The IRS Perspective on Captives Insurance Companies

The IRS is looking for economic justification and proper structure of the entity selected to operate a CIC.

When you are satisfied that the benefits of operating a captive are worth a deeper analysis, one key question will be, “What type of captive is best for my organization?” As you begin evaluating alternatives, you will quickly discover substantial differences in the various captive types and structures of captives. You’ll also notice that these differences have a substantial impact on the captive owner’s financials. For that reason, your CFO, attorney and tax advisor will be critical members of the team that evaluates the efficacy of captive formation. In particular, a key area of focus will be the tax implications of operating a captive. While tax considerations alone should never drive a captive-formation decision, they can’t be ignored and almost always play an important role in structure decisions.

Main organizational types

In most cases, when a captive insurance company is formed in a U.S. domicile, it is organized as a stock, mutual, limited liability, or reciprocal company. Captives formed offshore are most often stock or mutual companies.

A stock insurer is an incorporated organization that issues and sells stock to raise capital. Like many corporations, profits generated by a stock company are typically distributed to shareholders through dividends. They can also be returned to insureds through return of premium or renewal credits. As a corporation, a stock company benefits from limited liability.

A mutual insurer, unlike a stock company, does not issue stock. It is owned by policyholders, called “members,” who contribute surplus to fund the captive. When there is a profit, that profit is returned to the policyholders in the form of return of premium. Like a stock insurer, a mutual company is an incorporated entity which means members enjoy limited liability.

A limited liability company (LLC) sits somewhere between a stock company and a mutual. An LLC does not issue stock but it does offer limited liability to its members. In the world of captives, it is a relatively new structure that is gaining increased acceptance. For example, it was approved by Vermont as an eligible legal entity in the 2004 legislative session.

A reciprocal organization is an unincorporated association that is licensed by the domicile in which it is organized as a captive insurance company. A reciprocal’s subscribers contribute surplus, agree to share risks with one another and are governed by a Subscribers’ Advisory Committee (SAC). The reciprocal’s operating authority is granted to an attorney in fact by each of the subscribers. Any profits or income from investments can be allocated by the SAC to the reciprocal’s Subscriber Savings Account (SSA). One of the main advantages of operating a reciprocal under U.S. tax law is the annual deductibility of profits allocated to the SSA. Profits later distributed out of the SSA to subscribers pass tax-free.

The content of this press release is from the book Taken Captive by R. Wesley Sierk III and available on Amazon.com.