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Captive Insurance Companies 101


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Captive Insurance Companies 101

  1. 1. The Abernethy Law Firm, P.C. Matthew E. Abernethy, Esq. President
  2. 2.  Matthew E. Abernethy received his BSBA in Finance from Auburn University in 2007. Mr. Abernethy earned his Juris Doctorate from Georgia State University School of Law in 2011. He particularly excelled in the area of tax during law school, receiving the prestigious State Bar of Georgia Tax Scholar Award in 2010-2011. He now practices in the areas of Tax Planning, Estate Planning, Captive Insurance, Conservation Easements, Asset Protection, Bankruptcy, Tax Dispute Resolution, Banking/Finance, and Family Business Succession Planning. Mr. Abernethy mainly serves small businesses and high net wealth individuals.  In 2011 and 2012, under the mentoring of Professor Beckett G. Cantley, Mr. Abernethy assisted in the composition and editing of a series of articles on Captive Insurance and Conservation Easements.  The University of Richmond Journal of Global Law and Business published an article in which Mr. Abernethy assisted in the research, editing, and composition, entitled “The Forgotten Taxation Landmine: Application of the Accumulated Earnings Tax to IRC § 831(b) Captive Insurance Companies”. See 11 Rich. J. Global L. & Bus. 159 (2012).  The University of California-Davis Business Law Journal also published an article in which Mr. Abernethy assisted in the research, editing, and composition, entitled “Repeat as Necessary: Historical IRS Policy Weapons to Combat Conduit Captive Insurance Company Deductible Purchases of Life Insurance”. See 13 U.C. Davis Bus. L. J. 1 (2012).  The University of California-Hastings West-Northwest Journal of Environmental Law and Policy published an article in which Mr. Abernethy assisted in the research, editing, and composition, entitled “Environmental Preservation and the Fifth Amendment: The Use and Limits of Conservation Easements by Regulatory Taking and Eminent Domain”. See 20 Hastings W.-N.W. J. Envtl. L. & Pol’y 2015 (2014).
  3. 3.  Generally speaking, a Captive Insurance Company (“Captive” or “CIC”) is formalized self-insurance. A Captive is a C Corporation licensed to practice the business of insurance in a domicile that has statutory authority to license and regulate Captives. Unlike commercial insurers, captives do not generally insure the general public. Instead, Captives will generally only cover the customized risks of captive owners and affiliated businesses.  Captives have been very popular with Fortune 500 companies since the 1970s. Relatively recent legislation, most notably IRC § 831(b), has popularized the use of micro captives to level the risk management playing field for small businesses.
  4. 4.  Lowers Insurance Costs  Commercial insurance companies charge a premium for marketing and sales. Most commercial insurers spend between 6-8% of premiums collected on marketing and sales. A captive insurance company, because it primarily insures only related risks, faces very little costs in the way of marketing and sales. These savings are passed on to you, the parent business or family of business, under a Captive strategy.  Since a Captive is a licensed insurance company, a Captive can directly access the reinsurance marketplace. Essentially, the reinsurance marketplace is to the commercial marketplace as wholesale is to retail.
  5. 5.  Expands Actual Insurance Coverage  Most commercial insurance policies contain innumerable exclusions and exceptions, creating large gaps in coverage. Also, some needed coverage is largely commercially uninsurable (i.e. cyber terrorism, product recall). Therefore, many businesses are already unintentionally self-insuring for a lot of these risks (in a tax-disadvantaged manner, as well). CICs may hand-craft policies for the particular situations facing its parent businesses, largely avoiding these unintentional gaps in coverage (and doing so in a tax- advantaged manner—discussed in greater detail in the following slides).  Most commercial insurance policies also generally require the payment of a substantial deductible. CICs may avoid the requirement of deductibles. Furthermore, where some commercial insurance coverage is retained, CICs may be used to supplement coverage by insuring against the risk that you will have to pay a deductible on a commercial policy claim.  The parent business or family of businesses employ the captive managers at will. Therefore, CIC owners have indirect control over the claims handling process.
