There is little question that the tax implications of owning and operating a captive insurance company will be significant. For most organizations, the decision to insure through a captive versus a combination of traditional insurance and self-insurance is significantly influenced by tax implications. Many organizations first discover this difference in tax impact from a captive promoter—especially when the tax impact is significant in a way that is beneficial to the potential captive owner. However, if your only motive in forming a captive is to gain some tax advantage, you would be well advised to reconsider. Must pay claims if they are incurred, and so on. If, however, your operation is little more than a shell organization designed to provide predictable tax deductions, you should plan on an expensive and uncomfortable series of interactions with the regulators. If you ever receive different advice than this, please get a second opinion before making any commitments.
Assuming an organization decides to pursue a captive because operating a legitimate insurance company makes good business sense, the organization has passed the first hurdle to deductibility: a valid purpose for existence. If a captive exists for no other valid purpose than tax benefits, then no other analysis matters—deductibility will be challenged.
How to qualify as a legitimate insurance company for tax purposes has been the subject of significant judicial and regulatory activity. As far as the IRS is concerned, just calling your organization an insurance company doesn’t make it one. In fact, a company that has a license to operate as an insurance company in a particular jurisdiction isn’t automatically qualified as an insurance company for tax treatment according to the IRS (and the judicial system). Decisions from the appellate courts have made it clear that the term “insurance” is a term of art that has been given a specific legal meaning. Simply stated, if your organization does not meet certain requirements then it will not be considered an insurance company for tax purposes; to be sure, many captives fail to meet the required qualifications without ever realizing it. And when they find out, the lesson is a financially painful one.
“As I point out throughout this book, there are many legitimate reasons for operating a captive. In order to do so effectively and without raising the scrutiny of the IRS and insurance regulators, you must operate your captive like an insurance company. Your captive must be appropriately capitalized; it must underwrite and actually transfer and distribute risk.”
The content of this press release is from the book Taken Captive by R. Wesley Sierk III and available on Amazon.com.