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Tax Implications of Captive Insurance

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Captives insure risks that would otherwise be uninsurable or difficult and costly to insure. They are typically owned by those they insure. Corporations start captive insurance companies for the significant financial benefits and risk mitigation they offer. However, captives have tax implications.

Estate Planning

Did you know that your heirs can be owners of your captive? When a company pays its premiums, the capital accumulates in the captive. If the company owners will their captive to an heir, such as a child or grandchild, those assets pass to the heir. In addition, if no incident occurs, the heirs receive 100% of the captive’s capital and assets, and this distribution is tax free.

Tax Shelters

Captive premiums are not considered taxable income. However, a captive must receive at least 50% of its premiums from a third party that is not in the same industry or it must have at least 12 insured individuals who each hold at least 5% of the risk because the IRS requires the risk to be sufficiently distributed.

In addition, companies are able to deduct the premiums they pay even though they are paying them to a subsidiary. As the captive’s assets grow, some of this capital can be disbursed among the owners as dividends, which have a much lower tax rate than income.

IRS Audits

If a captive is small and offers poorly designed policies for risks that are covered by the commercial insurance industry, the IRS may see the captive as an abusive tax shelter. They will also investigate companies that charge excessive premiums, especially if these companies purchase coverage with traditional insurers for an economical rate.

Micro-captives that charge premiums in the exact or close to the amount of money companies need to reduce their tax burden for a year are also being investigated. In addition, profitable companies with annual premiums that are higher than $1.2 million are being regularly audited.

If you have risks that cannot be or are costly to insure, consider starting a captive. However, learn about the tax implications and be prepared for annual audits.