  6. 6.  Ensures Continuity of Insurance Coverage  Certain commercial insurance sub-industries, particularly trucking commercial insurers, are notorious for untimely coverage cancellations that can prevent the lawful operation of a truck or even an entire fleet. Temporary loss of trucking coverage can create disastrous supply- chain consequences, potentially bringing your business to its proverbial knees. The use of a CIC, even if only to front and then re-insure trucking risks, can help ensure continuity of coverage where there exists an indemnity and reinsurance agreement that only places the credit risk on the reinsure—there would exist no practical reason to cancel.
  7. 7.  Retains Underwriting Income  When your insurance claims experience beats actuarial projections, your insurer receives more premium than it pays in claims—creating underwriting income. If you have strong internal controls and a spotless claims history, why would you want a third party to retain underwriting income that could remain in your business coffers? A CIC strategy allows for the retention of such underwriting income within the family of businesses.
  8. 8.  Increases Asset Portfolio Liquidity  A Captive must maintain sufficient liquidity to pay claims as they are projected to occur, in order to be considered an insurance company for federal income tax purposes. Therefore, a Captive will generally have to maintain a large amount of its reserves in cash or relatively liquid, risk-free assets (such as T-bills or AAA rated, blue-chip publicly-traded securities. These holdings will increase the overall liquidity of the business family’s portfolio of assets (and on a tax-advantaged basis—discussed in greater detail in the following slides). Increasing asset portfolio liquidity is important for accessing new and cheaper forms of financing, fostering growth and expansion of the business family.
  9. 9.  Ability to Control Investment Decisions for CIC Reserves  Since CIC owners control the compensation of captive managers, the CIC owners may have significant influence on the investment decisions of CIC reserves.  However, while captive managers will generally accommodate reasonable investment choices, captive managers must maintain the CIC’s status as an insurance company, for federal income tax purposes. Therefore, captive managers must make investment decisions as would a reasonable insurance company (i.e. must maintain sufficient liquidity to pay claims as they are actuarially projected to come due).  It should also be noted that some investments, such as certain life insurance arrangements within a CIC (e.g. non-key man life, any split dollar arrangements, etc.), should be avoided due to concern over the application of various judicial tax doctrines that would destroy the federal income tax benefits discussed in greater detail in the coming slides
  10. 10.  Income Tax Benefits  So long as the CIC is considered an insurance company and the policies written are considered insurance, for federal income tax purposes, ordinary and necessary premiums paid would be currently deductible to the paying parent businesses under IRC §§ 162 and 482. This is also true of payments to commercial insurers; however, true self insurance (other than as formalized with a Captive) is not currently deductible—it would only be deductible as a claim arises.  IRC § 831(b) provides that a micro captive (that qualifies with and makes an election under such section) may exclude up to $1.2 million of premium, annually, from income for federal income tax purposes. Therefore, so long as a CIC does not receive more than $1.2 million in premium per year, it does not pay federal income tax on premium/underwriting income.  A captive must pay federal income tax on its investment income (at its applicable C corporation tax rates); however, investment decisions may be made to defer, minimize, and/or avoid the recognition of investment income altogether (e.g. municipal bonds, real estate, certain whole life insurance, equities). Once again, it must be noted that the investment choices of a CIC are limited to those that would be made by a reasonable, similarly-situated commercial insurance company (i.e. the timing of returns must maintain sufficient liquidity to pay projected claims).
  11. 11.  Income Tax Benefits (Continued)  When you consider all of these federal income tax benefits in combination (deductibility of premiums, non-recognition of underwriting income, and avoidance of investment income through limiting investment to municipal bonds), it is possible that no federal income tax will be paid on earnings until such earnings are distributed to CIC shareholder-beneficiaries.  Even then, upon distribution of earnings to CIC shareholder- beneficiaries (e.g. owners, family, key executives, etc.), such a distribution would likely be taxed as a capital gain where such shareholder-beneficiary has met the requisite holding period.  An appropriate CIC strategy may effectively take what would otherwise be considered ordinary income of the parent entity, defer the recognition of such income until a subsequent CIC distribution, use the pre-tax dollars to invest in tax-advantaged investment vehicles, and ultimately recharacterize the income as capital in nature!
