IRS Scrutiny Captive Insurance Agreements

IRS Scrutiny Captive Insurance Agreements

August 6, 2014

In the past year there has been a noticeable increase in the number of captive insurance arrangements that the Internal Revenue Service (“IRS”) is auditing. While many large organizations have used the captive insurance vehicle as a way to aid in mitigating risk, the IRS has been more closely examining smaller companies which are using these financial vehicles, specifically those captive insurance agreements that fall within the parameters of Internal Revenue Code (“IRC”) §831(b).

BACKGROUND

Captive insurance arrangements are a useful resource to businesses that are unable to find necessary insurance coverage. As established in The Harper Group v. Commissioner, 96 T.C. 45, 47 (1991), in order to qualify for a captive insurance arrangement, the business must conform to the following: (a) the arrangement involves the existence of an “insurance risk”; (b) there is both risk shifting and risk distribution; and (c) the arrangement is for “insurance” in its commonly accepted sense. IRC §831(b) allows for insurance companies with less than $1.2 million in premiums to be taxed on their investment earnings as opposed to their gross income.

IRS SCRUTINY OF CAPTIVE INSURANCE AGREEMENTS

The IRS is aware that there is the potential for abuse and is currently in the process of intensifying its review of business captive insurance arrangements. The goal of the IRS is to determine if it is a legitimate insurance arrangement or if the captive insurance arrangement is being used as a tax shelter vehicle. During its review of captive insurance arrangements, the IRS will be evaluating information and documentation that will assist in determining whether or not it is a valid insurance arrangement and, accordingly, should be treated as an insurance company. In determining whether or not there is a valid insurance arrangement the IRS will take into consideration various criteria including, but not limited to, the following:

  • A thorough review of the supporting documents to ascertain whether or not they emphasize premium deductions as opposed to insurance needs.
  • The probability of insurance coverage applying to the specific type of business or industry (if appropriate insurance coverage is taken for certain geographic areas and/or types of businesses).
  • Are the premiums close to or do they exactly equal the $1.2 million exemption amount?
  • Lack of claims history.

In addition to the above noted items, if the IRS is questioning a captive insurance arrangement they will also look to determine if the documentation supports a correct circular flow of funds with respect to the premiums paid. Regarding the circular flow of funds, the IRS is particularly interested if, through a series of events, the premiums paid end up with a closely related party or the business itself.

CONCLUSION

It is important to note the above are guidelines and any such particular instance would not automatically determine that a captive insurance arrangement could potentially be found to be invalid. The IRS will utilize the above noted guidelines in determining if the captive insurance arrangement lacks merit.

Please contact a member of WS+B’s Healthcare Services Group for further questions or assistance.

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