Considering captive insurance? The benefits and risks of an IRS challenge.

• Author: Laborsky, Jeff
• Position: ADVICE INSURANCE

I CANNOT HELP BUT scratch my head in wonder at why so many small and mid-sized businesses are surprised by the IRS assault on captive insurance vehicles.

Captive insurance has long been the alternative risk transfer technique favored by some of the largest companies in the U.S., with an estimated 10,000 filed in the U.S. The pendulum of rulings against the IRS in the early part of this decade expanded insurance agents' captive marketing efforts to small and mid-sized companies. Captives are usually structured as either onshore or offshore risk pooling schemes with the backing of administration from a large insurance company, called a "front."

So, as the pendulum swings back in favor of the IRS, let's examine the tax benefits of captives now being attacked.

Benefit: Time value of money. The captive parent can accelerate tax deductible losses based on projected claims. This is very beneficial over a self-insured arrangement, where insureds can only deduct losses as they pay them. Depending on the assumptions used by the captive parent, the acceleration of tax deductible losses can be significant.

Cost: IRS attack. The IRS has proposed rules and regulations that would put captive insurance vehicles on the same footing as self-insured taxpayers. The IRS has long challenged that the current arrangement creates an uneven playing field as captives build reserves to achieve earnings smoothing and positive cash flow ahead of their self-insured counterparts. Defensively, a major national insurance broker recently felt compelled to send out a letter to all of its captive clients advising them to seek legal and accounting counsel ahead of inquiry and action by the IRS. The IRS comment period on this issue ended December 27, and there is still uncertainty regarding whether the IRS will reconsider its position. Given the economic backdrop and the presidential election cycle, captives may make for an easy target to shore up some additional revenue for Uncle Sam.

Benefit: Return of over-funded reserves. Once losses are fully developed, capital can be returned to the captive parent in the form of a dividend, taxed at the attractive lower dividend rate.

Cost...