This presentation focuses on Captive Insurance Companies and their use in business, estate and asset protection planning

1. TAKE NO PRISONERS:
PITFALLS AND POSSIBILITIES WITH
CAPTIVE INSURANCE COMPANIES
September 29, 2010
J. SCOT KIRKPATRICK, ESQ. KAREN S. KURTZ, ESQ.
(404) 658-5421 (404) 863-8225
scot.kirkpatrick@chamberlainlaw.com karen.kurtz@chamberlainlaw.com

2. Introduction
With the prospect of very significant tax increases on the horizon,
the Captive Insurance Company is being touted as one of the
best solutions for business owners to the impending avalanche
of taxes Washington may unleash.
Even without the tax advantages, the captive is an excellent
business planning vehicle.
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3. What is a Captive?
• A licensed insurance company formed by a business owner
to insure the risks of related or affiliated businesses.
• A captive permits a business to manage its risks while
potentially providing substantial benefits to that related
business.
• Captives provide an opportunity to insure against liabilities
that are generally uninsurable or hard to insure
• Over 50% of the Fortune 1500 have captives
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4. Why Consider a Captive?
• Manage risks
• Premiums received by captive are invested rather than “lost”
• May issue property and/or casualty insurance coverage against
wide variety of possible liabilities
• Insure against commercially unavailable or unaffordable
liabilities
• Access to reinsurance market
• Limited tax benefits
• Potential estate planning opportunity
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5. Who is a Good Candidate for a Captive?
• Businesses with uninsured risks
• Businesses with a history of low insured losses
• Profitable Companies
• Clients willing to undertake the cost and management of the
formation and administration of the captive
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6. Types of Insurable Risks
Insured Risks Retained Risks
• Workers’ Comp • Deductibles
• General Liability • Construction Defects
• Health Insurance • Loss of Key Customer
• Auto • Loss of Key Employee
• Collision • Loss of Key Supplier
• Professional Liability • Administrative Action
• Errors & Omissions • Litigation
• Directors & Officers • Policy Exclusions
• Builder’s Risk • Contract Claims
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7. Reinsurance
Captives can purchase reinsurance to protect against risks.
• "Reinsurance" can be thought of as a means by which an
insurer transfers some or all of the risk under a policy of
insurance to another insurer or insurers.
• For example, a captive may only want to be exposed to
$500,000 per general liability claim. As a way to limit its
exposure, it could purchase reinsurance to pay 50% or all of a
claim exceeding $500,000
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8. Tax Considerations of a Captive
• Definition of “Insurance Company” – More than half of the business
during the taxable year is derived from issuing insurance or annuity
contracts or reinsuring risks. I.R.C. §§ 816(a), 831(c).
• Must be a “C” corporation for U.S. income tax purposes
– Treated as a per se corporation
• Life Insurance Company vs. Property and Casualty Insurance
Company
– Mean life reserves must not exceed 50% of total reserves to be
property and casualty insurance company
– Property and casualty insurance companies follow rules of a C
corporation with only certain exceptions
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9. Small v. Large Captives
• Large Captives
– No limitation on premiums received
– Must establish a reserve deduction actuarially
• Small Captives
– Premiums received limited to $1.2 million or less per year
– Election must be made to be treated as small captive under I.R.C.
§ 831(b) by attaching statement of election to Form 1120-PC.
• Election is not revoked unless the Service consents or upon
premiums exceeding $1.2 million in a year
– Exempt from income tax on first $1.2 million of premiums
received
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10. Taxation of Small Captives
• Deduction by operating company purchasing insurance
– Ordinary and necessary business expense under Code §
162
• Premiums up to $1.2 million exempt from income tax for
captive
– Under Code § 831(b)
• Owners of a small captive are taxed on dividends received
from company.
• Investment income of a small captive is taxed at both the
captive level and shareholder level.
• If a small captive does not make an election under Code §
831(b) it will be taxed under Code § 831(a).
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11. What is Insurance?
Insurance provided must involve fortuity or uncertainty, risk shifting
and risk distribution.
