Monday, March 28, 2022
Many businesses, including farming and ranching businesses, face rising insurance costs and higher self-insured risks for hazards that were not an issue in the past. This is particularly true for many ag businesses that face ever-increasing environmental rules and regulations that can impair operational profitability, heightened cyber threats, as well as supply chain and labor issues. As a result, some of these businesses have begun to investigate and utilize captive (and micro-captive) insurance.
What is captive insurance and what are the benefits of it? Where does it fit in the overall income tax and estate/business plan for a business, including farming and ranching operations? What concerns might the IRS have with captive insurance, and what do those concerns mean for practitioners?
Utilizing captive insurance as part of an income tax and estate/business plan that also is designed to minimize business risk - it’s the topic of today’s post. Part One of a three-part series.
Captive Insurance Defined
A captive insurance company is an insurer that is a wholly owned subsidiary that providing risk-mitigation services for its parent company or a group of related companies. A key to being a true captive insurance company is the provision of risk-mitigation. Often, the reason for forming a captive insurance company is when a business (the parent company) is unable to find standard commercial insurance to cover risks that are unique to the business. Without the creation of a captive insurance company, the business is left to self-insure against risks for which it is unable to acquire commercial insurance. In this situation, a captive insurance company provides the ability to shift self-insured risks to the captive company with policies tailored to fit the unique parent’s unique needs. The owners of the parent can retain control of the captive’s investments, and may also be able to achieve tax savings and wealth transfer benefits
Note: Since 2000, the potential risks to a business from contract non-performance (business interruption), a loss of key suppliers and input supplies, cyber-attacks, labor shortages, and administrative and/or regulatory actions have increased substantially. This is causing businesses (including farming and ranching operations) to search for cost-effective and tax efficient ways to manage these unique risks. A captive insurance company is viewed as one approach that can satisfy an overall risk-mitigation strategy. See, e.g., “Once Scrutinized, an Insurance Product Becomes a Crisis Lifeline,” The New York Times (Mar. 20, 2020).
Income Tax Aspects
Insurance is a transaction that involves an actual insurance risk and involves risk-shifting and risk-distributing. Helvering v. Le Gierse, 312 U.S. 521 (1941). Insurance premiums are deductible as an ordinary and necessary business expense under I.R.C. §162(a) if paid or incurred in connection with the taxpayer’s trade or business. Treas. Reg. §1.162-1(a). However, amounts set aside in a loss reserve as a form of self-insurance are not deductible. See, e.g., Harper Group v. Comr., 96 T.C. 45 (1991), aff’d., 979 F.2d 1341 (9th Cir. 1992). As Judge Holmes stated in Caylor Land & Development, Inc. v. Comr., T.C. Memo. 2021-30, “the line between nondeductible self-insurance and deductible insurance is blurry, and we try to clarify it by looking to four nonexclusive but rarely supplemented criteria:
- insurance risk; and
- whether an arrangement looks like commonly accepted notions of insurance.”
On the other side of the equation, an insurance company includes premiums that it receives in income, and the company is generally taxed on its income just like any other corporation. I.R.C. §831(a). But an insurance company that receives premiums under a certain amount during a tax year can elect to be taxed only on investment income. I.R.C. §831(b)(1)-(2).
Note: For premiums paid to be deductible, the captive must be respected as an insurance company for federal income tax purposes. Otherwise, what is involved non-deductible self-insurance. This means that qualified underwriting services must be used to determine the actual cost of similar coverage in the market or via an underwriting evaluation so that the policies are properly designed and the premiums are appropriate. This is key to getting the desired tax treatment and withstanding an IRS attack. Setting premiums too high coupled with claims that are less than anticipated will cause the captive’s stock value to rise. That value can be returned to shareholders in a tax-favorable manner as qualified dividends taxed at favorable capital gain rates. Hence, the importance of the proper structuring of the captive to avoid an IRS attack and the imposition of severe penalties (explained further below).
Estate and Business Planning Aspects
Before the Congress modified I.R.C. §831, the captive or micro-captive corporation could fit rather easily into an estate or succession plan, and could be held in various types of entities depending upon the overall estate and business plan of the owner(s). A straightforward approach, for example, was to have a parent (or parents) form a captive insurance company and name the children as the shareholders. As the parents paid the premiums, they achieved insurance coverage for their unique need(s) and transferred wealth to the children. Establishing the captive, however, must be justified by a legitimate business purpose of insuring risks of the business other than simply transferring wealth in a tax-efficient manner to the children.
Trust ownership. A trust could be established to own the captive insurance company. If the trust’s beneficiaries are the grantor’s children and/or grandchildren, it is possible to structure the trust such that the assets of the captive insurance corporation will not be included in the owner’s estate at death.
LLC/FLP ownership. Similarly, the captive corporation could be placed in a limited liability company (LLC) or a family limited partnership (FLP). The ownership structure of the LLC or FLP could involve various classes of ownership held by various members of the owner(s) family. This structure may be especially beneficial in the context of a small businesses such as a farm or ranch where the senior generation wants to maintain control over the business, investments, and distributions of the captive insurance corporation while simultaneously setting up valuation discounts for minority interest and/or lack of marketability.
Gift tax. From a federal gift tax standpoint, income tax deductible premiums made for adequate and full consideration are not a gift from the owners of the insured to the owners of the captive insurance company. Treas. Reg. §§25.2512-1(g)(1); 25-2512-8. The “full and adequate consideration” test of I.R.C. §2512 applies in the estate tax context such that the premium payments are not pulled back into the decedent/transferor’s estate at death for federal estate tax purposes under I.R.C. §2036 or I.R.C. §2038. This also means that the generation-skipping transfer tax (GSTT) would not apply.
