Will You Get Burnt With a Captive

For many years there has been a provision in the Tax Code that allows a “small” insurance company to earn premiums tax-free. As you can guess any time something can be earned tax-free there may end up being some abuses.

These “captive” insurance companies are created to provide insurance to the companies that create them. If these captive insurance companies are well diversified, then the IRS and Congress appears to not have any issues with them.

However, if the captive insurance company is owned by one entity or a group of controlled entities and these entities pay premiums that are fully deductible to a captive that does not pay any tax on the premiums then they get concerned.

The IRS for several years have indicated that these situations must be reported each year so that they can more easily reviewed or to audit them.

President Biden’s green book has several provisions to make these arrangements much more costly.

The proposal would create an “untaxed income account requirement” for any captive insurance companies that receive 20% of more of their premiums from any one policyholder or a related group of policy holders.

These companies would maintain an untaxed income account (UIA) to hold the premium income that has not been taxed via the election under Section 831(b) (this allows the company not to pay tax on these premiums). Any dividends or loans made to the captive’s insured or related parties would be treated as a deemed distribution from the UIA and taxed at a high rate.

How high of a rate would it be? It would be equal to the highest corporate tax rate plus 10%. It would also increase the amount of premiums that would be taxed and would tax all previously untaxed premium income.

Here is an example:

ABC Farm Operation LLC creates ABC Captive Insurance Co. in 2020. During 2020 and 2021, the farm pays $2 million to the Insurance Co. The Insurance Co. did not pay out any claims and the owners of the farm received a dividend of $2 million. If this proposal passes, the Insurance Company would owe tax as follows:

• The $2 million would be grossed up by dividing it by a factor equal to 1 minus 31% or 69%. This results in $2,899,000 being subject to tax.
• The $2,899,000 is then taxed at 31% or $899,000 of tax (rounded) or about 45% of the net premium earned.

To get around these proposals, most captives will try to make sure that no related group of companies will pay in more than 20% of total premium income. However, this then essentially reduces the benefit to many farm operations that have created these captives and you will likely see many of these go out of business. But they will still owe 45% tax on previous net premiums earned since it was created.

Will this pass. Likely not in the current form, but something will happen to reduce the benefit of these captives and it may be painful. We will keep you posted.