SlideShare utilise les cookies pour améliorer les fonctionnalités et les performances, et également pour vous montrer des publicités pertinentes. Si vous continuez à naviguer sur ce site, vous acceptez l’utilisation de cookies. Consultez nos Conditions d’utilisation et notre Politique de confidentialité.
SlideShare utilise les cookies pour améliorer les fonctionnalités et les performances, et également pour vous montrer des publicités pertinentes. Si vous continuez à naviguer sur ce site, vous acceptez l’utilisation de cookies. Consultez notre Politique de confidentialité et nos Conditions d’utilisation pour en savoir plus.
The Abernethy Law Firm, P.C.
Matthew E. Abernethy, Esq.
Matthew E. Abernethy received his BSBA in Finance from Auburn University in 2007. Mr. Abernethy
earned his Juris Doctorate from Georgia State University School of Law in 2011. He particularly excelled
in the area of tax during law school, receiving the prestigious State Bar of Georgia Tax Scholar Award in
2010-2011. He now practices in the areas of Tax Planning, Estate Planning, Captive Insurance,
Conservation Easements, Asset Protection, Bankruptcy, Tax Dispute Resolution, Banking/Finance, and
Family Business Succession Planning. Mr. Abernethy mainly serves small businesses and high net
In 2011 and 2012, under the mentoring of Professor Beckett G. Cantley, Mr. Abernethy assisted in the
composition and editing of a series of articles on Captive Insurance and Conservation Easements.
The University of Richmond Journal of Global Law and Business published an article in which Mr.
Abernethy assisted in the research, editing, and composition, entitled “The Forgotten Taxation
Landmine: Application of the Accumulated Earnings Tax to IRC § 831(b) Captive Insurance
Companies”. See 11 Rich. J. Global L. & Bus. 159 (2012).
The University of California-Davis Business Law Journal also published an article in which Mr.
Abernethy assisted in the research, editing, and composition, entitled “Repeat as Necessary:
Historical IRS Policy Weapons to Combat Conduit Captive Insurance Company Deductible
Purchases of Life Insurance”. See 13 U.C. Davis Bus. L. J. 1 (2012).
The University of California-Hastings West-Northwest Journal of Environmental Law and Policy
published an article in which Mr. Abernethy assisted in the research, editing, and composition,
entitled “Environmental Preservation and the Fifth Amendment: The Use and Limits of
Conservation Easements by Regulatory Taking and Eminent Domain”. See 20 Hastings W.-N.W. J.
Envtl. L. & Pol’y 2015 (2014).
Generally speaking, a Captive Insurance Company
(“Captive” or “CIC”) is formalized self-insurance. A
Captive is a C Corporation licensed to practice the
business of insurance in a domicile that has statutory
authority to license and regulate Captives. Unlike
commercial insurers, captives do not generally insure
the general public. Instead, Captives will generally only
cover the customized risks of captive owners and
Captives have been very popular with Fortune 500
companies since the 1970s. Relatively recent legislation,
most notably IRC § 831(b), has popularized the use of
micro captives to level the risk management playing
field for small businesses.
Lowers Insurance Costs
Commercial insurance companies charge a premium for
marketing and sales. Most commercial insurers spend
between 6-8% of premiums collected on marketing and
sales. A captive insurance company, because it
primarily insures only related risks, faces very little
costs in the way of marketing and sales. These savings
are passed on to you, the parent business or family of
business, under a Captive strategy.
Since a Captive is a licensed insurance company, a
Captive can directly access the reinsurance marketplace.
Essentially, the reinsurance marketplace is to the
commercial marketplace as wholesale is to retail.
Expands Actual Insurance Coverage
Most commercial insurance policies contain innumerable exclusions and
exceptions, creating large gaps in coverage. Also, some needed coverage is
largely commercially uninsurable (i.e. cyber terrorism, product recall).
Therefore, many businesses are already unintentionally self-insuring for a lot
of these risks (in a tax-disadvantaged manner, as well). CICs may hand-craft
policies for the particular situations facing its parent businesses, largely
avoiding these unintentional gaps in coverage (and doing so in a tax-
advantaged manner—discussed in greater detail in the following slides).
