A captive insurance company (or “captive”) is a licensed insurer generally established to meet the risk management needs of a specific company or group of companies. The risk management benefits are the primary reason for their formation, but the tax benefits can also be valuable. A captive must be licensed as an insurance company through a state or foreign jurisdiction and satisfy certain requirements for the premiums to be deductible as insurance for federal tax purposes. Assuming that the captive meets the requirements, its taxable income is typically based on underwriting income with some required adjustments for tax purposes. However, certain qualifying insurance companies may elect to be taxed only on taxable investment income.
Viewing a Sample of Captive Requirements
A captive must satisfy the following criteria to qualify as an insurance company for federal tax purposes:
1. Risk shifting and risk distribution must be present in the captive’s operations. Risk shifting refers to transferring the risk from the insured to the insurer. By contrast, risk distribution relies on the law of large numbers and, in doing so, reduces the risk of a single loss exceeding the premium collected.
2. More than 50% of its revenue must be from insurance activities.
3. Its transactions must involve insurance risk. The risk of loss cannot be business or investment risk.
4. Its business arrangements must involve insurance in the commonly accepted sense. In other words, the captive must operate as an insurance company should operate. It must not only be properly capitalized, but also establish premiums and reserves according to customary practices in the insurance industry.
Zooming In on Captive Insurance Taxation Nuances
Captive insurance companies are usually taxed on underwriting income after required adjustments for tax purposes. However, smaller captives can make an election – commonly referred to as an 831(b) election – to be taxed only on their taxable investment income. The 831(b) election is currently available to companies with net or direct written premiums of no more than $1.2 million. Net investment income includes taxable non-insurance income less qualifying investment expenses.
This election can be especially beneficial to captive owners. Although the insured companies receive a full tax deduction for the premium paid, the captive is taxed only on its net taxable investment income.
The Protecting Americans from Tax Hikes (PATH) Act includes significant changes to the 831(b) election for tax years beginning in 2017. The legislation will increase the premium threshold by $1 million to $2.2 million. It also adds the following as 831(b) election criteria:
1) diversification tests, which should be applied to premium income; and
2) ownership of the insurance company.
Bring Your Captive Insurance Taxation Benefits into Greater Focus
The CRI team is ready to advise you regarding how your organization can benefit from establishing a captive insurance company. We might even uncover small details that are hard to see at first glance. Contact us today!