The IRS has said that for an arrangement to be considered “insurance” for Federal income tax purposes risk shifting and risk distribution must exist. Shifting means you have moved the risk off your books and given it to a separate entity. According to the Financial Accounting Standards (FAS) a company that is self-insured has to account for liabilities. This often creates problems and confusion with many business owners. The business has to deduct these reserves for financial reporting, but they cannot take a deduction for tax-purposes. Self-insured losses are only deductible for tax purposes when the losses are incurred and paid.
This is clearly an example of risk that is not shifted to any other entity. The more difficult discussion is the distribution of risk once it is shifted to that separate entity.
Internal Revenue Code §831(b) offers small insurance companies a very powerful tax advantage that can provide financial resources to pay claims. This benefit assumes that legitimate risk is being transferred. It is available to both onshore and offshore captives. This election makes the premiums paid to the captive not subject to income taxes. The reserves are accumulated, and the insurance company is only taxed on its investment income. The application of the 831(b) election is straightforward. Any properly structured insurance captive writing less than $2.2 million of annual premium may take this election.
IRC 831(b) allows for a property and casualty company to be taxed only on its investment income. The advantage of this structure is that it allows the company to accumulate surplus from underwriting profits free from tax. However, it is important to note that while an 831(b) pays no tax on underwriting profits, its owners are still taxed on dividends and other compensation received.
An 831(b) insurance company has become a popular structure for captive promoters, and I have found the basic sales pitch is “how would you like to deduct $2.2 million and ultimately pay capital gains on the distribution?” Let me say this is dangerous and I will revisit this topic after my discussion of Non-831(b) insurance companies below.
If a captive insurance company receives more than $2.2 million in premiums or has not elected 831(b) insurance taxation; it is considered a “regular” captive insurance company. To review, the 831(b) company will enjoy tax-free premiums and tax liability on only the investment growth. A regular property-casualty company does not have the same tax treatment.
Non-831(b) companies are taxed on the premium income received. But they are afforded a deduction for legitimate reserves, incurred-but-not-reported (“IBNR”) losses, expenses, reinsurance, claims, etc. So, the non-831(b) company can still avoid paying taxes in circumstances where its approved deductions offset premium income. For example, even though a captive charges $5 million in premiums, it will pay no taxes if it has $500,000 in expenses and IBNR and can actuarially justify reserves of $4.5 million.