A brief Release so that you can Attentive Insurance
In the last 20 years, many small businesses have begun to insure their own 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 seeking to insure risks which can be either too costly or too difficult to insure through the standard insurance marketplace. Brad Barros, a specialist in the field of captive insurance, explains how “all captives are treated as corporations and must certanly be managed in a way in keeping with rules established with both the IRS and the appropriate insurance regulator.”
Based on Barros, often single parent captives are owned by a trust, partnership or other structure established by the premium payer or his family. When properly designed and administered, a company will make tax-deductible premium payments for their related-party insurance company. According to circumstances, underwriting profits, if any, could be paid out to the owners as dividends, and profits from liquidation of the company might be taxed at capital gains.
Premium payers and their captives may garner tax benefits only when the captive operates as a genuine insurance company. Alternatively, advisers and business owners who use captives as estate planning tools, asset protection vehicles, tax deferral or other benefits not related to the actual 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 reason behind this is that foreign jurisdictions offer lower costs and greater flexibility than their US counterparts. Usually, US businesses may use foreign-based insurance companies as long as the jurisdiction meets the insurance regulatory standards required by the Internal Revenue Service (IRS).
There are numerous notable foreign jurisdictions whose insurance regulations are recognized as safe and effective. These generally include Bermuda and St. Lucia. Bermuda, while higher priced than other jurisdictions, is home to most of the largest insurance companies in the world. St. Lucia, a far more affordable place for smaller captives, is noteworthy for statutes which can be both progressive and compliant. St. Lucia can also 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 finished with the help of competent and experienced counsel. The ramifications of failing continually to be an insurance company could be devastating and may include these penalties:
All in all, the tax consequences might be more than 100% of the premiums paid to the captive. Furthermore, attorneys, CPA’s wealth advisors and their clients might 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 a thing that should be taken lightly. It is important that businesses seeking to establish a captive use competent attorneys and accountants who’ve the requisite knowledge and experience required to avoid the pitfalls connected with abusive or poorly designed insurance structures. A general principle is a captive insurance product needs to have a legal opinion covering the essential aspects of the program. It is well recognized that the opinion should be provided by an unbiased, regional or national law firm.
Risk Shifting and Risk Distribution Abuses; Two key aspects of insurance are those of shifting risk from the insured party to others (risk shifting) and subsequently allocating risk amongst a big pool of insured’s (risk distribution). After several years of litigation, in 2005 the IRS released a Revenue Ruling (2005-40) describing the essential elements required to be able to meet risk shifting and distribution requirements.
For people 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 some 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 ( no less than 7 are required) are formed for non-tax business reasons, and that the separateness of these subsidiaries even offers a company reason. Furthermore, “risk distribution” is afforded as long as no insured subsidiary has provided a lot more than 15% or significantly 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 cash flow needed to fund future claims from about 25% to nearly 50%. In other words, a well-designed captive that meets certain requirements of 2005-40 brings about a cost savings of 25% or more.
While some businesses can meet certain requirements of 2005-40 within their own pool of related entities, most privately held companies cannot. Therefore, it’s common for captives to get “3rd party risk” from other insurance companies, often spending 4% to 8% per year on the amount of coverage necessary to meet up the IRS requirements.
One of many essential aspects of the purchased risk is that there surely is a fair likelihood of loss. As a result of 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 or other promoter can have 10 or even more of the clients’ captives enter right into a collective risk-sharing agreement. Contained in the agreement is a written or unwritten agreement not to produce claims on the pool. The clients like this arrangement because they get all the tax great things about running a captive insurance company without the risk connected with insurance. Unfortunately for these businesses, the IRS views these types of arrangements as something apart from insurance.
Risk sharing agreements such as for example these are considered without merit and should be avoided at all costs. They add up to nothing more than a glorified pretax savings account. If it can be shown a risk pool is bogus, the protective tax status of the captive could be denied and the severe tax ramifications described above will be enforced.
It established fact that the IRS discusses arrangements between owners of captives with great suspicion. The gold standard in the market is to get 3rd party risk from an insurance company. Anything less opens the doorway to potentially catastrophic consequences.
Abusively High Deductibles; Some promoters sell captives, and then have their captives be involved in a big risk pool with a high deductible. Most losses fall within the deductible and are paid by the captive, not the risk pool.
These promoters may advise their clients that considering that the deductible is so high, there is no real likelihood of 3rd party claims. The situation with this kind of arrangement is that the deductible is so high that the captive fails to meet up the standards set forth by the IRS. Groepsverzekering The captive looks more such as a sophisticated pre tax savings account: no insurance company.
A different concern is that the clients might be advised that they’ll deduct all their premiums paid into the risk pool. In case where the risk pool has few or no claims (compared to the losses retained by the participating captives employing a high deductible), the premiums allocated to the risk pool are simply too high. If claims don’t occur, then premiums should be reduced. In this scenario, if challenged, the IRS will disallow the deduction created by the captive for unnecessary premiums ceded to the risk pool. The IRS can also treat the captive as something apart from an insurance company as it didn’t meet with the standards set forth in 2005-40 and previous related rulings.
Private Placement Variable Life Reinsurance Schemes; Over the years promoters have attempted to produce captive solutions designed to supply abusive tax free benefits or “exit strategies” from captives. One of many more popular schemes is in which 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 risk re-insured.
Typically, the Reinsurance Company is wholly-owned by a foreign life insurance company. The legal owner of the reinsurance cell is a foreign property and casualty insurance company that is not susceptible to U.S. income taxation. Practically, ownership of the Reinsurance Company could be traced to the cash value of a life insurance plan a foreign life insurance company issued to the principal owner of the Business, or perhaps a related party, and which insures the principle owner or perhaps 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 owner of a life insurance plan will be considered the income tax owner of the assets legally owned by living insurance plan if the policy owner possesses “incidents of ownership” in those assets. Generally, for living insurance company to be viewed the owner of the assets in a different account, control over individual investment decisions must not be in the hands of the policy owner.
The IRS prohibits the policy owner, or perhaps 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 acquire any particular asset with the funds in the separate account. In effect, the policy owner cannot tell living insurance company what particular assets to invest in. And, the IRS has announced that there can’t be any prearranged plan or oral understanding in regards to what specific assets could be invested in by the separate account (commonly referred to as “indirect investor control”). And, in a continuing group of private letter rulings, the IRS consistently applies a look-through approach with respect to investments created by separate accounts of life insurance policies to locate 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.