The IRS every year creates a Dirty Dozen list of tax scams for each filing year, and this year, it has listed sham captive insurance companies as one of the abusive tax schemes against which the IRS will be guarding.
Not only does this publication act to warn consumers against scams, but it forecasts to consumers and professionals both what items the IRS may be more heavily scrutinizing. Below is an excerpt from IR-2015-19:
Captive Insurance
Another abuse involving a legitimate tax structure involves certain small or micro captive insurance companies. Tax law allows businesses to create captive insurance companies to enable those businesses to protect against certain risks. The insured claims deductions under the tax code for premiums paid for the insurance policies while the premiums end up with the captive insurance company owned by same owners of the insured or family members.
The captive insurance company, in turn, can elect under a separate section of the tax code to be taxed only on the investment income from the pool of premiums, excluding taxable income of up to $1.2 million per year in net written premiums.
In the abusive structure, unscrupulous promoters persuade closely held entities to participate in this scheme by assisting entities to create captive insurance companies onshore or offshore, drafting organizational documents and preparing initial filings to state insurance authorities and the IRS. The promoters assist with creating and selling to the entities often times poorly drafted insurance binders and policies to cover ordinary business risks or esoteric, implausible risks for exorbitant premiums, while maintaining their economical commercial coverage with traditional insurers.
Total amounts of annual premiums often equal the amount of deductions business entities need to reduce income for the year; or, for a wealthy entity, total premiums amount to $1.2 million annually to take full advantage of the Code provision. Underwriting and actuarial substantiation for the insurance premiums paid are either missing or insufficient. The promoters manage the entities captive insurance companies year after year for hefty fees, assisting taxpayers unsophisticated in insurance to continue the charade.
In short, the IRS is stating what has essentially been long-held U.S. jurisprudence in any event: a captive insurance company must walk, talk, and look like a real insurance company. Yes, well-created captive insurance companies might help their respective owners reduce taxes in the right circumstances. But in any event, the captive still has to operate like a real insurance company.
The risks covered must be real and actuarially insurable risks. The premiums charged for the insurance should be actuarially justifiable. The business of the captive should be run professionally rather than haphazardly.
A poorly created and maintained corporate structure can defeat its stated purpose of providing a liability shield when it, e.g., fails to contain bylaws, doesn’t create firewalls between corporate and personal assets, and does not maintain a structural corporate existence through annual meetings and/or filings.
Similarly, a poorly created and maintained captive, used purely as an attempted tax write-off, can lull the owner into a false sense of security while instead making the owner a target for further IRS scrutiny.
Captives serve very good purposes but they must be used correctly and within the law.
If you would like to read the IRS publication in its entirety, click here.