  12. 12.  Improves Cash Flow and Increases Profits  The parent business or family of businesses will greatly improve cash flow and profitability by: 1) lowering the cost of insurance; 2) limiting exclusions, exceptions, and deductibles; 3) retaining underwriting income; 4) investing such underwriting income; and 5) deferring the recognition of and recharacterizing business income.
  13. 13.  Asset Protection  As previously stated, captive insurance is essentially formalized self-insurance that allows for tax-advantaged re- investment. If, instead of using CIC reserve accumulations to self-insure, you were to self-insure “on-the-books” of the operating business entity, these funds would clearly be subject to the general liabilities of the operating business (and potentially even its partners). A CIC, as a separate and distinct C Corporation, would only be subjected to the liabilities of the operating businesses and/or the CIC shareholder-owners where the obligee can successfully “pierce the corporate veil” to get to the CIC reserves. The requirement of “piercing the corporate veil” adds extra layers of expense and uncertainty in pursuing claims against the CIC reserves.
  14. 14.  Estate Planning and Business Succession Planning Benefits  Captives are excellent estate and business succession planning tools where family members and/or business successors of the original owners of the operating businesses are named as shareholder-beneficiaries of the CIC.  Because reasonable, arms-length premiums are paid in the ordinary and necessary course of business, by a parent to a Captive, such transfers (which may result in reserve accumulation) are not subject to the estate and gift taxation regimes. If the parent entities pay the maximum $1.2 million in premiums and experience no claims in a given year, there is a possibility that the full $1.2 million will ultimately be transferred to the heirs, free of any estate or gift tax (that’s significantly more than the $14,000 (or $28,000 for couples) per heir allowed to otherwise be transferred free of estate and gift taxes under current law!). However, expectations must be tempered because it is very difficult to continually beat actuarial projections, absent significant claims control procedures and internal controls. Also, it should be noted that any heir who has not yet reached the age of 21 should have his or her interest as a shareholder-beneficiary of the CIC held in dynasty trust with a generation-skipping transfer tax provision (so as to avoid the application of family attribution rules).  The universal difficulties involved in business succession planning are transitioning voting power/operation control and funding an eventual buyout. A CIC provides a non-operational entity in which a departing owner-executive can maintain control over profits while allowing a younger family member or business successor to hold the ownership of and executive positions in the operating business. Furthermore, a CIC may be used to actively fund and implement the buyout.
  15. 15.  Commercial General Liability Coverage  Commercial Liability Umbrella Coverage  Commercial Policy Deductibles Coverage  Commercial Policy Exclusions & Exceptions Coverage  Commercial Property & Casualty Coverage  Machinery Coverage  Commercial Auto/Carrier Coverage  GAP Auto Coverage  Health Insurance Coverage  Disability Insurance Coverage  Worker’s Compensation Coverage  Employer Liability Coverage  Malpractice Liability Coverage  Professional Liability Coverage  Crime & Fiduciary Coverage  Director & Officer Errors and Omissions Coverage  Negligence/Reckless Occurrence Coverage  Employee Intentional Acts Coverage  Breach of Contract Coverage  Bad Debt and Collections Coverage  Business Disruption Coverage  Supply-Chain Disruption Coverage  Inventory Risks Coverage  Loss of Key Man Coverage  Loss of Key Contract Coverage  Loss of Key Customer Coverage  Intellectual Property Risks Coverage  Litigation Risks Coverage  Products Liability Coverage  Currency, Interest Rate and Other Economic Risks Coverage  Business Continuity, Succession and Transfer Financing Coverage  Loss of Goodwill Coverage  Natural Disaster Coverage  IT & Information Security Risks Coverage Expanded Lines of Coverage:
  16. 16. Tax Planning/ Asset Protection Estate Planning/ Retirement & Business Succession Planning Captive Insurance Insurance/Risk Management