• Risk Shifting
– Actual transfer of risk from insured to the captive
– Position supported by Service until recently – Economic Family
Doctrine
– Economic Family Doctrine later rejected by Courts for Balance Sheet
Test
• Risk Distribution
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12. Economic Family Doctrine
• Risk must be transferred outside of economic family
to be true insurance – Rev. Rul. 77-316
– Parent-child captive structure and brother-sister captive
structure not permitted under this approach
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13. Parent-Child Captive Structure
Operating Company
PREMIUMS INSURANCE
POLICIES
Subsidiary
Subsidiary Subsidiary
Captive Insurance
Company A Company B
Company
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14. Brother-Sister Captive Structure
Operating Company
PREMIUMS INSURANCE
POLICIES
Subsidiary
Subsidiary Subsidiary
Captive Insurance
Company A Company B
Company
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15. Rejection of the Economic Family Doctrine
• Carnation Company v. Commissioner, 640 F.2d 1010 (9th Cir. 1981) and
Clougherty Packing Co. v. Commissioner, 84 T.C. 948 (1985)
– Relied on the Balance Sheet Test but did not explicitly reject Economic
Family Doctrine
• Humana, Inc. v. Commissioner, 881 F.2d 247 (6th Cir. 1989)
– Explicitly rejected Economic Family Doctrine
– Allowed brother-sister captive structure, but not parent-child
• Harper Group v. Commissioner, 979 F.2d 1341 (9th Cir. 1992)
– Premiums paid by BOTH parent and subsidiaries deductible if
approximately 30% of premiums from third party insureds
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16. Balance Sheet Test
• Company will be allowed to deduct premiums paid only
if there will be a net change on the company’s balance
sheet when the loss is paid
– Does not allow deductions by companies that are too closely
related
– Allows brother-sister captive structure
– Does not allow parent-child captive structure unless there are a
sufficient number of third party insureds
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17. Service Gives Up
• Rev. Rul. 2001-31
– Service stated that it would no longer raise economic
family doctrine
– Service will use case-by-case analysis to challenge risk
shifting and risk distribution
– Will carefully scrutinize capitalization and parental
guarantees
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18. Safe Harbor Rulings
• Rev. Rul. 2002-89
– 50% of premiums from unrelated businesses paid to subsidiary
captive are sufficient for risk shifting/distribution
– 10% of total premiums from unrelated business is not enough
• Rev. Rul. 2002-90
– 12 subsidiaries, with no more than 15% and no less than 5% of
total risk insured, enough for risk shifting/distribution
• Rev. Rul. 2005-40
– 12 subsidiary test satisfied if all insureds have common owner
provided that each entity was nondisregarded entity
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19. Safe Harbor Rulings
• TAM 200816029
– Limited partnerships with a common general partner will
not be treated as separate entities
– Much disputed decision
• Rev. Rul. 2009-26
– When determining risk shifting/distribution in reinsurance
contract, risks of ultimate insured must be examined
– Primary (underlying) insurance policy
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20. Risk Distribution
• Rev. Rul. 2002-91
– A distribution of risk allows an insurer to reduce the
possibility that single claim will exceed premiums received.
– The pooling of premiums is necessary to reduce the potential
that a related insured is paying for its own risks and
obtaining tax deduction.
• Unrelated business creates sufficient risk distribution
– No floor, but 2% not enough, and 30% is enough
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21. Risk Distribution Pools
• Formed for exchange of insurance business among captives to
spread risk and enhance participation in non-related business
• Combines the investments of many captives into single account
held by a reinsurance company
– Risk transferred from individual captive through quota share of
reinsurance agreement
– Contract issued between reinsurance company and each captive for
reinsurance company to retain funds in trust account for a certain
period
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22. Structure and Formation of Captives
– Insurance audit/Feasibility study
– Determine Type of Captive
– Income Tax Considerations
– Corporate Formation and Place of Domicile
– Capitalization
– Management
– Shareholders
– Underwriting/Development of Policies
– Insurance Certificate
– Bank Account
– Reporting Requirements
– Investment Restrictions
– Captive Regulatory Management
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23. Insurance Audit/Feasibility Study
• Audit existing insurance coverages
– Determine what risks should be retained and what risks
should be transferred.