Most commercial insurance policies also generally require the payment of a
substantial deductible. CICs may avoid the requirement of deductibles.
Furthermore, where some commercial insurance coverage is retained, CICs
may be used to supplement coverage by insuring against the risk that you
will have to pay a deductible on a commercial policy claim.
The parent business or family of businesses employ the captive managers at
will. Therefore, CIC owners have indirect control over the claims handling
Ensures Continuity of Insurance Coverage
Certain commercial insurance sub-industries, particularly
trucking commercial insurers, are notorious for untimely
coverage cancellations that can prevent the lawful
operation of a truck or even an entire fleet. Temporary
loss of trucking coverage can create disastrous supply-
chain consequences, potentially bringing your business to
its proverbial knees. The use of a CIC, even if only to front
and then re-insure trucking risks, can help ensure
continuity of coverage where there exists an indemnity
and reinsurance agreement that only places the credit risk
on the reinsure—there would exist no practical reason to
Retains Underwriting Income
When your insurance claims
experience beats actuarial
projections, your insurer receives
more premium than it pays in
income. If you have strong internal
controls and a spotless claims
history, why would you want a
third party to retain underwriting
income that could remain in your
business coffers? A CIC strategy
allows for the retention of such
underwriting income within the
family of businesses.
Increases Asset Portfolio Liquidity
A Captive must maintain sufficient liquidity to pay claims
as they are projected to occur, in order to be considered
an insurance company for federal income tax purposes.
Therefore, a Captive will generally have to maintain a
large amount of its reserves in cash or relatively liquid,
risk-free assets (such as T-bills or AAA rated, blue-chip
publicly-traded securities. These holdings will increase
the overall liquidity of the business family’s portfolio of
assets (and on a tax-advantaged basis—discussed in
greater detail in the following slides). Increasing asset
portfolio liquidity is important for accessing new and
cheaper forms of financing, fostering growth and
expansion of the business family.
Ability to Control Investment Decisions for CIC Reserves
Since CIC owners control the compensation of captive managers, the
CIC owners may have significant influence on the investment
decisions of CIC reserves.
However, while captive managers will generally accommodate
reasonable investment choices, captive managers must maintain the
CIC’s status as an insurance company, for federal income tax
purposes. Therefore, captive managers must make investment
decisions as would a reasonable insurance company (i.e. must
maintain sufficient liquidity to pay claims as they are actuarially
projected to come due).
It should also be noted that some investments, such as certain life
insurance arrangements within a CIC (e.g. non-key man life, any split
dollar arrangements, etc.), should be avoided due to concern over the
application of various judicial tax doctrines that would destroy the
federal income tax benefits discussed in greater detail in the coming
Income Tax Benefits
So long as the CIC is considered an insurance company and the policies written are
considered insurance, for federal income tax purposes, ordinary and necessary premiums
paid would be currently deductible to the paying parent businesses under IRC §§ 162 and
482. This is also true of payments to commercial insurers; however, true self insurance
(other than as formalized with a Captive) is not currently deductible—it would only be
deductible as a claim arises.
IRC § 831(b) provides that a micro captive (that qualifies with and makes an election
under such section) may exclude up to $1.2 million of premium, annually, from income
for federal income tax purposes. Therefore, so long as a CIC does not receive more than
$1.2 million in premium per year, it does not pay federal income tax on
A captive must pay federal income tax on its investment income (at its applicable C
corporation tax rates); however, investment decisions may be made to defer, minimize,
and/or avoid the recognition of investment income altogether (e.g. municipal bonds, real
estate, certain whole life insurance, equities). Once again, it must be noted that the
investment choices of a CIC are limited to those that would be made by a reasonable,
similarly-situated commercial insurance company (i.e. the timing of returns must
maintain sufficient liquidity to pay projected claims).
Income Tax Benefits (Continued)
When you consider all of these federal income tax benefits in
combination (deductibility of premiums, non-recognition of
underwriting income, and avoidance of investment income
through limiting investment to municipal bonds), it is possible
that no federal income tax will be paid on earnings until such
earnings are distributed to CIC shareholder-beneficiaries.