  17. 17. Sounds too good to be true, right?! Well, the benefits section of this presentation is over. Now it’s time to talk about why every small business isn’t already using Captive Insurance. Captive Insurance is expensive to implement, requiring immense upfront costs and a team of professionals. Realistically, a Micro Captive will need the services of: 1) a Captive Manager; 2) an Actuary; 3) a CPA; 4) a federal income and estate tax advisor; and 5) a Reinsurance Broker. A simple, pure Micro Captive can generally be formed and operated for between 6-10% of premiums.* More typical group and fronted Micro Captive arrangements; however, have formation and operating expenses that range between 12-28% of premiums. Of course these operating expenses do not reflect claims losses, simply Captive overhead. These high up-front and continuing overhead expenses mean that Captive Insurance is not economically practical for all small businesses. Furthermore, the risk of facing a catastrophic claim in excess of premiums paid is simply too much for some conservative investors to stomach. *The all-in fees for the services required for a simple, pure IRC § 831(b) Micro Captive typically run from between $50,000 & $100,000 for formation and between $40,000 & $80,000 for annual maintenance & filings (depending on the level of premiums and quality of counsel). Some so-called “Captive Cowboys” often attempt to undercut these prices with cookie-cutter Captive mills; however, Captives require much expertise and individual attention. Failing to choose appropriate counsel can have disastrous consequences. The Costs
  18. 18.  Companies with at least $250,000, but ideally $1MM+ in annual profits.  Profitable enterprise families of businesses involving 12 or more separate entities.  Companies who are currently severely underinsured (whether it be unavailability or unaffordability of commercial insurance, high deductibles, and/or innumerable policy exclusions & exceptions).  Companies with an established low insurance claims payment history and excellent internal controls.  Companies looking to grow their operations and accumulate wealth in a comprehensive manner.  Companies with an appetite for risk and an expectation of long-term investment.
  19. 19. (1) Hire an actuary and a federal income and estate tax advisor. (2) Conduct a Feasibility Study to determine what risk the Micro Captive should consider insuring. (3) Determine the appropriate type of Micro Captive (pure, group, cell, fronted, etc.). (4) Determine who will be the shareholders of the Micro Captive—businesses, trusts, and/or individuals. (5) Determine the appropriate jurisdiction for the Micro Captive. Choice of jurisdiction can greatly affect capitalization, reporting, and regulatory requirements. (6) Hire a Captive Management Company (or “Captive Manager”) that is licensed in such jurisdiction to handle the day-to- day insurance operations of the Micro Captive (sometimes this step will occur sooner if the Captive Manager is involved in the Feasibility Study—some Captive Managers will conduct a Feasibility Study in-house for free if you sign an agreement guaranteeing them your business if/when you pursue a Micro Captive program). (7) Incorporate a C Corporation in the appropriate jurisdiction, publish notice of incorporation, draft bylaws, hold annual shareholder and director meetings (complete with minutes), obtain a federal EIN, obtain a state taxpayer ID, and open a corporate bank account. (8) Make an IRC § 831(b) election to be taxed as a small Micro Captive insurance company. The IRC § 831(b) election is made by attaching a statement to the Captive’s tax return. An IRC § 831(b) election will apply to an insurance company as long as the company’s premiums do not exceed $1.2 million or until the election is revoked with the consent of the IRS. The IRS generally does not consent to the revocation of an election unless a material change in circumstances is shown. (9) For offshore Micro Captives, consider whether an IRC § 953(d) election should be made to treat the CIC as a U.S. taxpayer. (10) Arrange for adequate capitalization prior to applying for an insurance license. (11) Conduct underwriting and develop individual policies with the assistance of the Captive Manager, Actuary, and federal income and estate tax advisor. (12) Obtain one or more insurance licenses, as is appropriate for the relevant Micro Captive jurisdiction. You may be required to have a business plan, a budget, and the audited proforma financial statements of the parent(s) to obtain a license. May also be required to file an anti-money laundering affidavit. (13) Issuing purchase orders for captive lines of coverage. (14) Be sure to satisfy local reporting requirements, including the payment of any relevant state or local premium or self- procurement taxes. (15) Establish a uniform claims handling procedure. (16) Hire a CPA to handle the accounting work and implement the accounting system. A Captive operating as a small property and casualty company must file a Form 1120-PC income tax return and report its income on Schedule B. (17) Meet regularly with your captive manager, federal income & estate tax advisor, actuary, and CPA team to ensure that the Captive maintains regulatory compliance and obtains the benefits discussed herein.
