August 1, 2018

Captive Insurance in the Middle Market

Holland & Knight Private Wealth Services Blog
Gal N. Kaufman | John D. Dadakis

The New York office of Holland & Knight recently held "Captive Insurance in the Middle Market." The event was moderated by John D. Dadakis, lead partner in Holland & Knight's Private Wealth Services Group in New York. Michael A. DiMayo from Oxford Risk Management Group and Gal N. Kaufman from Holland & Knight's Private Wealth Services Group in Tysons, Va., presented on the various issues and challenges for owners of middle market companies when using captive insurance companies.

Mr. DiMayo led off the discussion by talking about the compliance issues that captive insurance companies face. Recently, the Internal Revenue Service (IRS) has challenged captive insurance arrangements on the grounds that the premiums paid in these arrangements are not legitimate ordinary business expenses, and thus an income tax deduction should not be afforded for the premiums paid. He stressed the importance of using independent actuaries to develop justifiable premium amounts, rather than have premiums dictated by tax motives. Additionally, taxpayers have to make sure that the captive insurance companies are indeed set up as actual insurance companies, in such that there is actual risk shifting and risk distribution. In the recently decided U.S. Tax Court case of Avrahami v. Commissioner, the court disallowed deductions for premiums paid to a captive insurance company because the arrangement did not constitute insurance under federal income tax law. Testimony in that case revealed that there would be little to no possibility that any legitimate claims would be made against the policies due to the types of risks insured. In fact, there were not any claims made until the IRS began its audit of the taxpayers.

Mr. DiMayo continued by explaining that if properly structured, captive insurance can be a great risk management tool. Certain enterprise risks that traditional commercial insurance typically does not cover, such as loss of a key customer or loss of business due to legislative change, can be covered using a captive insurance company. It was noted that a restaurant in Disney World had insured against business disruption risk of the park being shut down, which happened due to Hurricane Irma in 2017, even though the restaurant itself suffered no physical damage from the hurricane. Mr. DiMayo also explained how captive insurance is philosophically different than traditional commercial insurance in that the profits of the insurance company belong to the owner of the captive, rather than an independent insurance company.

Mr. Kaufman shared valuable insight into the tax aspects of captive insurance. Specifically, section 831(b) of the Internal Revenue Code provides significant tax advantages for small insurance companies. For tax year 2018, premiums up to $2.3 million paid to a captive 831(b) insurance company are not subject to income tax; income tax is paid only on the investment income. Furthermore, from an estate planning perspective, many owners of captive insurance companies prefer to own their captives in an irrevocable trust to further enhance the transfer tax planning involved with captive insurance companies. It was noted that, in order for a captive to be owned by an irrevocable trust, one of two requirements must be met under section 831(b). One requirement is the captive insurance company has to share 80 percent of risk with others (and therefore for others). Alternatively, there is a requirement that the ownership of the captive insurance company must in essence be the same as the ownership of the insured business. Mr. Kaufman and Mr. DiMayo both repeatedly stressed that although there is potential tax and estate planning benefits from captive insurance, captive insurance should be viewed primarily as a risk management strategy.

The program was attended by 40 professionals from various industries, including financial advisors, public accountants, insurance brokers and other Holland & Knight peers. One of the attendees noted that the presenters "did an awesome job" in enlightening the group on the proper way to have a qualified captive insurance company as part of a business strategy.

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