IRS Scrutinizing Aggressive Tax Strategy

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captive insuranceI always get a kick when I see a book or an article with “what your CPA doesn’t want you to know” in the title.  The strategy that is being pushed is either a well established strategy that most competent CPAs already know about or the strategy is a sham.  One strategy that fits more closely into the latter category is the captive insurance company.

The Basics of a Captive Insurance Company

Basically this strategy involves a profitable business that sets up a related captive insurance company.  The business enters into an insurance agreement with the related insurance company to cover risk the likelihood of which is almost certain never to occur.  The business will take a deduction for the insurance premiums.  The captive insurance company files an election under IRC  Section 831(b) to only pay tax on investment income–basically the captive insurance company does not pay tax on the premiums it receives–it only pays tax on the investment income it earns on the premiums.

Example:  Sham-How Corp is expecting profit of $200,000 this year.  To shelter some of its income, it forms a captive insurance company.  It then takes out a policy covering risk of a Godzilla attack.  It pays the captive insurance company $100,000 in premiums.  Sham-How Corp takes a $100,000 deduction.  The captive insurance company does not pay tax on the $100,000 of premiums it receives–it only pays tax on the investment income it earns on the $100,000.  Wanting to push its luck even more, Sham-How Corp then borrows $100,000 from the insurance company (loans are tax-free).

The Party is Ending

While these transactions have worked, they are very aggressive.  The IRS is classifying captive insurance arrangements as a transaction of interest.  This classification requires businesses entering into these transactions to disclose the transaction to the IRS.  This will subject the transaction to close scrutiny–someone just called the cops and the party is winding down.

Why the Scrutiny?

The IRS is scrutinizing captive insurance arrangements because these arrangements tend to have the following characteristics:

  • the coverage involves an implausible risk
  • the coverage does not match a business need or risk of the business
  • the description of the coverage in the insurance policy is vague, ambiguous, or illusory
  • the coverage duplicates coverage provided to the business by an unrelated, commercial insurance company, and the policy with the commercial insurer often has a far smaller premium.

The premiums paid to the captive insurance company have one or more of the following characteristics:

  • the insurance premiums are designed to be deductible
  • the payments are determined without an underwriting or actuarial analysis that conforms to insurance industry standards
  • the premium payments are not made consistently with the schedule in the policy
  • the premiums are set without comparing the amounts of the premiums to premiums that would be made under policies with unrelated insurance companies

The management of the captive insurance company has one or more of the following characteristics:

  • the insurance company fails to comply with some or all of the laws applicable to insurance companies in the jurisdiction where it is organized
  • the insurance company does not issue policies or binders in a timely manner consistent with industry standards
  • the insurance company does not have defined claims administration procedures that are consistent with industry standards
  • the insured does not file claims for each loss that is covered by the policy
  • the insurance company does not have adequate capital
  • the insurance company invests its capital in illiquid or speculative assets usually not held by insurance companies
  • the insurance company loans or otherwise transfers its capital to the business, related businesses, or owners of the business.

For tax strategies that work, give us a call at 248-538-5331.

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Buzzkill Disclaimer:  This post contains general tax information that may or may not apply in your specific tax situation. Please consult a tax professional before relying on any information contained in this post.

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