  20. 20.  Lack of Risk Shifting and/or Risk Distribution  Excessive Premiums  Accumulated Earnings Tax (“AET”)  Lack of Economic Substance  Improper Investments  Excessive Loan-Backs  Investment Portfolio Illiquidity  Life Insurance
  21. 21.  In order to obtain the tax benefits described herein, a Captive must be considered an “insurance company” and the policies written by the Captive must be considered “insurance”, for federal income tax purposes. The Internal Revenue Code (“IRC”) does not provide a definition for the term “insurance.” However, in Helvering v. Le Gierse,* the U.S. Supreme Court set forth the standard that true insurance must have risk shifting and risk distribution. Risk shifting is the actual transfer of the risk from the insured to the Captive insurance company. Risk distribution is the Captive insurance company’s exposure to adequate third-party risk to obtain the risk-pooling effect had by most traditional insurance companies. After the IRS abandoned the “economic family doctrine”, IRS safe harbor provisions have helped clarify the areas of risk shifting and risk distribution. These guidelines and safe harbors, if followed, should protect a Captive in the event of an IRS challenge.  One safe harbor provision, Rev. Rul. 2002-90, provides that 12 non-disregarded subsidiaries, with each subsidiary having no more than 15% and no less than 5% of the total risk insured, which are paying premiums to an affiliated Captive insurance company was enough for appropriate risk distribution and risk shifting to have occurred.  The other major safe harbor provision provides that sufficient risk distribution and risk shifting will have occurred where a Captive takes on at least 30% of unrelated insurance risk (meaning no family, no common owners). To acquire 30% of unrelated premium, a Captive may participate in a “risk distribution pool”. A risk distribution pool is formed for the exchange of insurance business among Captives to spread risk and enhance participation in a non-related business. A risk distribution pool combines the investments of many Captives into a single account that is held by a reinsurance company. Risk is transferred from each individual Captive through a quota share reinsurance agreement whereby the reinsurer accepts a stated percentage of each and every risk within a defined category of business on a pro rata basis. This quota share agreement provides a fixed and certain risk for all Captives that bought coverage from the reinsurance company. A contract is issued between the reinsurance company and each Captive for the reinsurance company to retain funds in its trust account for a certain period.  In Rev. Rul. 2009-26, the IRS stated that when determining risk distribution and risk shifting in a reinsurance contract, the risks of the ultimate insured must be examined. This contract would be the primary (underlying) insurance policy. *Essentially, Helvering v. Le Gierse held that true insurance does not exist where the insured, absent tax benefits, remains in the same economic position— where there exists no degree of fortuity or uncertainty.