– Determine if a risk should be retained, or retained to a
certain amount with reinsurance on any claims higher than
that amount.
– Audit business risk insurance coverages in relation to the
risks the business faces.
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24. Determine the Type of Captive
• This outline primarily targeted at “pure captive”
• Pure captive is most simplistic form of captive and is
common format for small captives
• Other Types of Captives
– Association Captive
– Group Captive
– Agency Captive
– Rent-a-Captive
– Protected Cell Captive
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25. Pure Captive Design
Shareholder(s)
(Same or Related Owners)
Client’s Operating
Business & Entities
Premiums paid to
Captive
Captive Insurance
Company
Insurance Policies
issued to Operating
Business and Related
Entities
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26. Income Tax Considerations
• Is a large or small captive appropriate?
• Onshore captive must obtain United States Employer
Identification Number (EIN) from Service.
• Offshore captive must determine whether Code § 953(d)
election should be made to treat captive as U.S. taxpayer
– If election made, must obtain EIN from Service
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27. Corporate Formation and Place of Domicile
– Offshore v. Onshore
• Offshore
– Caribbean nations have relaxed standards such as lower
capitalization requirements
– Sometimes not as responsive or accommodating
– Accessibility of government agencies substantially limited
• Onshore
– Some domestic jurisdictions have recently become more
accommodating to captive owners
– Larger capitalization requirements
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28. Capitalization
• To obtain an insurance license, a captive is required to have a
minimum amount of capital.
• Beware of “Thin Capitalization.”
• Capitalization requirements vary among jurisdictions.
• Onshore jurisdictions generally have higher capitalization
requirements than offshore jurisdictions.
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29. Management – Officers and Directors
• It is recommended that management company be engaged to
handle captive operations.
• The members of management company may also serve as most
of officers and directors of captive.
• Owners or representatives of the captive may consider having a
limited role in the management of the company.
• Limiting client or client representative involvement in
management and operations of offshore captive may limit
requirement to file certain tax returns (inc. state income tax
returns)
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30. Shareholders
• May be individuals, business, or trust
• Estate planning opportunities arise if a trust set up for the
business owner’s descendants captive. This concept will be
discussed in detail later in this presentation.
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31. Other Considerations
• Insurance Certificate
– Must obtain one or more insurance licenses in appropriate jurisdiction
– Consideration must be given to type of insurance captive will issue to
ensure appropriate licenses obtained
• i.e. workers’ compensation insurance or medical insurance
• Underwriting and Development of Policies
– Actuary often used to review type and amount of insurance that will be
issued to operating company
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32. Other Considerations
• Bank Account
– Separate bank account should be opened for captive
– Account may be opened in the United States regardless of whether
the captive is an onshore or offshore entity.
• Reporting Requirements
– Depending upon the jurisdiction in which a captive is organized,
there may be local reporting requirements.
• Investment Restrictions
– Restrictions exist for how premiums paid to captive may be invested.
For example, many jurisdictions require a captive to maintain
reserves equal to 30% of the premiums it writes in a year, and such
reserves may be held in cash, money market funds, or government
bonds or CDs with terms of 90 days or less.
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33. Captive Regulatory Management
• Regulatory management of captives should include:
(i) Insurance company accounting and records
(ii) Regulatory filing and reporting
(iii) Quarterly financials
(iv) Annual captive efficiency review
(v) Liaison with investment manager, tax preparer,
auditor, and regulatory body
• Captive management company can assist in processing
claims.
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34. Exit Strategies
• Creating captive is time and cost intensive, a client should
not expect to immediately pull funds out of a captive.
• Exiting a captive should only be done after determination
by experienced professionals that continuation of captive is
not in client’s best interest.
