An election does not make a captive an insurance company. TJ Strickland, managing partner at Strickland Hardee PLLC, sets out what regulators, auditors, and the IRS actually look for, and why the work of proving it is never finished
For many captive owners, the conversation around Sections 831(b) and 953(d) begins with taxes. Unfortunately, that is often where the conversation ends. In reality, these elections are simply tax provisions. They do not create an insurance company, establish a valid captive arrangement, or ensure favourable treatment by regulators, auditors, or the Internal Revenue Service (IRS). Those outcomes depend on something much more fundamental: whether the captive operates as a genuine insurance company.
After many years of auditing, preparing tax returns for, and consulting with captive insurance companies, we have observed a common theme. Rarely do problems arise because an election was unavailable. Instead, problems arise because the captive's operations and oversight failed to support the election.
Understanding that distinction is essential. Although Sections 831(b) and 953(d) are frequently mentioned together, they accomplish entirely different objectives. Section 831(b) allows qualifying small property and casualty insurance companies to elect to be taxed only on investment income rather than underwriting income, provided the company satisfies the statutory requirements and premium limitations. Section 831(b) does not create insurance, eliminate the need for risk distribution, replace actuarial pricing, excuse poor corporate governance, or protect an arrangement lacking economic substance. The election simply changes the way a qualifying insurance company is taxed.
Section 953(d) serves a completely different purpose. It allows certain foreign insurance companies to elect to be treated as a domestic corporation for US tax. This allows captives domiciled in other countries to simplify their US tax reporting requirements, as well as securing their desired regulatory oversight in the domicile they choose.
One of the biggest misconceptions we continue to encounter is the belief that once the election has been filed, the difficult work is complete. The election itself typically requires only a few pages of paperwork.
Supporting that election may require years of documentation. If a captive were examined five years after formation, management should expect to produce evidence supporting every significant aspect of its operations, including actuarial pricing, board governance, investment policies, claim files, executed policies, and accounting records. Experienced auditors often say that if something was not documented, it effectively did not happen.
Where captives commonly get into trouble
Premiums without adequate actuarial support: premium calculations should reflect the risks assumed, not a desired tax result. Independent actuarial analysis is one of the strongest pieces of evidence supporting premium reasonableness.
Weak corporate governance: board governance is often viewed as a yearly 'check the box' requirement. When reviewing board minutes, we frequently see the following sequence of events: open the meeting, approve service providers, adjourn the meeting. While many domiciles only require one meeting each year, we believe that, depending on the captive's programme, quarterly (or more frequent) meetings are necessary to demonstrate continuous review of the captive's underwriting operations, reinsurance, and investments. Meeting minutes should demonstrate active oversight, not merely satisfy an annual filing requirement.
Claims activity that does not look like insurance: insurance companies exist to pay claims. If years pass without documented consideration of reported and incurred-but-not-reported losses, claim evaluations, reserve analyses, or loss monitoring, outside reviewers naturally begin asking questions.
Inconsistent financial reporting: while not desired, small inconsistencies between financial statements, tax returns, declaration pages, and similar documents are inevitable. Material inconsistencies lead to additional questions from regulators, certified public accountants (CPAs), and, if audited, the IRS. Strong corporate governance and internal controls are crucial in supporting accurate regulatory and financial reporting.
Captive owners sometimes assume auditors are primarily evaluating tax positions when, in reality, the audit begins with fundamental questions. Does the captive maintain adequate accounting records? Are investments properly valued? Are loss reserves reasonable? Have premiums been earned appropriately? Does surplus satisfy regulatory requirements? Are related-party transactions properly disclosed? Is there sufficient evidence supporting management's estimates? These are just fundamental indicators of the broader compliance picture. Strong financial reporting supports strong tax reporting.
There is no I in team
Successful captive programmes require effective communication among captive management, counsel, actuaries, CPAs, owners, and regulators, as each party only sees a piece of the picture. Each participant sees only one portion of the overall programme. Small issues can compound over time before they become visible. All parties can do their job perfectly, but when the dots do not connect, problems can emerge.
For example, we have seen a situation where the insured expanded operations internationally through a business acquisition. While there was nothing on the surface wrong with that move, not all parties were aware of it. This resulted in premiums no longer reflecting the insured risks; other risks had effectively disappeared but continued to be insured; and reserves were being developed using assumptions that no longer matched actual operations.
None of the individual advisers made a mistake: the issue arose because no one connected all the pieces.
Practical recommendations
Captive owners should periodically ask themselves several straightforward questions. If regulators, auditors, or the IRS requested documentation tomorrow, could management quickly provide all the pieces of the puzzle to support their financial statements, tax positions, premiums, and loss reserve estimates? If the answer is yes, the captive is well prepared to undergo scrutiny.
If the answer is no, it is important to prepare now, as an examination is not the time to strengthen documentation.
Final thoughts
Sections 831(b) and 953(d) remain valuable provisions within the Internal Revenue Code and continue to play an important role in captive insurance planning. However, successful captive programmes are not built on elections alone. The election may only take a moment to file, but demonstrating compliance is a year-round responsibility.
