What Does the IRS Say About Captive Insurance?

When you have a business, you have at least two types of people to please: your customers and the IRS.

You don’t want any or even both of them breathing down your necks.

That’s why it can be a potential problem if you’re thinking of doing captive insurance. On the upside, working with a captive insurance attorney may force the tax collection agency to leave you alone.

Why Do Companies Form Captive Insurance?

The IRS considers small captive insurance as possible tax scams. It usually ends up in the Dirty Dozen List to serve as a warning for the taxpayers. To understand why this happens, it’s best to recall the primary reasons for setting up this type of insurance in the first place. Why would companies make one when there are plenty of third-party insurance providers out there?

The definition of the word can differ among states, but it all boils down to one thing: it is a wholly owned subsidiary of the insureds or the parent company. A stand-alone business can already be captive insurance as long as it meets the state requirements, such as articles of incorporation, capital, and reserves. If you’re in Georgia, you can read the steps here.

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At first glance, companies would want to do this mainly to improve risk management. For one, the captive can design coverage that suits the exact needs of the business or even the industry. 

In a traditional insurance setting, it’s possible that the policy excludes essential risk mitigation options or the company ends up paying for services they don’t need. The insured will also have better control over their profits, cash flow, and the amount paid for insurance.

Captive insurance, though, also has some tax implications. First, companies may be able to reduce their tax liability by deducting the premiums paid on business insurance. That’s not all. Even if they cannot reduce their taxes with funds set aside for self-insurance, they can do it with the losses.

Some can also use it to earn more money in the future. For instance, a business owner may decide to wind up the company within the next ten years. The moment it closes its doors, it will have the option to liquidate the investments, along with their income.

What’s the IRS’s Beef?

To be fair, the IRS is not against the idea of captive insurance. It also doesn’t have jurisdiction over it as the authority lies on the Congress and the state insurance commissions. The tax department doesn’t like how some businesses use the concept of captive insurance to evade their tax liability.

For example, the captive doesn’t shield the business from any significant risk. It may also deduct an unlimited amount as a premium expense, so it pays taxes only on income from investments. Some may also use it to shelter their assets as part of estate planning.

Captive insurance has been around for years, and thousands of companies do it because it is useful. You, though, don’t want the attention of the IRS, which can be damaging on your income and reputation.

If you want to set up a captive, work with an attorney who will help you stay compliant with the state rules and the IRS provisions.

Adam Hansen