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35. Potential IRS Challenges
• Legitimate Business Reason for Forming Captive
• Payment of Excessive Premiums to Captive
• Role of Life Insurance in Captive
• Loan-Backs
• Thin Capitalization
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36. Legitimate Business Purpose
• Captive must possess a legitimate business reason to
avoid being characterized as a sham by the Service
• Legitimate Business Reasons
– To obtain coverage where insurers are unwilling to do so
– To reduce premium payments
– To control risk
– To increase cash-flow
– To gain access to reinsurance market
– To create diversification
– To balance coverage
– Tax planning (Rev. Rul. 2001-31)
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37. Excessive Premiums
• Code § 162(a) – insurance premiums paid by taxpayer are
deductible if connected directly with taxpayer’s trade or
business
– Must be ordinary and necessary business expense
• Challenges on two grounds
– Taxpayer is paying premiums that are too high for
amount of insurance he is receiving
– Taxpayer is suddenly obtaining a significantly higher and
unnecessary amount of insurance
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38. Excessive Premiums – Reliable Actuarial Method
• Gulf Oil Corp. v. Commissioner, 89 T.C. 1010 (1987)
– Premiums charged by captive and amount of insurance provided by
captive must be based on reliable actuarial estimation of risk of loss
– If premiums consistently in great excess of actual losses paid,
indicator that:
• Taxpayer could be attempting to evade taxes by taking advantage of
Code § 831(b) exclusion OR
• Company could be retaining risk and captive is not providing insurance
• Non Docketed Service Advice Review, 2002 I.R.S. N.S.A.R. 20160
– If a captive charges exactly $1.2 million in premiums, it suggests
that actuarial method was not used and captive is tax fraud
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39. Consequences of Excessive Premiums
• Premium-paying company will lose income deduction
– Most likely have to pay interest and penalties
• Captive may have taxable income
• Gift Tax Issues
– If captive is owned by business owner’s descendants or trusts
then transfer may be subject to gift tax
– If no gift tax return was filed, may be subject to failure to file
penalties also
– Client may consider filing gift tax return (Form 709) every
year a premium is paid to the captive
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40. Avoiding Excessive Premiums
• To avoid determination that premiums paid are excessive and
increase amount of deduction available, company can attempt
to find insurable risks for which third party insurance is not
commercially available or not commercially affordable
• Risk must have some degree of fortuity or uncertainty
• Getting more insurance so can justify paying higher premiums
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41. Life Insurance
• Should not be primary asset owned by captive
• Excessive amounts of life insurance inside captive can trigger
Service to challenge captive structure as attempt to deduct life
insurance premiums
• No income tax deductions for life insurance premiums paid
• Purchase must be for a significant non-tax purpose
• When life insurance is not primary asset of captive, but minority
portion of diversified investment portfolio, likelihood of
successful challenge by Service is significantly reduced
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42. Loan-Backs
• Used to invest captive funds back into operating business and
usually takes form of bond issuance (fundamentally no different
than a loan)
• Limited guidance on loan-backs and no objective standard to
determine whether will be considered bona fide indebtedness
• Often analyzed in loan-back to premiums paid ratio
– If significant portion of premiums paid are borrowed, concerns
of circular cash flow arise
• Service determined loan-back invalid where a captive loaned 97.5%
of assets to operating business – FSA 200202002 (September 28,
2001)
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43. Estate Planning Benefits of Captive
• Captive owned by trust for benefit of spouse and/or
descendants may create substantial estate planning
benefits
– Captive should not be includible in business owner’s taxable
estate and should not be subject to creditor’s claims
• Captive can be initially formed by trust or trust may
gain ownership of captive through gift or sale
– Gift or sale of any portion of a captive must be disclosed on a
Form 709 Gift Tax Return
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44. Case Study
• A high net worth client owns successful retain sales operations
(multiple companies) in the United States. The client desires to
maintain control of the family business, for now, while better
protecting his investment in the family businesses and planning for
the efficient transfer of his business and wealth to future generations
of family members.
• Client creates offshore captive insurance company, taxable as U.S.
corporation by making a Code § 953(d) election.
