In the last 20 years, many small businesses have begun to insure their particular risks via a product called “Captive Insurance.” Small captives (also called single-parent captives) are insurance companies established by the owners of closely held businesses looking to insure risks which are either too costly or too hard to insure through the standard insurance marketplace. Brad Barros, a professional in the field of captive insurance, explains how “all captives are treated as corporations and should be managed in a method in keeping with rules established with the IRS and the appropriate insurance regulator.”

Based on Barros, often single parent captives are owned with a trust, partnership and other structure established by the premium payer or his family. When properly designed and administered, a business could make tax-deductible premium payments with their related-party insurance company. Depending on circumstances, underwriting profits, if any, could be paid out to the owners as dividends, and profits from liquidation of the organization may be taxed at capital gains.

Premium payers and their captives may garner tax benefits only when the captive operates as an actual insurance company. Alternatively, advisers and business owners who use captives as estate planning tools, asset protection vehicles, tax deferral and other benefits not related to the true business purpose of an insurance company may face grave regulatory and tax consequences.

Many captive insurance companies are often formed by US businesses in jurisdictions outside of the United States. The explanation for this is that foreign jurisdictions offer lower costs and greater flexibility than their US counterparts. Usually, US businesses can use foreign-based insurance companies provided that the jurisdiction meets the insurance regulatory standards required by the Internal Revenue Service (IRS).

There are many notable foreign jurisdictions whose insurance regulations are recognized as safe and effective. These include Bermuda and St. Lucia. Bermuda, while more expensive than other jurisdictions, is home to many of the largest insurance companies in the world. St. Lucia, an even more reasonably priced location for smaller captives, is noteworthy for statutes which are both progressive and compliant. St. Lucia can be acclaimed for recently passing “Incorporated Cell” legislation, modeled after similar statutes in Washington, DC.

Meeting the high standards imposed by the IRS and local insurance regulators could be a complex and expensive proposition and should only be completed with the help of competent and experienced counsel. The ramifications of failing continually to be an insurance company could be devastating and may include the next penalties:

Overall, the tax consequences may be greater than 100% of the premiums paid to the captive. Additionally, attorneys, CPA’s wealth advisors and their clients may be treated as tax shelter promoters by the IRS, causing fines as great as $100,000 or even more per transaction.

Clearly, establishing a captive insurance company is not something that ought to be taken lightly. It is crucial that businesses seeking to begin a captive use competent attorneys and accountants who’ve the requisite knowledge and experience necessary to steer clear of the pitfalls related to abusive or poorly designed insurance structures. An over-all guideline is that a captive insurance product must have a legal opinion covering the essential elements of the program. It’s well recognized that the opinion should really be supplied by an unbiased, regional or national law firm.

Risk Shifting and Risk Distribution Abuses; Two key elements of insurance are those of shifting risk from the insured party to others (risk shifting) and subsequently allocating risk amongst a large pool of insured’s (risk distribution). After many years of litigation, in 2005 the IRS released a Revenue Ruling (2005-40) describing the essential elements required in order to meet risk shifting and distribution requirements.

For folks who are self-insured, the usage of the captive structure approved in Rev. Ruling 2005-40 has two advantages. First, the parent does not have to generally share risks with every other parties. In Ruling 2005-40, the IRS announced that the risks could be shared within the exact same economic family as long as the separate subsidiary companies ( a minimum of 7 are required) are formed for non-tax business reasons, and that the separateness of those subsidiaries also has a business reason. Furthermore, “risk distribution” is afforded provided that no insured subsidiary has provided a lot more than 15% or less than 5% of the premiums held by the captive. Second, the special provisions of insurance law allowing captives to take a current deduction for an estimate of future losses, and in a few circumstances shelter the income earned on the investment of the reserves, reduces the bucks flow needed to fund future claims from about 25% to nearly 50%. In other words, a well-designed captive that fits certain requirements of 2005-40 will bring about a price savings of 25% or more.

While some businesses can meet certain requirements of 2005-40 within their particular pool of related entities, most privately held companies cannot. Therefore, it’s common for captives to buy “third party risk” from other insurance companies, often spending 4% to 8% per year on the total amount of coverage necessary to meet up the IRS requirements.

