Finding Love in All of the “Right” Places – Part 1: Deferred Compensation Opportunities within Captive Insurance Companies - Ownership within Roth IRAs and Roth 401(k)s



In my last article, I produced an overview of closely held insurance companies aka captive insurance companies and their excellent tax benefits for businesses. Separate and apart from the risk management benefits of captive insurance companies which are first and foremost represent the core business purpose of the captive insurance company. Absent this business purpose, the sponsor of a captive insurance company can “take his ball and go home”.

Relying on the legal Doctrine of the Quacking Duck, i.e. “If it looks like a Duck and quacks like a duck, it must be a Duck”, the captive insurance must look like an insurance company and operate like an insurance company in order to receive the favorable treatment of insurance regulators and tax authorities. Property and Casualty (P&C) insurance companies underwrite and insure risks pricing their policies using claims and actuarial data and pa claims.

Nevertheless and beyond the obvious risk management benefits of captive insurance companies. Captive provide extraordinary tax benefits for closely held business owners. The tax benefits are both income and wealth (estate and gift) transfer based. One aspect in this arsenal of tax attributes that is rarely focused on is the retirement planning benefits of the captive insurance arrangement.

The first installment on this topic focuses on the ownership of shares of a captive insurance company that has made the IRC Sec 831(b) election within a Roth IRA or Roth 401(k). The tax authority to accomplish this planning relies on a series of Tax Court cases, and Department of Labor (DOL) advisory opinions dealing with Interest Charge- Domestic International Sales Corporations (IC-DISC) and its predecessor, the Foreign Sales Corporation (FSC).

IRC Sec 831(b) Election

The Internal Revenue Code provides special tax treatment for small property and casualty insurers by providing for a tax election under IRC Sec 831(b). This tax election treats the first $1.2 million of annual underwriting income (premium) to receive tax-exempt treatment. The small insurer does not need to maintain reserves and is only taxed on its investment income under the regular tax rates for regular corporations.

From a tax planning perspective of the captive owner, i.e. the business owner, the tax attributes are significant. First, the tax exempt treatment for annual premium income up to $1.2 million far exceeds any qualified retirement plan limit. Secondly, the captive owner's active management control provides for much control than the prohibited transaction rules allow in the qualified retirement plan area. Dividend payments by the captive receive preferential tax treatment and qualify as qualified dividends. Ultimately, the captive owner receives long-term capital gain treatment upon the sale or liquidation of the captive versus the ordinary income treatment on pension plan distributions. Nevertheless, the primary purpose of the captive is to operate as an insurance company.

Ownership of Shares of the Captive Insurer within the Roth IRA and Roth 401k

The strategy calls for the ownership of captive shares within the taxpayer’s Roth IRA or Roth 401(k). Pursuant to the IRC Sec 831(b) election, the captive insurer is not taxable for its corporate tax purposes on its premium underwriting income up to $1.2 million in premium per year. The captive insurer is only taxed on its investment income at corporate rates. The captive is able to pay a deductible to the Roth IRA or Roth 401(k) on a tax-free basis for the benefit of the shareholder.

The history of these types of arrangements is relatively low key. Most of the action has been with IC-DISC (Interest Charge Domestic International Sales Corporations) and its predecessor the Foreign Sales Corporation. Baker McKenzie partner Neal Block is a tax litigator and an expert on IC-DISCs. He successfully litigated against the IRS in Tax Court in the last several years on this strategy.

The tax considerations are briefly outlined below. The strategy is important as small captives have exploded in popularity as a result of its marketing by financial service professionals. The tax benefits are powerful for the business owner. First, the business is able to make tax deductible premium payments to the captive. The captive insurer itself as a result of the 831(b) election will be very lightly taxed. The dividend payments to the Roth IRA or Roth 401(k) result in tax-free treatment at the Roth level. Future distributions to the shareholder will be made on a tax-free basis. In short, taxable business income is converted to tax-free income as a result of the planning structure.

Let me say once again that the tax benefits are secondary to the risk management benefits. The “tail must not wag the dog”. At the same time, it is not a crime (or tax crime) to take advantage of statutory tax benefits providing that a valid business purposes exists and the formalities of operating a captive insurer are followed.

