March 28th, 2017 Captive Insurance – Three Recent Developments to Watch In recent years, captive insurance companies have been attracting more and more attention in the construction industry. A number of companies have expressed interest in both the risk management advantages and potential tax benefits of forming a captive. If you are considering forming a captive insurance company, or if your contracting firm already operates one, some recent developments could have a major impact on your decision. What is a Captive Insurance Company? A captive insurance company is a legally licensed, limited-purpose property and casualty insurance company formed to insure the risks of its owners. Contractors can form captives to provide coverage against a variety of risks including professional liability, errors and omissions, general and umbrella liability, and workers’ compensation reimbursement. Many contractors use a captive to insure against risks their commercial policies exclude, or to add coverage above their commercial policies’ maximum limits. As a legitimate insurance company, the captive can directly access major reinsurance underwriters to cover these risks, without paying a commercial carrier’s commission. Another common strategy is to purchase high-deductible, low-cost coverage from a commercial insurer and then use a captive insurance company to provide so-called “first dollar” coverage for losses below the deductible. Tax Considerations In addition to risk management considerations, there are also some potential tax benefits that lead some companies to consider forming a captive. If a captive is properly structured and meets all the necessary risk-shifting and risk-distribution standards to qualify as a legitimate insurance company, the premiums it collects could be exempt from federal income tax. Instead, it would be taxed solely on its investment income. At the same time, though, those premiums are a deductible business expense to the operating company that pays them, provided certain specific conditions are met. This potential tax benefit is obviously attractive to many companies, but it also has attracted the attention of the IRS, which has targeted certain types of captives as potentially “abusive tax shelters.” Current Developments Most contractors that form a captive insurance company do so under the provisions of section 831(b) of the Internal Revenue Code. It is this section that makes it possible for a captive’s premium income to be exempt from federal income tax. This provision allows a captive to qualify as a legitimate insurance company — even if it does not meet some traditional insurance company conventions — as long as its gross premium income does not exceed $1.2 million annually and it meets certain other qualifications. But three recent developments could have a significant effect on this provision: Legislative changes — The $1.2 million income cap was established in 1986 and didn’t change for nearly 30 years. Congress raised the limit to $2.2 million starting this year, and it will be indexed to inflation from now on. This could open up the potential tax benefits to more companies. At the same time, though, Congress also added some diversification requirements that could discourage family ownership of captives. Notice 2016-66 — Last November, as part of its intensifying scrutiny, the IRS issued a notice designating certain types of 831(b) captives to be “Transactions of Interest.” As the notice is written, most captives will now have to file Form 8886, “Reportable Transaction Disclosure Statement,” which could lead to IRS audits. The deadline for this year’s filing is May 1, 2017. Pending tax court decision — The IRS has not had much success against 831(b) captives in recent U.S. Tax Court cases, but a pending decision, Avrahami v. Commissioner, could change that. This case was argued before the court in 2015 and a ruling is expected sometime this year. Many industry observers expect the court’s decision to provide more clarity into what is and is not permitted under 831(b) In addition to following these ongoing developments, it’s also important to remember an important principle: the decision to form a captive should never be made on the basis of tax considerations alone. Rather, the relevant business and risk management considerations should always be the primary factors driving the decision. For more information on Sansiveri’s Construction and Related Services Group and how we can assist your company, please contact Jason DaPonte, CPA, CIT, CCIFP at 401-752-0558.