There continues to be a buzz about Section 831(b) micro captives as having multiple benefits for companies that make the election and own a captive insurance company that meets IRS requirements.
Potential customers are attracted to the idea of establishing an 831(b) captive because of the substantial potential benefits, including :
- Insurance companies with less than $1.2 million in annual premiums pay $0 income tax on insurance profits (only investment income is taxed)
- The Captive can insure risks not currently insured
- Captive profits may be distributed as tax-advantaged dividends or capital gains
- Premiums are deductible if market comparable and can be valued by an actuary
- Can potentially transfer millions to heirs tax efficiently
However, there are qualifiers and pitfalls that you should consider before you decide whether this strategy is a fit for your company:
- The company insured by the captive should have a minimum of $1.5 million in predictable pre-tax earnings. Any less pre-tax profits and you are negating the benefits and tying up cash that may be needed for other purposes.
- It is more suitable to insure lower frequency, higher severity risks as the election allows for a more tax efficient build-up of surplus to pay for the losses in the years in which they occur.
- Once you make an 831(b) election, the captive loses the ability to carry forward net operating losses. While the election works to your benefit when you make an underwriting profit, it can work against you if the captive has losses.
- The IRS may challenge and not agree with your actuarial assumptions and the reasonableness of premiums causing you to lose the benefit of tax deductibility
A word of caution: Some aggressive captive providers have proliferated recently who are ignoring common sense risk management and taxation issues and are putting their clients at risk. Historically, many good business ideas that have tax benefits have been abused and distorted by over-zealous promoters. The end result is often a complete closure of the benefit by Congress or the IRS. We hope that the few “bad advisors” in the 831(b) space do not cause the same result with this beneficial risk management and financial planning tool.
To be on the safe side, the captive should exist and be viable independent of the tax election. It should exist first and foremost for insurance reasons, not just for tax reasons. If the captive is structured in this manner and meets the qualifications to make an 831(b) election it should withstand any scrutiny from the IRS.
For more information contact:
Senior Vice President
Insurance Associates, a Marsh & McLennan Agency LLC Company