Even then, upon distribution of earnings to CIC shareholder-
beneficiaries (e.g. owners, family, key executives, etc.), such a
distribution would likely be taxed as a capital gain where such
shareholder-beneficiary has met the requisite holding period.
An appropriate CIC strategy may effectively take what would
otherwise be considered ordinary income of the parent entity,
defer the recognition of such income until a subsequent CIC
distribution, use the pre-tax dollars to invest in tax-advantaged
investment vehicles, and ultimately recharacterize the income
as capital in nature!
Improves Cash Flow and
The parent business or family of
businesses will greatly improve cash
flow and profitability by: 1) lowering
the cost of insurance; 2) limiting
exclusions, exceptions, and
deductibles; 3) retaining
underwriting income; 4) investing
such underwriting income; and 5)
deferring the recognition of and
recharacterizing business income.
As previously stated, captive insurance is essentially
formalized self-insurance that allows for tax-advantaged re-
investment. If, instead of using CIC reserve accumulations to
self-insure, you were to self-insure “on-the-books” of the
operating business entity, these funds would clearly be subject
to the general liabilities of the operating business (and
potentially even its partners). A CIC, as a separate and distinct
C Corporation, would only be subjected to the liabilities of the
operating businesses and/or the CIC shareholder-owners
where the obligee can successfully “pierce the corporate veil”
to get to the CIC reserves. The requirement of “piercing the
corporate veil” adds extra layers of expense and uncertainty in
pursuing claims against the CIC reserves.
Estate Planning and Business Succession Planning Benefits
Captives are excellent estate and business succession planning tools where family members
and/or business successors of the original owners of the operating businesses are named as
shareholder-beneficiaries of the CIC.
Because reasonable, arms-length premiums are paid in the ordinary and necessary course of
business, by a parent to a Captive, such transfers (which may result in reserve accumulation)
are not subject to the estate and gift taxation regimes. If the parent entities pay the maximum
$1.2 million in premiums and experience no claims in a given year, there is a possibility that
the full $1.2 million will ultimately be transferred to the heirs, free of any estate or gift tax
(that’s significantly more than the $14,000 (or $28,000 for couples) per heir allowed to
otherwise be transferred free of estate and gift taxes under current law!). However,
expectations must be tempered because it is very difficult to continually beat actuarial
projections, absent significant claims control procedures and internal controls. Also, it should
be noted that any heir who has not yet reached the age of 21 should have his or her interest
as a shareholder-beneficiary of the CIC held in dynasty trust with a generation-skipping
transfer tax provision (so as to avoid the application of family attribution rules).
The universal difficulties involved in business succession planning are transitioning voting
power/operation control and funding an eventual buyout. A CIC provides a non-operational
entity in which a departing owner-executive can maintain control over profits while allowing
a younger family member or business successor to hold the ownership of and executive
positions in the operating business. Furthermore, a CIC may be used to actively fund and
implement the buyout.
Commercial General Liability Coverage
Commercial Liability Umbrella Coverage
Commercial Policy Deductibles Coverage
Commercial Policy Exclusions & Exceptions
Commercial Property & Casualty Coverage
Commercial Auto/Carrier Coverage
GAP Auto Coverage
Health Insurance Coverage
Disability Insurance Coverage
Worker’s Compensation Coverage
Employer Liability Coverage
Malpractice Liability Coverage
Professional Liability Coverage
Crime & Fiduciary Coverage
Director & Officer Errors and Omissions
Negligence/Reckless Occurrence Coverage
Employee Intentional Acts Coverage
Breach of Contract Coverage
Bad Debt and Collections Coverage
Business Disruption Coverage
Supply-Chain Disruption Coverage
Inventory Risks Coverage
Loss of Key Man Coverage
Loss of Key Contract Coverage
Loss of Key Customer Coverage
Intellectual Property Risks Coverage
Litigation Risks Coverage
Products Liability Coverage
Currency, Interest Rate and Other
Economic Risks Coverage
Business Continuity, Succession and
Transfer Financing Coverage
Loss of Goodwill Coverage
Natural Disaster Coverage
IT & Information Security Risks Coverage
Expanded Lines of Coverage:
Sounds too good to be true, right?! Well, the benefits section of this
presentation is over. Now it’s time to talk about why every small business isn’t
already using Captive Insurance. Captive Insurance is expensive to implement,
requiring immense upfront costs and a team of professionals. Realistically, a
Micro Captive will need the services of: 1) a Captive Manager; 2) an Actuary; 3)
a CPA; 4) a federal income and estate tax advisor; and 5) a Reinsurance Broker.