Among the essential elements of the purchased risk is that there surely is an acceptable likelihood of loss. Due to this exposure, some promoters have experimented with circumvent the intention of Revenue Ruling 2005-40 by directing their clients into “bogus risk pools.” In this somewhat common scenario, an attorney and other promoter will have 10 or even more of their clients’ captives enter right into a collective risk-sharing agreement. Within the agreement is a published or unwritten agreement not to produce claims on the pool. The clients such as this arrangement because they get every one of the tax great things about owning a captive insurance company without the danger related to insurance. Unfortunately for these businesses, the IRS views these kinds of arrangements as something apart from insurance.

Risk sharing agreements such as for instance they’re considered without merit and should really be avoided at all costs. They add up to only a glorified pretax savings account. If it may be shown that a risk pool is bogus, the protective tax status of the captive could be denied and the severe tax ramifications described above is likely to be enforced.

It established fact that the IRS talks about arrangements between owners of captives with great suspicion. The gold standard on the market is to buy third party risk from an insurance company. Anything less opens the entranceway to potentially catastrophic consequences.

Abusively High Deductibles; Some promoters sell captives, and then have their captives take part in a large risk pool with a high deductible. Most losses fall within the deductible and are paid by the captive, not the danger pool.

These promoters may advise their clients that considering that the deductible is indeed high, there is no real likelihood of third party claims. The issue with this type of arrangement is that the deductible is indeed high that the captive fails to meet up the standards set forth by the IRS. The captive looks more such as a sophisticated pre tax savings account: no insurance company.

A different concern is that the clients may be advised that they can deduct each of their premiums paid into the danger pool. In the case where the danger pool has few or no claims (compared to the losses retained by the participating captives using a high deductible), the premiums allocated to the danger pool are just too high. If claims don’t occur, then premiums should really be reduced. In this scenario, if challenged, the IRS will disallow the deduction made by the captive for unnecessary premiums ceded to the danger pool. The IRS might also treat the captive as something apart from an insurance company since it didn’t meet with the standards set forth in 2005-40 and previous related rulings.

Private Placement Variable Life Reinsurance Schemes; Over time promoters have attempted to generate captive solutions designed to supply  Bedrijf abusive tax free benefits or “exit strategies” from captives. Among the very popular schemes is where a business establishes or works together with a captive insurance company, and then remits to a Reinsurance Company that portion of the premium commensurate with the portion of the danger re-insured.

Typically, the Reinsurance Company is wholly-owned with a foreign life insurance company. The legal owner of the reinsurance cell is really a foreign property and casualty insurance company that’s not at the mercy of U.S. income taxation. Practically, ownership of the Reinsurance Company could be traced to the bucks value of a life insurance coverage a foreign life insurance company issued to the principal owner of the Business, or a related party, and which insures the principle owner or a related party.

Investor Control; The IRS has reiterated in its published revenue rulings, its private letter rulings, and its other administrative pronouncements, that the master of a life insurance coverage is likely to be considered the income tax owner of the assets legally owned by the life insurance coverage if the policy owner possesses “incidents of ownership” in those assets. Generally, to ensure that the life insurance company to be viewed the master of the assets in a separate account, control over individual investment decisions must not maintain the hands of the policy owner.

The IRS prohibits the policy owner, or a party related to the policy holder, from having any right, either directly or indirectly, to require the insurance company, or the separate account, to get any particular asset with the funds in the separate account. In effect, the policy owner cannot tell the life insurance company what particular assets to invest in. And, the IRS has announced that there cannot be any prearranged plan or oral understanding as to what specific assets could be invested in by the separate account (commonly known as “indirect investor control”). And, in an ongoing number of private letter rulings, the IRS consistently applies a look-through approach regarding investments made by separate accounts of life insurance policies to find indirect investor control. Recently, the IRS issued published guidelines on when the investor control restriction is violated. This guidance discusses reasonable and unreasonable degrees of policy owner participation, thereby establishing safe harbors and impermissible degrees of investor control.

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