The Internal Revenue Service has taken a renewed interest in company’s compliance with the 831(b) regulation governing captive insurance entities. These captives are generally started by companies that have no more than $1.2M in risk to insure annually. Companies that have these arrangements or their parent companies are allowed to select their preferred tax structure. In the past most companies elected the 501(c)(15) exemption, but the 831(b) captive structure has become more popular due to cost effective ways for certain companies to manage risk. As these structures grow in popularity, the IRS has taken a renewed interest in compliance and enforcement to ensure proper compliance. While the increase in scrutiny is not surprising giving the increased popularity, it is important to ensure your entity is in compliance with regulations.
At the heart of the new approach at the IRS is the concern that captive arrangements are not being properly managed. There is concern that many companies are turning to these structures because of the corporate tax planning benefits and not focusing enough on providing the corporate risk protection these entities are designed to offer. IRS regulations require that captive insurance companies provide a meaningful risk shifting and distribution benefit to the parent company. This means that the parent company must show it has transferred specific risks to the captive and provides a reasonable premium for the assumption of that risk. It also means the captive must accept risks from multiple separate entities by participating in risk pooling with unrelated businesses. To help captive entities, the IRS has provided guidance on arrangements it views as complying with these requirements, which include:
- Risk Thresholds – The risk or a parent company cannot be insured by a captive unless the captive has at least 50% of its risks insured through third parties.
- Premium Sharing – The risks of 12 sister operating companies may be insured by a captive but it requires that each insured company pay no more than 15% of the total premium.
- Unrelated Risks – There is an opportunity for unrelated risks to be insured by the captive entity. However, the IRS guidance states that risk on unrelated parties in a group captive can be insured as long as no one insured company pays less than 5% or more than 15% of premiums.
- Additional Risks – Risks of specific single member limited liability companies classified as disregarded by the parent company may not be insured by a captive since all the risk would fall onto the parent company.
The rules guiding captive insurance companies are complex. The last thing anyone wants to experience is an IRS investigation. If you have questions about your captive or to discuss risk transfer activities, we want to help.