A simple, pure Micro Captive can generally be formed and operated for
between 6-10% of premiums.* More typical group and fronted Micro Captive
arrangements; however, have formation and operating expenses that range
between 12-28% of premiums. Of course these operating expenses do not reflect
claims losses, simply Captive overhead. These high up-front and continuing
overhead expenses mean that Captive Insurance is not economically practical
for all small businesses. Furthermore, the risk of facing a catastrophic claim in
excess of premiums paid is simply too much for some conservative investors to
*The all-in fees for the services required for a simple, pure IRC § 831(b) Micro Captive typically run from between $50,000 & $100,000
for formation and between $40,000 & $80,000 for annual maintenance & filings (depending on the level of premiums and quality of
counsel). Some so-called “Captive Cowboys” often attempt to undercut these prices with cookie-cutter Captive mills; however,
Captives require much expertise and individual attention. Failing to choose appropriate counsel can have disastrous consequences.
Companies with at least $250,000, but ideally $1MM+
in annual profits.
Profitable enterprise families of businesses involving 12
or more separate entities.
Companies who are currently severely underinsured
(whether it be unavailability or unaffordability of
commercial insurance, high deductibles, and/or
innumerable policy exclusions & exceptions).
Companies with an established low insurance claims
payment history and excellent internal controls.
Companies looking to grow their operations and
accumulate wealth in a comprehensive manner.
Companies with an appetite for risk and an expectation
of long-term investment.
(1) Hire an actuary and a federal income and estate tax advisor.
(2) Conduct a Feasibility Study to determine what risk the Micro Captive should consider insuring.
(3) Determine the appropriate type of Micro Captive (pure, group, cell, fronted, etc.).
(4) Determine who will be the shareholders of the Micro Captive—businesses, trusts, and/or individuals.
(5) Determine the appropriate jurisdiction for the Micro Captive. Choice of jurisdiction can greatly affect capitalization,
reporting, and regulatory requirements.
(6) Hire a Captive Management Company (or “Captive Manager”) that is licensed in such jurisdiction to handle the day-to-
day insurance operations of the Micro Captive (sometimes this step will occur sooner if the Captive Manager is involved in
the Feasibility Study—some Captive Managers will conduct a Feasibility Study in-house for free if you sign an agreement
guaranteeing them your business if/when you pursue a Micro Captive program).
(7) Incorporate a C Corporation in the appropriate jurisdiction, publish notice of incorporation, draft bylaws, hold annual
shareholder and director meetings (complete with minutes), obtain a federal EIN, obtain a state taxpayer ID, and open a
corporate bank account.
(8) Make an IRC § 831(b) election to be taxed as a small Micro Captive insurance company. The IRC § 831(b) election is made
by attaching a statement to the Captive’s tax return. An IRC § 831(b) election will apply to an insurance company as long
as the company’s premiums do not exceed $1.2 million or until the election is revoked with the consent of the IRS. The IRS
generally does not consent to the revocation of an election unless a material change in circumstances is shown.
(9) For offshore Micro Captives, consider whether an IRC § 953(d) election should be made to treat the CIC as a U.S. taxpayer.
(10) Arrange for adequate capitalization prior to applying for an insurance license.
(11) Conduct underwriting and develop individual policies with the assistance of the Captive Manager, Actuary, and federal
income and estate tax advisor.
(12) Obtain one or more insurance licenses, as is appropriate for the relevant Micro Captive jurisdiction. You may be required
to have a business plan, a budget, and the audited proforma financial statements of the parent(s) to obtain a license. May
also be required to file an anti-money laundering affidavit.
