The IRS is filing an increasing number of civil and criminal cases with existing companies making it harder to receive a private letter ruling.
Jeffrey S. Freeman, J.D., LL.M
Captive insurance companies have been utilized since the 1950s by large companies. Originally only the largest companies could afford the set-up costs, mandatory capitalization levels and strict staffing requirements associated with running an insurance company. Over the years the requirements have changed and now both small and mid-sized companies are able to take advantage of captive insurance companies. They benefit by reducing their premiums, control their risk, and create income tax savings. Specific incentives have actually been developed for business and professionals to create their own captive insurance company. In 2002 the IRS started issuing private letter rulings stating if a bona fide insurance arrangement exist between related parties. The IRS looked at the company’s risk distribution and risk shifting to determine if the captive insurance company was in fact a true insurance company.
Recently there has been increased scrutiny by the IRS regarding the proper tax treatment of captive insurance companies. There has been a noticeable increase in the number of civil IRS exams and cases, but more surprising is the number of criminal investigations focusing on the insurance professionals, legal and tax professionals, and sometimes the insured.
The planning, formation and management of a captive insurance company is a complex undertaking. For years it was believed that a captive insurance company that follows the safe harbor rules established by the IRS and takes advantage of the $1.2mm annual income exclusion would easily pass IRS scrutiny and produce a Private Letter Ruling.
Times have changed and companies can no longer expect to easily receive a Private Letter Ruling. In December 2013 the IRS Chief Counsel memorandum pointed out several major areas of concerns regarding captive insurance companies seeking a Private Letter Ruling. Through intense scrutiny they are looking at if the arrangement actually did provide for risk shifting and distribution. Were insurance contracts actually covering investment or business risks? And did the insurance premiums paid constitute an arm’s length transaction? This sets the bar higher for obtaining a Private Letter Ruling by looking at the substance and not just the form of the captive insurance arrangement.
Establishing a captive insurance company can provide substantial tax and non-tax benefits, but with increased scrutiny from the IRS it may become harder for new captive insurance companies to be formed and take advantage of the financial benefits.
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