The ever-growing field of captive insurance gives potential tax advantages to businesses, but also additional IRS scrutiny.
Here’s what a captive insurance program does. Say a doctor is paying $500,000 a year for medical malpractice insurance. If no one files a claim at year’s end, the money gets forfeited to the insurance carrier. While the doctor does receive the tax reduction for it, he’s out of pocket the half million dollars.
A captive insurance attempts to fix that problem. That same doctor forms an entity separate from his medical practice to insure the business and pays that firm $500,000. The doctor continues to get the tax deduction but now can then invest that money to generates a return. Though the IRS considers the gains taxable income, the base remains a tax free asset. Moreover, if the doctor decides to liquidate that captive insurance company, he gives himself all of the assets to use at his discretion.
As captive insurance grows in popularity, the IRS now takes a closer look at these programs. The two big red flag issues are micro captive insurance and coverage. Returning to that example of the doctor, if an individual pays the exact same premiums to an insurer with a singular policy holder, it begs the question of whether that insurance company, captive or otherwise, can cover the cost of a catastrophic claim.
In that situation, the doctor didn’t shift the risk to another company that has pooled contributions from other policy holders, but in reality kept it close hand. The IRS looks at that in kind of simplistic terms, but what is any different about making that payment to this quote, unquote insurance company? How is it any different than just moving money to a savings account? It’s not. You shouldn’t be able to get the deduction that something that does not offset the risk, and then get the money back in a future date. Those micro captive insurance companies have been under an incredible amount of scrutiny and have made in the last two years at least under the IRS’ “Dirty Dozen” tax scam list.
The second one is when the captive insurance covers implausible or unlikely insured events. Some promoters of these programs attempt to be more aggressive in this area. Using the doctor example again, nefarious captive insurance policies may cover a $2 million terrorism insurance policy, even though the likelihood of ever filing a claim for terrorism is next to nothing. The net result would be his anticipated return of that through the captive process, and that’s the second way that the IRS has been attacking these.