There is no one-size-fits-all policy for business insurance. Companies have many different needs, and finding the right policy may take lots of time and energy. It is always important to consider your options carefully to ensure that your business risks are minimized and that you are using the most cost-efficient option.
Some businesses decide to create a self-insurance arrangement through a captive insurance company. These companies can provide cost savings and flexibility, among other benefits, but there are also many risks and consequences of forming this kind of entity — including tax issues. The Internal Revenue Service (IRS) monitors some of these arrangements with extra scrutiny.
What is a captive insurance company, when would you need one, and what are the associated tax perks? This is your guide to everything you need to know about captive and micro-captive insurance companies, including their risks and benefits.
Understanding Captive Insurance Companies
A captive insurance company is an insurer that is owned and operated by its insured. This approach is a form of self-insurance for the original business, and the captive company does not insure any other entity. As with any insurance firm, there are pros and cons. A captive insurance company may provide more flexibility for the insured and may lower insurance premium costs, for example, but it also creates new risks to consider. We will be discussing these risks and benefits in more detail later. Another version of this approach is a micro-captive insurance company. This entity is a small captive insurance company, but it may be viewed negatively by the IRS. These arrangements were included on the IRS’s list of “Dirty Dozen” tax scams in years past because they are often a disguised estate-planning tactic or abusive tax shelter designed to give the owner significant tax deductions.
When Would You Set Up a Captive Insurance Company?
Any business can set up a captive insurance company, though not all do. These entities are usually formed by larger corporations that have the bandwidth to comply with terms and take on additional costs of running a captive insurance company. Here are a few scenarios that lead businesses to take this approach:
No Better Option
Businesses may create a captive insurance company if they don’t have another third-party insurance option that will cover their particular business risks.
Tax Savings
Some businesses create this entity for the tax savings, though that is typically not their only motivation. We will discuss tax benefits in more detail in the next section.
Better Coverage
A business may decide to form a captive insurance company if the parent company needs significant protection and is looking for better, more affordable insurance coverage.
Businesses that meet these criteria may end up realizing attractive returns from this approach. Those who are careful about setting up a captive insurance company could see it pay off in several ways.
4 Benefits of Captive Insurance Companies
Captive insurance companies may be the right option for your business if you are looking for something customizable and are open to taking on the new responsibilities required when forming this separate entity. Here are four perks:
1. Investment Benefits
A captive insurance company allows a business owner to form the entity, own its shares, and pay premiums to that company. Premiums are still deductible by the business owner, and then the contributed funds can be invested and earn money for the business. The business owner can then liquidate this entity when they retire.
2. Lower Insurance Costs
Owners of a captive insurance company may be able to customize their insurance plan, so premiums may be more affordable.
3. More Specific Risk Coverage
Each business may have its own risk-coverage needs. Sometimes other insurance companies may not be willing to cover everything necessary, or they will not be as flexible about customizing options. Going with a captive company can expand the risk protection a business has because they are in control.
4. Tax Benefits
A captive company with annual premiums less than $2.3 million may be able to exclude premiums from income and only be taxed on income earned from investments if all requirements are met. The premiums would still be deductible by the operating company.
These are significant benefits of captive insurance companies, and for some businesses, they can noticeably improve the profit picture. However, businesses can quickly get into trouble if they are not aware of the risks.
Biggest Risks of Captive Insurance Companies
What are the risks associated with captive and micro-captive insurance companies? Most are associated with taxes. Here are a few that you need to be aware of before you decide to use this option:
- The IRS is especially skeptical of micro-captive companies. Always make sure the entity has been formed for risk and management purposes, and not just for the tax savings.
- The IRS requires risk distribution and risk shifting to exist for a transaction to qualify as insurance, and any suspicious transactions could be scrutinized to check for tax-evasion tactics.
- There will likely be additional costs associated with running a separate entity, including setup, administrative, and management expenses.
- A traditional insurance company spreads the risks among its insured parties. With a captive insurance company, that shared risk doesn’t exist, and reinsurance is usually used to further protect the insured. If a large claim comes along, the reinsurance cost could increase quickly.
It is not always easy to understand these risks and potential consequences and how they might apply to your situation. Work with a tax expert so you don’t have to face these issues on your own.
Contact an Expert With Questions about Captive Insurance Companies
Finding the right solution for your business insurance can take time and expertise. Silver Tax Group’s tax attorneys can talk to you about these self-insurance arrangements and advise whether this is the right avenue for your business. We also help with any other tax-related questions you may have. Reach out to Silver Tax Group today with your questions about captive insurance companies.