Statutory modifications. In late 2015, the Congress passed “extender” legislation that included new rules impacting certain captive insurance companies. Under the new rules, effective for tax years beginning after 2016, the maximum amount of annual premiums that a captive insurance company may receive became capped (subject to an inflation adjustment). The cap is $2.45 million for 2022. In addition, a captive insurance company must satisfy one of two “diversification” tests that bear directly on the ability to transfer wealth to the next generation without transfer tax. Under this requirement, the ownership of the underlying business of the captive must be within two percent of the ownership of the captive. The new rule applies to all I.R.C. §831(b) captive insurance companies regardless of when formed.
Under revised I.R.C. §831(b), a captive that makes an I.R.C. §831(b) election must satisfy one of the following two requirements designed to prevent it from being used as a wealth transfer tool (notice the second requirement is written in the negative – the captive must not satisfy it):
- No more than 20 percent of the net written premiums (or, if greater, direct written premiums) of the company for the tax year is attributable to any one policyholder;
Note: I.R.C. §831(b) was retroactively amended by the Consolidated Appropriations Act, 2018 (CAA) such that “policyholder” means “each policyholder of the underlying direct written insurance with respect to such reinsurance or arrangement.” Thus, a risk management pool itself is not considered to be the policyholder. Instead, each insured paying premiums into the pool is considered a policy holder. As long as none of those insureds accounts for more than 20 percent of the total premiums paid to the captive, the 20 percent test is satisfied. I.R.C. §831(b)(2)(D)
- The captive company does not meet the 20 percent requirement and no person who holds (directly or indirectly) an interest in the company is a spouse or lineal descendant of a person who holds an interest (directly or indirectly) in the parent company who holds (directly or indirectly) aggregate interests in the company which constitute a percentage of the entire interests in the company which is more than a 2 percent percentage higher than the percentage interests in the parent company with respect to the captive held (directly or indirectly) by the spouse or lineal descendant.
Note: Essentially, the second requirement means that if the spouse or lineal descendants’ ownership of the captive company is greater than 2 percent of their ownership of the parent company, the second requirement is not satisfied.
The CAA modified the second test (the ownership test) to eliminate spouses from the definition of “specified holder” unless the spouse is not a U.S. citizen. Thus, the ownership test only applies to lineal descendants of either spouse, spouses that are not U.S. citizens, and spouses of lineal descendants. I.R.C. §831(2)(B)(iii). The CAA also added a new aggregation rule to apply to certain spousal interests such that any interest held, directly or indirectly, by the spouse of a specified holder is deemed to be held by the specified holder. In addition, the CAA modified the ownership test to look at the aggregate amount of an interest in the trade, business, rights or assets insured by the captive, held by a specified holder, spouse or “specified relation.” I.R.C. §831(b)(2)(B)(iv)(I). The rule excludes assets that have been transferred to a spouse or other related person by bequest, devise or inheritance from a decedent during the taxable year of the insurance company or the preceding tax year. Id.
Thus, in the estate planning/succession planning context if a parent (i.e., father or mother) or parents is (are) the sole owner of the parent company and the captive company, the captive company can make the I.R.C. §831 election. That’s because no lineal descendant has any ownership in the captive company. But, if a parent(s) is (are) the sole owner of the parent company and the and children own the captive company, the captive cannot make the I.R.C. §831 election (100 percent is more than 2 percent greater than zero percent). The result is the same if the captive is held (indirectly) in a trust with the children as the beneficiaries. But, for example, if the parent owns half of the parent company and half of the captive company with the children owning the other half of each entity, the captive company can make the I.R.C. §831 election.
Note: If the children meaningfully own the parent company, they can own the captive company. The converse is also true.
Given the modifications to I.R.C. §831(b) it remains possible to use a captive insurance company as part of an estate/business succession plan if the ownership of the parent and the captive is structured properly with the appropriate ownership percentages in both the parent and captive business entities. For example, a captive company could be capitalized with cash from an intentionally defective grantor trust (IDGT) that has been established for the benefit of a child. I recently posted an article on the use of an IDGT in estate planning. You may read that article here:
The gift of funds to the IDGT is a completed gift for federal gift tax purposes and removes that value from the grantor’s estate at death. The income the IDGT receives from the captive is taxed to the grantor, and the grantor deducts the premiums paid to the captive company and reports the net profits from the captive as a qualified dividend. That is the case even though the cash flows from the parent company (the family business) to the captive insurance company and then to the IDGT and then on to the grantor’s child/children. But, again, the ownership percentages of the parent and the captive insurance company must be carefully structured to stay within the borders of I.R.C. §831.
As an alternative, as noted above, the captive insurance company could be held in an FLP and the parents could gift FLP interests to the children annually consistent with the present interest annual exclusion (presently $16,000 per donee per year (and, spouses can elect “split-gift” treatment)). Each FLP interest entitles the owner a share of the captive company’s profits. It may also be possible for the parents to claim valuation discounts on the gifts of interests in the FLP. But, of course, the percentage ownerships of the parent company and the captive must stay within the “guardrails” of I.R.C. §831.
In Part Two I will examine the issues that give the IRS concern about captive insurance companies and discuss various court cases construing the IRS position.