(13) Issuing purchase orders for captive lines of coverage.
(14) Be sure to satisfy local reporting requirements, including the payment of any relevant state or local premium or self-
(15) Establish a uniform claims handling procedure.
(16) Hire a CPA to handle the accounting work and implement the accounting system. A Captive operating as a small property
and casualty company must file a Form 1120-PC income tax return and report its income on Schedule B.
(17) Meet regularly with your captive manager, federal income & estate tax advisor, actuary, and CPA team to ensure that the
Captive maintains regulatory compliance and obtains the benefits discussed herein.
Lack of Risk Shifting and/or Risk Distribution
Accumulated Earnings Tax (“AET”)
Lack of Economic Substance
Investment Portfolio Illiquidity
In order to obtain the tax benefits described herein, a Captive must be considered an “insurance company” and the
policies written by the Captive must be considered “insurance”, for federal income tax purposes. The Internal Revenue
Code (“IRC”) does not provide a definition for the term “insurance.” However, in Helvering v. Le Gierse,* the U.S. Supreme
Court set forth the standard that true insurance must have risk shifting and risk distribution. Risk shifting is the actual
transfer of the risk from the insured to the Captive insurance company. Risk distribution is the Captive insurance
company’s exposure to adequate third-party risk to obtain the risk-pooling effect had by most traditional insurance
companies. After the IRS abandoned the “economic family doctrine”, IRS safe harbor provisions have helped clarify the
areas of risk shifting and risk distribution. These guidelines and safe harbors, if followed, should protect a Captive in the
event of an IRS challenge.
One safe harbor provision, Rev. Rul. 2002-90, provides that 12 non-disregarded subsidiaries, with each subsidiary having
no more than 15% and no less than 5% of the total risk insured, which are paying premiums to an affiliated Captive
insurance company was enough for appropriate risk distribution and risk shifting to have occurred.
The other major safe harbor provision provides that sufficient risk distribution and risk shifting will have occurred where
a Captive takes on at least 30% of unrelated insurance risk (meaning no family, no common owners). To acquire 30% of
unrelated premium, a Captive may participate in a “risk distribution pool”. A risk distribution pool is formed for the
exchange of insurance business among Captives to spread risk and enhance participation in a non-related business. A risk
distribution pool combines the investments of many Captives into a single account that is held by a reinsurance company.
Risk is transferred from each individual Captive through a quota share reinsurance agreement whereby the reinsurer
accepts a stated percentage of each and every risk within a defined category of business on a pro rata basis. This quota
share agreement provides a fixed and certain risk for all Captives that bought coverage from the reinsurance company. A
contract is issued between the reinsurance company and each Captive for the reinsurance company to retain funds in its
trust account for a certain period.
In Rev. Rul. 2009-26, the IRS stated that when determining risk distribution and risk shifting in a reinsurance contract, the
risks of the ultimate insured must be examined. This contract would be the primary (underlying) insurance policy.
*Essentially, Helvering v. Le Gierse held that true insurance does not exist where the insured, absent tax benefits, remains in the same economic position—
where there exists no degree of fortuity or uncertainty.
Under IRC § 162(a) and Treas. Reg. § 1.162-1(a), insurance premiums paid by a taxpayer are deductible if they are connected directly
with the taxpayer’s trade or business. However, the insurance premiums must be an ordinary and necessary business expense in
order to be deductible. Therefore, a business must be able to prove that any premiums paid to a Captive are an ordinary and
necessary business expense in the event of a challenge by the IRS. The IRS has challenged premiums as being “excessive” and not an
ordinary and necessary business expense on two grounds. First, taxpayers that pay overly high premiums for the insurance they are
receiving will not be able to deduct those premiums. Second, taxpayers that are suddenly obtaining a significantly higher and
unnecessary level of insurance will not be able to deduct those premiums.
