Strickland Hardee
TJ Strickland, managing partner at Strickland Hardee, explains the federal tax implications for captives in the US and how to reduce the risk of IRS scrutiny
What are the general federal tax implications for captive insurance companies in the US? Are there specific tax benefits or deductions available to such companies?
Captive insurance companies in the US face distinctive federal tax implications, with several specific benefits and deductions available to them. For tax purposes, captives typically qualify as insurance companies, enabling them to deduct ordinary and necessary business expenses similarly to other corporate entities.
Additionally, captives can deduct losses and loss adjustment expenses incurred during their insurance operations. Captive insurance companies can also establish reserves for claims. This practice, similar to that of traditional insurance companies, enables captives to effectively manage their taxable income. Furthermore, captives may be eligible for various credits and deductions available to other corporations, including those related to employee benefits and other business expenses.
Smaller captives, defined as those with annual premiums not exceeding US$2.8 million for the tax year 2024, have the option to opt for taxation under Internal Revenue Code (IRC) Section 831(b). This election allows them to evade taxation on underwriting income, leading to the imposition of tax solely on investment income, which offers substantial tax benefits.
While captive insurance companies are subject to tax on investment income, they have the ability to optimise tax efficiency by employing investment strategies, such as investing in tax-exempt securities. This allows captives to manage their investment portfolios in a manner that minimises their overall tax liability.
Do state and local tax treatments for captive insurance companies differ significantly? How can businesses effectively navigate these differences?
Each state in the US has its own set of licensing requirements for captive insurance companies, with some jurisdictions offering a more favourable and streamlined process than others. This variation can significantly influence a business's decision regarding where to domicile its captive. States impose different premium tax rates on captives, which can substantially impact the overall cost structure.
To attract captives, some states offer tax incentives, such as reduced premium tax rates or exemptions.
Additionally, the treatment of captive income varies by state. Certain states may impose income taxes or franchise taxes on captives, which can have a significant effect on profitability.
Moreover, the rules governing the deductibility of reserves differ across states, affecting the extent to which captives can deduct amounts for tax purposes.
Given these variations, businesses should conduct a comprehensive analysis when selecting a potential domicile, considering factors such as premium tax rates, regulatory requirements, and the overall business climate.
It is advisable to engage tax advisors and legal professionals with expertise in captive insurance in order to navigate state-specific regulations and effectively optimise tax strategies.
Under what conditions can businesses deduct premiums paid to their captive insurance companies? Are there any limitations or restrictions that apply?
Under certain conditions, businesses can generally deduct premiums paid to their captive insurance companies, however they must consider specific limitations and restrictions.
First, the premiums must qualify as ordinary and necessary expenses related to the business's operations, meaning that the insurance coverage must serve a legitimate business purpose.
Furthermore, to qualify as a legitimate insurance arrangement for tax purposes, the captive insurance company must exhibit significant risk transfer and distribution, signifying its ability to distribute risk among multiple insured parties or policies.
Finally, the captive should provide coverage for insurable risks that the business would typically address through commercial insurance.
How does a captive insurance company tax its investment income? Are there any options for tax-deferred or tax-free investments?
Investment income earned by a captive insurance company is subjected to federal income tax in the same way as other corporations, typically at the prevailing corporate tax rate of 21 per cent.
Although investment income is taxable, captives can employ a variety of strategies and investment options to achieve tax deferral or even tax-free treatment in certain cases.
For instance, investing in municipal bonds can yield tax-exempt interest income, which exempts the earned interest from both federal income tax and state taxes, depending on the state of issuance.
Additionally, captives have the option to invest in life insurance products, which can accumulate cash value on a tax-deferred basis. Generally, these products pay out the death benefit tax-free, providing potential tax advantages.
Captives may also consider investing in certain annuity products that allow for tax-deferred growth, with taxes only due upon fund distribution.
How are losses incurred by a captive insurance company treated for tax purposes? Can these losses be carried forward or backward?
Nonlife insurance companies have the ability to carry back net operating losses (NOLs) for a period of two years and carry them forward for a maximum of 20 years. This treatment differs from that of other corporations. The Tax Cuts and Jobs Act (TCJA) allows for the indefinite carryforward of NOLs arising in tax years beginning after 31 December 2017, but generally prohibits their carryback, except for specific types of losses.
Starting with the 2021 tax year, NOLs can only offset up to 80 per cent of taxable income for traditional corporations. This limitation means that if a non-insurance business has substantial taxable income, the NOL may not completely eliminate the tax liability.
