The IRS recently filed a petition to enforce subpoenas issued to investigate tax liabilities arising from a business’s involvement in an insurance transaction. While captives can have many advantages – ranging from increased control, reduced costs and favorable tax benefits – the IRS petition emphasizes the importance of structuring and implementing captives in accordance with all applicable laws.
Often seen as an alternative to traditional insurance markets, a captive is a wholly owned subsidiary insurance company that provides coverage for its parent company or a group of related companies. Like a traditional insurer, a captive is subject to jurisdiction-specific regulations, such as financial reporting, solvency and reserve requirements, and annual actuarial opinions. Each jurisdiction also provides specific guidelines for the formation and administration of prisons.
As is the case with traditional insurance, the insured pays a premium to his own insurer in exchange for coverage. However, because a captive is owned and controlled by the insured, it may offer broader or more specialized coverage than traditional insurance products, including protection against certain risks that might otherwise be uninsured. Other benefits of captives can include reduced operating costs, increased control over claims and tax savings. For example, captive insurers can pay dividends to owners and premiums can be tax-deductible business expenses if the captive’s risk-sharing arrangement meets certain standards.
While captives offer many benefits, they can present additional challenges if not set up and implemented properly, as evidenced by the IRS’s petition in United States v. Prince, No. 8:22-cv-1456 (MD Fla., filed June 27, 2022). in prince, the IRS issued administrative subpoenas as part of its examination of tax liabilities for two entities involved in a life insurance transaction. Over two tax years, related parties using the indemnity insurance arrangement took more than $425,000 in business expense deductions for indemnity insurance premium payments, all of which the insurance company reported on its returns as tax-exempt. According to the petition, which was served on the individual shareholder and cooperative representative for the two entities, the companies failed to comply with the subpoenas.
Given the state of the insurance market and continued difficulties with high premiums, less favorable terms and reduced capacity for many lines of coverage, companies continue to look for alternative risk transfer options – such as captives, risk retention groups and self-insurance – outside the traditional insurance market. Captives can be an attractive alternative given the potential flexibility, control and cost savings. However, the prohibited must be structured and implemented correctly to take advantage of these benefits, including any tax savings such as those in prince. The IRS specifically examines subordinates to ensure that the entity is a bona fide insurance company, that it is formed for a legitimate business purpose, and that any preferential tax treatment of premium payments is permissible under applicable tax laws. Retaining experienced risk professionals at every stage of the process, including attorneys to advise not only on insurance and regulatory compliance, but also corporate and tax matters, can help maximize the benefits of a closed-end formation and minimizing the risk of disputes with state, federal or foreign government agencies.