  22. 22.  Under IRC § 162(a) and Treas. Reg. § 1.162-1(a), insurance premiums paid by a taxpayer are deductible if they are connected directly with the taxpayer’s trade or business. However, the insurance premiums must be an ordinary and necessary business expense in order to be deductible. Therefore, a business must be able to prove that any premiums paid to a Captive are an ordinary and necessary business expense in the event of a challenge by the IRS. The IRS has challenged premiums as being “excessive” and not an ordinary and necessary business expense on two grounds. First, taxpayers that pay overly high premiums for the insurance they are receiving will not be able to deduct those premiums. Second, taxpayers that are suddenly obtaining a significantly higher and unnecessary level of insurance will not be able to deduct those premiums.  A reliable actuarial method is required to avoid a challenge for excessive premiums. In Gulf Oil Corp., the Tax Court decided that insurance premiums charged by a CIC and the amount of insurance provided by the CIC must be based on a reliable actuarial estimation of the risk of loss. Having premiums that are consistently in great excess of the actual losses paid is an indicator that one of two things is occurring. First, the taxpayer could be attempting to evade taxes by taking advantage of the Section 831(b) exclusion. Second, the company could, in reality, be retaining the risk, and the IRS might conclude that the Captive was not actually providing insurance. As a practical matter, the Captive should actually pay claims to its insureds every year. A red flag for the IRS has also been when the Captive is charging exactly $1.2 million in premiums. Under IRC § 831(b), a small insurance company can deduct up to $1.2 million dollars in insurance premiums. If a Captive is charging exactly that amount, it may suggest to the IRS that an actuarial method was not used and that the Captive is a tax sham.  If the IRS or a court determines that the insurance premiums being charged by the Captive are excessive, undesirable consequences follow. First, the premium-paying company loses the income tax deduction and, most likely, also has to pay interest and penalties. Second, the Captive may have taxable income. There also could be gift tax issues with the transfer for Captive business structures where the Captive is owned by the business owner’s descendants or trusts. If the taxpayer-owner did not file a gift tax return, the taxpayer may be subjected to failure to file penalties, as well as other penalties. For this reason, the client may consider filing a gift tax return every year a premium is paid to a Captive. By filing the Form 709 and making proper disclosure, the gift tax statute of limitations will begin to run, and, thus, the transfer tax risk should be reduced.  To avoid a determination that the premium payments are excessive and at the same time increase the deduction available, the company can attempt to find insurable risks for which third-party insurance is not commercially available or not commercially affordable. An insurable risk must have some degree of fortuity or uncertainty. Traditional business or investment risks do not have the necessary degree of fortuity and thus, are not insurable. By obtaining insurance on risks that the company would not normally be able to insure through a third-party insurer, the company will potentially be able to pay higher premiums without the insurance or the premiums becoming excessive. This may result in the justification for a higher income tax deduction under IRC § 162(a).
  23. 23.  The Accumulated Earnings Tax is a penalty tax “designed to prevent corporations from unreasonably retaining after-tax” earnings and profits “in lieu of paying current dividends to shareholders,” where such income would be taxed for a second time as ordinary income at applicable shareholder tax rates. If a CIC is liable for the AET under IRC § 532(a), a fifteen percent tax is imposed for each taxable year on the corporation’s accumulated taxable income. The AET is imposed in addition to any other taxes imposed under the IRC.  A CIC is only penalized under the AET if it retains earnings and profits in excess of reasonable business needs with the intent to avoid shareholder taxes. The fact that a CIC accumulated earnings and profits beyond the reasonable needs of the business is “determinative of the purpose to avoid income tax with respect to its shareholders, unless the corporation proves the contrary by a preponderance of the evidence.”  “The reasonable business needs of a corporation include not only its current needs, but also its ‘reasonably anticipated‘ future business needs as well.” “Under the Treasury Regulation, the needs of the business are determined at the close of the taxable year in issue.” The CIC should make a practice of documenting its current and anticipated future business needs at the end of each cycle, but will not be required to show such formal planning if a definite and feasible plan can be otherwise proven. The end of the business cycle is when “management presumably decides how much cash is needed for normal business operations, and for future adverse risks and contingencies.” The excess should “be distributed to shareholders as dividends, to be taxed as ordinary income.”
  24. 24.  In 2010, Congress codified the “doctrine of substance over form” and the “step transaction doctrine” into IRC § 7701(o) (the so-called codified Economic Substance Doctrine or “ESD”). IRC § 7701(o) provides that a transaction shall be found to have economic substance only if: (1) the transaction changes in a meaningful way (apart from federal income tax effects) the taxpayer’s economic position and (2) the taxpayer has a substantial business purpose (apart from federal income tax effects) for entering into the transaction. New strict liability penalties starting at 20% apply if a transaction fails to meet the new two-pronged codified Economic Substance Doctrine. When designing and operating a Captive, extra attention is needed to document all non-tax economic and business purposes and benefits.
