Good business owners and managers are always hunting for ways to reduce costs without impacting their companies. You may have heard of companies starting their own insurance company but not have considered it a valid option for your company because of its size. Starting an insurance company to cover business risks can be accomplished by businesses of any size through the use of the micro-captive insurance company tax elective. This primer will help you understand what a micro-captive is and the considerations that need to be made before starting one.
What Is a Captive Insurance Company?
To understand the purpose of section 831(b) micro-captives, it is first important that you understand the purpose of captive insurance, a special type of insurance company where the insurer and policyholder have a level of shared ownership. There are times when a company will need to insure a business risk that is either not covered by the policies offered by traditional insurers or the available policies are too expensive. If the company were to set aside money to cover those risks, they would lose out on the tax benefit for paying an outside insurer. The owners can circumvent this by starting a captive insurance company to hold the risk and accept premiums.
Captive insurance companies are licensed through regulators in their domicile, so they must meet all the same criteria that a regular insurance company must meet which includes a shifting of risk, diversification of risk, insuring a real risk, charging reasonable premiums for that risk, and having adequate money on hand to cover policies written.
What Is a Section 831(b) Micro-Captive Insurance Company?
Like regular insurance companies, captives perform better when there is a larger premium pool with a wider risk distribution. This presents a problem for smaller companies seeking to start captives, and this is where "micro-captives" come into play. When filing taxes, captive insurance companies have the option to use IRS Code section 831(b) to ignore the income from premiums and instead only pay taxes on their income from investments. In order to qualify for the exemption, the captive must take in less than $32.2 million in net written premiums annually for 2018. As long as the captive stays below that threshold, a smaller company can receive a substantial tax incentive to support their switch away from the commercial insurance market.
Micro-captives face additional scrutiny in the form of diversification requirements which stipulate that no single policyholder is paying over 20% of the captive's premiums or that no owner holds more than 2% ownership in the captive as compared to their ownership in the insured company.
Other than their smaller size, tax elective, and diversification requirements, micro-captives are no different from a normal captive insurance company.
Controversies with 831(b) Micro-Captive Insurance Companies
In 2015, the New York Times published a piece about the IRS investigating 831(b) micro-captives for their potential use in tax evasion scams. The report followed up on the inclusion of micro-captives in the IRS's "Dirty Dozen" tax scams earlier that year, including a glance at a lawyer who sheltered $840,00 for himself and a talk with an accountant who helped a client set up terrorism insurance for their dental office. A case settled in 2017 showed how a jewelry store owner used micro-captives charging unrealistic premiums with no claims as a tax shelter during this time. As a direct result of tax evasion schemes like these, the diversification rule was added to 831(b) while increasing the excludable taxable income up to the $3 million level.
Even with the additional requirement, abuse of the tax elective continued as predicted by the response of captive promoters to the Times piece. The IRS officially declared that micro-captives are a transaction of interest in 2016. The notice stipulates the inclusion of additional information from some 831(b) micro-captives and their material advisors. This is a step below labeling micro-captives a listed transaction, recognizing that there are many micro-captives that operate as intended to give smaller companies greater choice for insurance.
Successfully Utilizing 831(b) Micro-Captive for Your Company
Starting your own micro-captive insurance company is a feasible endeavor for any small-to-medium business. The trick is finding your way through the chaos of accounting needed to successfully launch your micro-captive and avoid failing to fulfill a requirement that could unexpectedly leave your taxable income significantly understated. R&A CPAs have the experience with captive insurance companies needed to guide you through the paperwork so you can focus on running your business with lower costs. Contact R&A today with information about your company to learn more about your options for beginning your own micro-captive.
About this Author
Charlie is a CPA as well as a Certifed Forensic Accountant with 35 years public accounting experience. He is predominately involved as an assurance partner for R&A. Charlie is also involved with tax and consulting engagements for several family business groups.