Using captives to manage risk.

• Author: McGrath, Clinton N., Jr.

A captive insurance arrangement is an alternative risk management mechanism that has become popular in today's business environment for managing certain risks as part of a company's (or group of companies') overall risk management program. Captives typically have been used to fund property and casualty insurance coverage, such as general liability, products liability and workers' compensation. Depending on the business reason for using captives, their tax implications vary.

Domestic Tax Benefits

Premium deductions: Insurance premiums (which qualify as "insurance" for Federal tax purposes) paid by policyholders to a captive are deductible as ordinary and necessary business expenses under Sec. 162(a). In contrast, reserves set aside for self-insuring certain risks are not deductible; see Spring Canyon Coal Co., 13 BTA 189 (1928), aff'd, 43 F2d 78 (10th Cir. 1930), and Pan-American Hide Co., 1 BTA 1249 (1925).

Insurance company tax rules: Captives (which qualify as "insurance" companies for Federal tax purposes) are taxed as insurance companies. Thus, they can take advantage of certain Code provisions specifically targeted to insurance companies. Examples include the captive's being able to:

* Recognize premium income as it is earned, rather than when paid, under Sec. 832(b)(4);

* Deduct accrued losses in a manner unavailable to other taxpayers (due to the Sec. 461(h) "all events" test), by deducting currently an estimate of losses incurred and future expenditures needed to settle such losses, under Sec. 832(b)(5) (rather than deducting when paid);

* Elect to be taxed only on investment income under Sec. 831 (b), if net written premiums (or if greater, direct written premiums) for the tax year do not exceed $1.2 million (as revised by the Pension Funding Equity Act of 2004 (PFEA)); and

* Qualify for tax-exempt status under Sec. 501(c)(15) if gross receipts for the tax year do not exceed $600,000, more than 50% of which are derived from premiums (rather than investment income); see PFEA Section 206. State taxes: Captives generally are not subject to state income taxes, but instead pay state premium taxes. This may result in permanent tax savings on income-producing assets held within the captive.

Requirements

To take advantage of these tax benefits, a captive must satisfy two primary requirements: (1) a valid insurance arrangement must exist between the captive and its policyholders (2) and the captive must be an insurance company for Federal...