How a captive insurance company is structured and, therefore, how it is taxed, is based on many factors.
Factors include the company’s risk perspective, the goals of the program — building liquidity, filling a hole in a risk management program, building a war chest of insurance funds to combat long-term contingent liability — where the captive is based, its size and more. How a company ultimately structures its captive, and who it chooses to help, sets the stage for everything that follows.
“When the business plan for the captive is created, the tax impact on the financial statement plays a big role in driving its financial success,” says Andrew Seger, general counsel at Imprise Financial.
Smart Business spoke with Seger about some of the common tax structures that may apply to captive insurance programs and their implications.
What should be the initial considerations when determining the tax structure of a captive insurance program?
Tax considerations generally hinge on whether the captive is based inside or outside of the U.S — and if it’s a foreign captive, whether it’s controlled by a small group of stakeholders or not. Then it’s a matter of whether the captive is in the life insurance business or the property and casualty insurance business, and whether it qualifies as a large or small insurance company.
Most captive programs tend to be property and casualty, so how it’s taxed comes down to whether it’s considered a large or small company and where it’s located.
The tax code allows large U.S. property and casualty companies to recognize premium revenue over the life of a policy, which spreads revenue out over term of policy without spreading out expenses. On long-term policies, this may delay revenue recognition (and taxation) for several years.
Small property and casualty companies that are U.S. taxpayers can elect not to pay federal income tax on insurance income, while foreign captive insurance companies, provided they are not owned by a small group of stakeholders, may not be subject to U.S. income tax at all.
Under what circumstances can captives elect not to pay federal taxes?
Certain small property and casualty companies can elect not to pay tax to the federal government on their insurance income. There are still other income taxes to pay, but none on insurance income.
To qualify for an exemption, the small captive insurance company has to be under a designated premium limit. That amount changes every year because it’s tied to inflation — it’s $2.3 million this year, up from $2.2 million in 2017. If the captive has less than the designated premium amount and meets other check-the-box requirements designed to ensure companies aren’t abusing the structure as a tax shelter, then the captive can elect not to be taxed on its insurance profits left over after it pays claims.
Who should business owners work with to both determine the best tax structure and set it up?
The process should be managed by the company’s captive manager, which will oversee this aspect of the captive’s creation on behalf of the company.
Captive management companies rely on specialized and knowledgeable accountants to develop tax models for clients through pro forma financial statements that project the potential effects of the financial performance of the captive within the applicable tax structures.
Accountants involved in the tax setup must understand insurance taxation because it’s a specific part of the U.S. tax code. Insurance taxation structures are too complicated for generalists, so companies will want to make sure their captive manager has a solid and healthy relationship with tax accounts who are experts in this specific area of the tax code.
Companies should be wary of a captive manager that asks them to retain their own accountants to advise on the tax structure because if the captive manager and the accountant aren’t the same page, it could result in costly setbacks.
In the end, tax planning is an important part of putting a captive together, but it’s just one of many considerations for how a program is structured. ●
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