  25. 25.  Excessive Loan-Backs  A Captive’s lending money back to an operating business that the Captive insures is often referred to as a “loan-back”. A loan-back is used to invest Captive funds in the operating business. The arrangement usually takes the form of a bond issuance but is fundamentally no different than a loan. The IRS carefully scrutinizes loan-backs and has contemplated issuing regulations relating to them. To date, the IRS has issued limited guidance on loan-backs and has not provided an objective standard to determine whether a loan-back will be considered a bona fide debt and thus be found to have non-tax economic substance.  Loan-backs are often analyzed in terms of the loan-back to premiums-paid ratio. If a significant portion of the premiums paid are borrowed, concerns of a circular cash flow arise. In a situation where a Captive loaned 97.5% of its assets to the operating business, the IRS determined the loan-back to be invalid and stated by “loaning out substantially all of its assets to an affiliate, Insurance Subsidiary resembles an incorporated pocket-book, representing a reserve for self- insurance....” Therefore, a loan-back must be issued with great caution, must be a bona fide debt, and should not represent a significant portion of the Captive’s assets or premiums paid.
  26. 26.  Investment Portfolio Illiquidity  Where a Captive is undercapitalized, involves risks substantially covered through parental guarantees, or fails to maintain sufficient liquidity to pay claims as they are actuarially projected to come due, the arrangement may be challenged on economic substance grounds. The theory is generally that the insurance is a sham transaction, lacking true business purpose. Above all, premiums must be actuarially correct and the Captive must be maintained in a manner which permits it to pay claims as they are actuarially projected to come due. Therefore, a Captive must primarily maintain its investment reserves in short-term, fairly liquid assets (cash, T-bills, short-term CDs, publicly traded securities, precious metals, etc.). Limited long-term, riskier investments are allowed where such investments are specifically designed to meet long-term liabilities (for example, a partnership buy-out reserve).
  27. 27.  Life Insurance  Since the investment income of a Captive must be taxed as C corporation income, investment vehicles that are not subject to current income tax are attractive assets for Captives to hold. In that respect, permanent life insurance policies would seem an ideal asset for a Captive to consider owning because increases in cash value are not subject to current income taxation. On the other hand, IRC § 264 states that life insurance premiums cannot be deducted either directly or indirectly. Therefore, when a Captive owns life insurance, the IRS could conceivably attempt to collapse the business’ payment of premiums to the Captive and the Captive’s payment of premiums to the life insurance company, deeming them to be a single payment of premiums directly to the life insurance company—a non-deductible transaction that cannot be made deductible via a conduit entity. Such classification would result in a determination that any income tax deductions taken for premiums paid to the Captive were improper. Because there is no authority on this issue, prudence and common sense are advisable to reduce any IRS risk. For instance, if life insurance is being contemplated as an investment for a Captive, the client should apply for it only after the Captive has been formed. Also, its purchase should be for a significant nontax purpose. When life insurance is not a primary asset of a Captive, but a minority portion of a diversified investment portfolio, the likelihood of a successful challenge by the IRS under IRC § 264 should be significantly reduced.  Certain key-man life insurance policies, the premiums from which are otherwise allowed as deductible business expenses outside of the context of Captives, would not be prohibited investments for Captives.
  28. 28.  The core components of a comprehensive feasibility study include:  Identifying your organization's risk management goals and concerns  Assessing current insurance coverage, gaps and retention  Reviewing historical loss data  Assessing the types of insurance coverages suitable for a captive  Estimating costs of new captive coverages  Estimating captive coverage losses  Assessing suitable domiciles for your captive  Estimating the cost of forming a captive  Estimating annual operating expenses of the captive  Determining the capital and surplus requirements for the captive  Summarizing the cost-benefit analysis  Preparing and explaining the financial performance projections for both expected and adverse loss scenarios  Explaining the tax implications, uncertainties, assumptions and elections  Explaining proposed coverage lines, limits, rates and policy type in some detail  Addressing reinsurance and pooling aspects and requirements if applicable  Documenting the business purposes and expected economic benefits  Advising as to investment objectives and options of captive
  29. 29. The Abernethy Law Firm, P.C. Matthew E. Abernethy, Esq. President (404) 314-7759