Summary of the Tax Authority

Two cases dealing with the ownership of IC-DISC shares within an IRA or Roth IRA have been favorably decided by the U.S. Tax Court in favor of the taxpayer – (1) Hellwig v. Commissioner, T.C. Memo 2011-58; (2) Ohsman v. Commissioner, T.C. Memo 2011-98. An earlier case Swanson v. Commissioner, 106 T.C. 76 (1996) dealt with attorney’s fees in IRS litigation. The cases did not focus on the taxation of DISC shares within an IRA but did address of the Prohibited Transaction Rule in favor of the taxpayer.

In Hellwig, the Tax Court consolidated three separate cases with similar fact patterns dealing with the ownership of IC-DISC shares within a Roth IRA. The Service attempted to recharacterize the payments of IC-DISC dividends payable to the Roth IRA as distributions from the IC-DISC to the taxpayer who then made excess contributions to the Roth IRA. The Tax Court held that the IC

DISC commission payments did not represent distributions to the shareholders (taxpayer) along with excess contributions by the shareholders to their respective IRA.

Further, the Tax Court ruled that the taxpayers (shareholders) were not liable for excise taxes under IRC Sec 4973 for excess contributions or accuracy-related penalties under IRC Sec 6662(a).   IRC Sec 4973 imposes a six percent excise tax on excess contributions to an IRA or Roth IRA. The excise tax is applicable each year until the excess payments are removed from the IRA.

In Ohsman, the Tax Court ruled in a virtually identical manner for a taxpayer who owned the shares of a Foreign Sales Corporation, the predecessor of the IC-DISC, within a Roth IRA. The Tax Court again ruled favorably that the dividend payment to the Roth IRA could not be recharacterized as a distribution to the taxpayer followed by an excess contribution to the Roth IRA. The taxpayer was not liable for accuracy-related penalties or excise taxes for excess contributions to the Roth IRA.

The IRS previously argued in the Swanson case that the IC-DISC transaction within a Roth IRA that ownership of IC-DISC shares within an IRA is a Prohibited Transaction under IRC Sec 4975(c)(1)(A) and (E). IRC Sec 4975(c) (1) (A) defines a prohibited transaction as including any “sale or exchange, or leasing, of any property between a plan and a disqualified person”. IRC Sec 4975(c) (1) (E) further defines a prohibited transaction as including any “act by a disqualified person who is a fiduciary whereby he deals with the income or assets of a plan in his own interest or for his own account”.

Even though the Swanson ruling was not specifically focused on the Prohibited Transaction issue, the Tax Court ruled that it felt that the IRS’s position was unreasonable. The Tax Court determined the Prohibited Transaction argument to be unreasonable because the shares in the taxpayer’s corporation were newly issued prior to the transfer and the corporation had no share or shareholders and warded the taxpayer attorney’s fee. The Tax Court reasoned that a corporation without shares or shareholders did not fit within the definition of a disqualified person under IRC Sec 4975(e) (2) (G). 

In Hellwig the Tax Court followed the same line of reasoning regarding the issue of Prohibited Transactions used in Swanson. The Tax Court cited its ruling in Swanson:

The stock acquired in that transaction was newly issued-- prior to that point in time, Worldwide had no shares or shareholders.    A corporation without shares or shareholders does not fit within the definition of a disqualified person under section 4975(e) (2) (G). It was only after Worldwide issued its stock to IRA #1 that petitioner held a beneficial interest in Worldwide’s stock, thereby causing Worldwide to become a disqualified person under section 4975(e)(2)(G).

In an earlier Field Service Advisory (FSA 200128011), with similar facts as Swanson, the Service conceded to the Tax Court’s position in Swanson.

In light of Swanson, we conclude that a prohibited transaction did not occur under section 4975(c)(1)(A) in the original issuance of the stock of FSCA to the IRAs in this case. Similarly, we conclude that payment of dividends by

FSCA to the IRA(s) in this case is not a prohibited transaction under section 4975(c)(1)(D).

We further conclude, considering Swanson, that we should not maintain that the ownership of FSC A stock by the IRAs, together with the payment of dividends by FSCA to the IRAs, constitutes a prohibited transaction under section 4975(c)(1)(E).