A reliable actuarial method is required to avoid a challenge for excessive premiums. In Gulf Oil Corp., the Tax Court decided that
insurance premiums charged by a CIC and the amount of insurance provided by the CIC must be based on a reliable actuarial
estimation of the risk of loss. Having premiums that are consistently in great excess of the actual losses paid is an indicator that one
of two things is occurring. First, the taxpayer could be attempting to evade taxes by taking advantage of the Section 831(b)
exclusion. Second, the company could, in reality, be retaining the risk, and the IRS might conclude that the Captive was not actually
providing insurance. As a practical matter, the Captive should actually pay claims to its insureds every year. A red flag for the IRS
has also been when the Captive is charging exactly $1.2 million in premiums. Under IRC § 831(b), a small insurance company can
deduct up to $1.2 million dollars in insurance premiums. If a Captive is charging exactly that amount, it may suggest to the IRS that
an actuarial method was not used and that the Captive is a tax sham.
If the IRS or a court determines that the insurance premiums being charged by the Captive are excessive, undesirable consequences
follow. First, the premium-paying company loses the income tax deduction and, most likely, also has to pay interest and penalties.
Second, the Captive may have taxable income. There also could be gift tax issues with the transfer for Captive business structures
where the Captive is owned by the business owner’s descendants or trusts. If the taxpayer-owner did not file a gift tax return, the
taxpayer may be subjected to failure to file penalties, as well as other penalties. For this reason, the client may consider filing a gift
tax return every year a premium is paid to a Captive. By filing the Form 709 and making proper disclosure, the gift tax statute of
limitations will begin to run, and, thus, the transfer tax risk should be reduced.
To avoid a determination that the premium payments are excessive and at the same time increase the deduction available, the
company can attempt to find insurable risks for which third-party insurance is not commercially available or not commercially
affordable. An insurable risk must have some degree of fortuity or uncertainty. Traditional business or investment risks do not have
the necessary degree of fortuity and thus, are not insurable. By obtaining insurance on risks that the company would not normally
be able to insure through a third-party insurer, the company will potentially be able to pay higher premiums without the insurance
or the premiums becoming excessive. This may result in the justification for a higher income tax deduction under IRC § 162(a).
The Accumulated Earnings Tax is a penalty tax “designed to prevent corporations from
unreasonably retaining after-tax” earnings and profits “in lieu of paying current dividends to
shareholders,” where such income would be taxed for a second time as ordinary income at
applicable shareholder tax rates. If a CIC is liable for the AET under IRC § 532(a), a fifteen percent
tax is imposed for each taxable year on the corporation’s accumulated taxable income. The AET is
imposed in addition to any other taxes imposed under the IRC.
A CIC is only penalized under the AET if it retains earnings and profits in excess of reasonable
business needs with the intent to avoid shareholder taxes. The fact that a CIC accumulated
earnings and profits beyond the reasonable needs of the business is “determinative of the
purpose to avoid income tax with respect to its shareholders, unless the corporation proves the
contrary by a preponderance of the evidence.”
“The reasonable business needs of a corporation include not only its current needs, but also its
‘reasonably anticipated‘ future business needs as well.” “Under the Treasury Regulation, the
needs of the business are determined at the close of the taxable year in issue.” The CIC should
make a practice of documenting its current and anticipated future business needs at the end of
each cycle, but will not be required to show such formal planning if a definite and feasible plan
can be otherwise proven. The end of the business cycle is when “management presumably
decides how much cash is needed for normal business operations, and for future adverse risks
and contingencies.” The excess should “be distributed to shareholders as dividends, to be taxed as
In 2010, Congress codified the “doctrine of substance over
form” and the “step transaction doctrine” into IRC § 7701(o)
(the so-called codified Economic Substance Doctrine or
“ESD”). IRC § 7701(o) provides that a transaction shall be
found to have economic substance only if: (1) the transaction
changes in a meaningful way (apart from federal income tax
effects) the taxpayer’s economic position and (2) the taxpayer
has a substantial business purpose (apart from federal
income tax effects) for entering into the transaction. New
strict liability penalties starting at 20% apply if a transaction
fails to meet the new two-pronged codified Economic
Substance Doctrine. When designing and operating a
Captive, extra attention is needed to document all non-tax
economic and business purposes and benefits.
