiliated with an association, members of which have a shared focus. Generally, all members of the association can be members of the captive. X Industry Captives –Similar to an association captive except that its members are from the same industry. Often it is established to solve a specific insurance problem such as the unavailability of a specific type of insurance. X TYPES OF CAPTIVE COMPANIES X

Insurance risk,

X

Risk shifting to the insurer,

X

Risk distribution, and

X

Commonly accepted notions of insurance.

X