– Provides critical and cost effective business insurance coverage to the
client’s principal U.S. businesses
– Captive is owned by a separate dynasty trust created by client for
benefit of his spouse and descendants
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45. Formation of Captive Insurance Company
Irrevocable
“Defective” Grantor
Trust Captive Insurance Company
Details
100% Shareholder • Corporation formed in offshore
jurisdiction.
• Taxed as a U.S. Corporation
• Insures affiliates.
• Formed to insure key men, litigation
expenses, business losses, etc.
Captive Insurance
Company
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46. Case Study
• As insurance premiums paid by client’s business to Captive,
businesses benefit
– Enhanced liability protection from boarder insurance coverage
– Reduced insurance costs for certain types of coverage
– Significant ancillary tax benefits
– Captive can grow and accumulate substantial wealth if premium
revenues exceed claims and expenses paid over time
– Wealth accumulation will inure to benefit of client’s spouse and
descendants since captive is wholly owned by the trust created
for their benefit
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47. Premiums Paid to Captive Insurance Company
Irrevocable “Defective”
Grantor Trust
$1.2 Million in 100% Shareholder
premiums paid to
Insurance Company
($1.2 Million
Affiliates Reserve
Deduction)
Captive Insurance
Company
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48. Case Study
• The $1.2 million in premiums is paid to the captive year after
year. After a few years of premiums, we can assume that the
captive has $5.0 million in assets.
• To facilitate efficient transfer of business interests to
descendants, client creates dynasty irrevocable “defective”
grantor trust for benefit of spouse and descendants,
recapitalizes his companies by issuing voting and nonvoting
common stock and then gives and sells nonvoting common
stock to trust in exchange for cash and promissory notes.
Importantly, the value of the stock sold should be reduced
since the premiums reduce the net operating income of the
business.
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49. B usiness Structure Follow ing R ecapitalization
Taxpayer
220 V 970 V
21,780 N V 96,030 N V
Taxpayer's
Children
2 V 20 V
198 N V 1,980 N V
M y C o., Inc. M y O ther C orp.
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50. Tax p a yer’s G ift an d S ale o f N o n voting S tock to Tru st I
G ift and S ale o f 11 ,100
N V Sha res o f M y C o ., Inc.
P ro m isso ry N o te fo r M y
C o ., Inc . S hare s
Ta xpayer
Taxpayer Irre voca ble Trust I
P rom isso ry N o te fo r M y
O th er C orp. Shares
G ift and Sale o f 49,500 N V
S hares of M y O ther C o rp.
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51. Case Study
• By engaging in these preliminary transactions, client ensured
that future growth of family businesses will inure to primary
benefit of his descendants, but client maintains current control
of businesses through retention of voting common stock.
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52. C u rre n t B u sin e ss S tructu re
T a xp a ye r
220 V 970 V
4 6 ,53 0 N V
1 0 ,68 0 N V
T a x p a ye r's
C h ild r e n
2 V 20 V
198 NV 1 ,9 80 N V
T a x p a ye r
Irre vo c a b le T ru s t I
M y C o ., In c. 1 1 ,10 0 N V 4 9 ,50 0 N V M y O th e r C o rp .
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53. Case Study
• Client has enhanced business and estate planning, efficiently
transferred wealth during lifetime to his family, maintained
control of and better protected his businesses, saved income
taxes and facilitated growth of new business by making
insurance premium payments to a company that is already
owned, effectively, by the next generation
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54. Conclusion
• Clients should enter into the captive insurance company realm
with their “eyes wide open”
• Professionals should be utilized in the creation and maintenance
of a captive insurance company to ensure that Internal Revenue
Service requirements are met
• When done properly, a captive insurance company can be an
invaluable planning tool for many clients
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55. Disclaimers
• The information contained in this presentation is for illustration purposes
only and not intended to be formal tax or legal advice.
• The rules imposed by IRS Circular 230 require us to state that, unless it is
expressly stated, any opinions expressed with respect to a significant tax
issue are not intended or written by the practitioner to be used, and
cannot be used by the recipient, for the purpose of avoiding penalties that
may be imposed on the recipient or any other person who may examine
this correspondence in connection with a Federal tax matter.
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