What key factors does the IRS consider when evaluating the legitimacy of a captive insurance arrangement? How can businesses reduce the risk of IRS scrutiny?
The Internal Revenue Service (IRS) rigorously scrutinises captive insurance arrangements to prevent their use as mere tax avoidance mechanisms. The following are key factors considered by the IRS, along with strategies businesses can employ to reduce the risk of scrutiny:
Risk transfer: The arrangement must demonstrate substantial risk transfer from the parent company to the captive, meaning that the captive must assume genuine insurance risk. To meet this requirement, consider structuring the captive to provide coverage for multiple subsidiaries or related entities.
Risk distribution: Captives should distribute risk across multiple insured parties or various types of coverage, which supports the position that the arrangement operates as a bona fide insurance company. A captive with only a few policyholders or limited coverage options may attract scrutiny from the IRS.
Legitimate business purpose: The captive must serve a legitimate business purpose beyond tax advantages. The parent company should establish the captive to address real insurable risks.
Actuarially sound premiums: The captive's premiums should be based on actuarial principles and accurately reflect the risks being insured. This entails maintaining appropriate underwriting and claim management practices.
Ensuring that the captive’s premium calculations and risk assessments are consistent with industry standards is crucial, which may include obtaining independent actuarial evaluations.
Detailed recordkeeping: It is critical to maintain comprehensive records of the captive's operations, including policy details, claims, and premium calculations. A lack of proper documentation may lead to questions regarding the arrangement's legitimacy.
Operational substance: The captive should exhibit the characteristics of a genuine insurance business, not merely exist as a 'paper entity'. This includes having appropriate governance, sufficient capitalisation, and robust operational procedures.
Professional guidance: Engaging tax advisors and legal professionals who specialise in captive insurance is highly advisable. They can assist in ensuring compliance with IRS regulations and adherence to best practices.
By adhering to these guidelines, businesses can strengthen the legitimacy of their captive insurance arrangements and minimise the risk of IRS scrutiny.
How does the IRS apply the ‘substance over form’ doctrine to captive insurance arrangements? What steps can businesses take to ensure their captive insurance arrangement meets IRS requirements?
The IRS applies the ‘substance over form’ doctrine, looking beyond the formal structure of a transaction to examine its actual substance and economic reality. In the context of captive insurance arrangements, this doctrine means that the IRS evaluates whether the arrangement genuinely functions as an insurance policy or merely serves as a vehicle for tax avoidance.
The IRS carefully assesses whether there is a legitimate transfer of risk. A bona fide captive insurance company should assume risks from its parent company or affiliates, thereby demonstrating that it is operating as a true insurance entity. The arrangement must display key characteristics of traditional insurance, such as underwriting, premium collection, and claims handling.
If these elements are absent or only minimally present, the IRS may challenge the validity of the arrangement. Moreover, the captive must serve a clear business purpose beyond providing tax benefits. If the primary motivation appears to be tax avoidance, the IRS may disallow the associated deductions.
Conducting a comprehensive feasibility study is essential before establishing a captive to ensure its effective underwriting of the intended risks. Establishing the captive as a separate legal entity with appropriate capitalisation and adherence to insurance regulatory standards is crucial.
Additionally, make sure to clearly define and document the risks under insurance, along with the rationale behind the premiums charged. This includes maintaining thorough records of risk assessments, underwriting procedures, and claims management processes to support the legitimacy of the captive insurance arrangement.
What ongoing tax compliance obligations do captive insurance companies face? How can CPAs help businesses ensure they meet these obligations?
Captive insurance companies are required to file annual federal tax returns using Form 1120-PC and pay corporate income taxes on their taxable income.
They must also comply with specific IRS regulations related to the taxation of insurance companies, including the possibility of being classified as a 'small insurance company' under IRC Section 831(b).
Additionally, captives may be subject to filing state tax returns, which can vary widely by jurisdiction. Some states impose premium taxes on insurance premiums written by captives, while others may levy state income, net worth, franchise, or privilege taxes.
Certified Public Accountants (CPAs) can accurately prepare and file both federal and state tax returns, ensuring that all necessary forms are completed and submitted on time.
They can establish a compliance calendar to monitor upcoming filing deadlines and obligations, helping businesses avoid late penalties. Moreover, CPAs can prepare and review financial statements required for regulatory compliance and tax filings, ensuring accuracy and adherence to accounting standards.
By leveraging their expertise in tax compliance and accounting, CPAs play a crucial role in assisting captive insurance companies in meeting their ongoing obligations, maximising operational efficiency, and minimising compliance risks.