A Captive’s lending money back to an operating business that the Captive
insures is often referred to as a “loan-back”. A loan-back is used to invest Captive
funds in the operating business. The arrangement usually takes the form of a
bond issuance but is fundamentally no different than a loan. The IRS carefully
scrutinizes loan-backs and has contemplated issuing regulations relating to them.
To date, the IRS has issued limited guidance on loan-backs and has not provided
an objective standard to determine whether a loan-back will be considered a bona
fide debt and thus be found to have non-tax economic substance.
Loan-backs are often analyzed in terms of the loan-back to premiums-paid ratio. If
a significant portion of the premiums paid are borrowed, concerns of a circular
cash flow arise. In a situation where a Captive loaned 97.5% of its assets to the
operating business, the IRS determined the loan-back to be invalid and stated by
“loaning out substantially all of its assets to an affiliate, Insurance Subsidiary
resembles an incorporated pocket-book, representing a reserve for self-
insurance....” Therefore, a loan-back must be issued with great caution, must be a
bona fide debt, and should not represent a significant portion of the Captive’s
assets or premiums paid.
Investment Portfolio Illiquidity
Where a Captive is undercapitalized, involves risks substantially
covered through parental guarantees, or fails to maintain sufficient
liquidity to pay claims as they are actuarially projected to come due,
the arrangement may be challenged on economic substance grounds.
The theory is generally that the insurance is a sham transaction,
lacking true business purpose. Above all, premiums must be
actuarially correct and the Captive must be maintained in a manner
which permits it to pay claims as they are actuarially projected to
come due. Therefore, a Captive must primarily maintain its
investment reserves in short-term, fairly liquid assets (cash, T-bills,
short-term CDs, publicly traded securities, precious metals, etc.).
Limited long-term, riskier investments are allowed where such
investments are specifically designed to meet long-term liabilities (for
example, a partnership buy-out reserve).
Since the investment income of a Captive must be taxed as C corporation income, investment
vehicles that are not subject to current income tax are attractive assets for Captives to hold. In that
respect, permanent life insurance policies would seem an ideal asset for a Captive to consider
owning because increases in cash value are not subject to current income taxation. On the other
hand, IRC § 264 states that life insurance premiums cannot be deducted either directly or indirectly.
Therefore, when a Captive owns life insurance, the IRS could conceivably attempt to collapse the
business’ payment of premiums to the Captive and the Captive’s payment of premiums to the life
insurance company, deeming them to be a single payment of premiums directly to the life insurance
company—a non-deductible transaction that cannot be made deductible via a conduit entity. Such
classification would result in a determination that any income tax deductions taken for premiums
paid to the Captive were improper. Because there is no authority on this issue, prudence and
common sense are advisable to reduce any IRS risk. For instance, if life insurance is being
contemplated as an investment for a Captive, the client should apply for it only after the Captive has
been formed. Also, its purchase should be for a significant nontax purpose. When life insurance is
not a primary asset of a Captive, but a minority portion of a diversified investment portfolio, the
likelihood of a successful challenge by the IRS under IRC § 264 should be significantly reduced.
Certain key-man life insurance policies, the premiums from which are otherwise allowed as
deductible business expenses outside of the context of Captives, would not be prohibited
investments for Captives.
The core components of a comprehensive feasibility study include:
Identifying your organization's risk management goals and concerns
Assessing current insurance coverage, gaps and retention
Reviewing historical loss data
Assessing the types of insurance coverages suitable for a captive
Estimating costs of new captive coverages
Estimating captive coverage losses
Assessing suitable domiciles for your captive
Estimating the cost of forming a captive
Estimating annual operating expenses of the captive
Determining the capital and surplus requirements for the captive
Summarizing the cost-benefit analysis
Preparing and explaining the financial performance projections for both expected and
adverse loss scenarios
Explaining the tax implications, uncertainties, assumptions and elections
Explaining proposed coverage lines, limits, rates and policy type in some detail
Addressing reinsurance and pooling aspects and requirements if applicable
Documenting the business purposes and expected economic benefits
Advising as to investment objectives and options of captive
The Abernethy Law Firm, P.C.
Matthew E. Abernethy, Esq.