In regard to the Prohibited Transaction Rule, the treatment of stock ownership by the trustee or beneficiary is viewed through the stock attribution rules of IRC 267(c)(1). Under IRC Sec 267(c)(1), stock owned, directly or indirectly, by or for a corporation, partnership, estate, or trust shall be considered as being owned proportionately by or for its shareholders, partners, or beneficiaries. However, a fiduciary (trustee of the IRA) is not treated as a “disqualified” person when acting in a fiduciary capacity and is only a “disqualified” person when acting in the interest of other parties outside of the IRA or for himself in a non-fiduciary capacity.

These rules are interpreted by the Department of Labor (DOL) and not the IRS. The DOL has ruled twice regarding this issue. The DOL ruled in DOL Adv. Op No. 97-23A and again in DOL Adv. Op No. 2003-15A, which involved pension plan ownership involving 50-100 percent of the shares of wholly owned subsidiaries were not prohibited transaction. Specifically, the DOL noted that initial and subsequent contributions and distributions would not be treated as prohibited transactions.

IRC Sec 995(g) dealing with IC-DISCs treats dividend income and any other income within the IC-DISC payable to a tax-exempt entity as unrelated business taxable income (UBTI). UBTI taxes at corporate or trust marginal tax brackets, income that would ordinarily be tax-exempt. IRC Sec 512 typically would exclude dividend income.

IRC Sec 995(g) points to IRC Sec 511(a)(2) and (b)(2) for the types of tax-exempt structures covered under the code section. The definition includes qualified retirement plans and 501(c)(3) charitable organizations. Arguably, the provisions of IRC Sec 995(g) are limited to IC-DISCs and do not apply to 831(b) electing captive insurers.

Noticeably, the provision excludes Plans covered under IRC Sec 408 (IRA) and IRC Sec 408A (Roth IRA). Therefore, the payment of dividend income by the Captive to a Roth IRA should not be characterized as UBTI to the Roth IRA or Roth 401(k).

Roth IRA Basics

A taxpayer that files jointly is able to contribute to a Roth IRA if the taxpayer’s modified adjusted gross income (AGI) does not exceed $181,000. The contribution phases out between $181,000-191,000.

The calculation of modified AGI excludes the proceeds from an IRA rollover or qualified plan. This important distinction generally speaking makes it easier for a taxpayer to position himself to do a conversion from a traditional IRA to a Roth IRA.

The primary difference between the Roth IRA and IRA or qualified plan is that the Roth IRA does not have required minimum distributions. Distributions from the Roth IRA are not subject to income taxation. However, the distribution must be a “qualified” distribution. Qualified distributions require five years of “seasoning” within the plan unless the taxpayer is at least age 59 ½.

Distributions before age 59 ½ are subject to the 10 percent early withdrawal penalty as well as normal tax treatment on the distribution (as if it were a traditional IRA). Like the IRA, exceptions to these rules exist for a distribution for a first-time homebuyer; distribution to a disabled taxpayer, or a distribution to a beneficiary on account of the taxpayer’s death.

The account balance is included in the taxpayer’s taxable estate. At death, the remaining distribution of the account is subject to the same rules as the traditional IRA. A surviving spouse as the beneficiary of the Roth IRA can treat the Roth IRA as her own. Other beneficiaries must distribute the balance over their life expectancies.

The investment guidelines for a Roth IRA are similar to the restrictions for a traditional IRA. The policyholder can expand the investment guidelines through the use of a self-directed arrangement. The prohibited transaction guidelines applicable to the traditional IRA apply to the Roth IRA as well as the tax rules on unrelated business taxable income (UBTI).

The Internal Revenue Code has a number of exceptions under IRC Sec 72(t) to the early withdrawal rules. These exceptions include provisions for distributions for medical expenses, disability and the death of the account holder. Other notable exceptions include distributions for qualified tuition expenses, distributions for a first time homebuyer and substantially equal and periodic payments.


The 831(b) electing captive has gained popularity as a planning tool. It is first and foremost an excellent risk management tool for business owners. Did I mention that it has strong tax benefits as well for the business owner? This article has outlines an additional planning wrinkle to enhance the benefits of the 831(b) captive.

Don’t forget to count your blessings today!

Topics:  401k, Captive Insurance Company, Deferred Compensation, Financial Products, IRA

Published In: Business Organization Updates, Insurance Updates, Tax Updates

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

© Gerald Nowotny, Osborne & Osborne, PA | Attorney Advertising

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