Captive Insurance: Feds Promote Tax Benefits, but Pay Attention to the Details

by Baker Donelson

Recent IRS rulings and a U.S. Tax Court decision continue to lay a solid foundation for captive insurance companies. However, the tax requirements must be strictly followed. Below we provide an update to assist captives in achieving their tax objectives.

A captive insurance company (or "captive") is an insurance company formed under the laws of and regulated by a state or foreign jurisdiction by a business to insure (or reinsure) the risks of that business or of related or affiliated entities. A captive can convert non-tax deductible self-insured risk into tax deductible insurance premiums while satisfying a variety of business purposes, including augmenting existing commercial coverage, providing access to the reinsurance market, and providing insurance for risks where commercial coverage costs are economically unattractive.

General guidance. The captive must be an "insurance company" and issue "insurance," as defined for federal income tax purposes. In addition, the captive needs to be adequately capitalized, and premiums must be actuarially determined and not excessive. The captive must also be operated in a commercially reasonable manner and satisfy legitimate, non-tax business purposes. In addition, it must provide coverage for insurable risks.

Defining "insurance company." For tax purposes, qualifying as an "insurance company" generally means that more than half of the captive's business must be issuing insurance or annuity contracts or reinsuring risks.

An example of this can be seen in Revenue Ruling 2014-15 (May 9, 2014), in which the taxpayer maintained a single-employer voluntary employees' beneficiary association, or "VEBA," to provide health benefits coverage to retired employees and their dependents. The VEBA secured accident and health coverage from an independent life insurance company (IC). To reduce the cost of the premiums, the taxpayer formed a subsidiary captive insurance company which issued a contract of reinsurance to IC. Because the reinsurance contract was the captive's sole business and only reinsurance contract, the captive qualified as an "insurance company" for tax purposes.

Defining "insurance." For a captive's insurance or reinsurance contracts to qualify as "insurance" for tax purposes, there must be "risk shifting" (i.e., the risk of an economic loss must be transferred from the insured to the captive) and "risk distribution" or spreading the risk of loss among numerous policyholders.

An example of this can be seen in the same Revenue Ruling as above. Although the reinsured risks were insured by the VEBA, they were risks of loss of the retired employees and their dependents. Thus, the risks that were shifted to the captive were not those of the taxpayer or the VEBA, but of the retirees. Likewise, there was risk distribution because the risks were those of a large number of retirees and their dependents.

Another example is found in Letter Ruling 201419007 (January 29, 2014). In this ruling, a captive was formed to issue extended warranties to a taxpayer's customers. Risk shifting and risk distribution were present, because the risks of economic loss were those of the taxpayer's customers (their costs of repair) and a large number of customers purchased the extended warranties.

Safe harbors. Since 2000, the IRS has issued a number of "safe harbor" rulings concerning captives. Although the rulings have addressed a variety of fact patterns and types of captives, they have predominantly focused on how the IRS will apply the risk distribution requirement for "insurance." Despite some IRS flexibility towards captives, it will still challenge captive insurance arrangements that it perceives as abusive. For example, so-called "notional risk pools," related party guarantees, premium loan-backs, certain IRC § 831(b) "small captives," and other issues are audit focus areas of the IRS.

Risk distribution. While the IRS has abandoned some historical audit positions on questions of risk shifting, it has been giving intense scrutiny to risk distribution. Despite that scrutiny, earlier this year in Rent-A-Center, Inc. v. Commissioner (Jan. 14, 2014), the U.S. Tax Court focused on the number of "statistically independent risks" insured by the captive in finding that risk distribution was satisfied, as opposed to the "safe harbor" rulings.

When properly planned and implemented, a captive insurance company can serve a valuable business and tax planning function.

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.

© Baker Donelson | Attorney Advertising

Written by:

Baker Donelson

Baker Donelson on:

Readers' Choice 2017
Reporters on Deadline

"My best business intelligence, in one easy email…"

Your first step to building a free, personalized, morning email brief covering pertinent authors and topics on JD Supra:
Sign up using*

Already signed up? Log in here

*By using the service, you signify your acceptance of JD Supra's Privacy Policy.
Custom Email Digest
Privacy Policy (Updated: October 8, 2015):

JD Supra provides users with access to its legal industry publishing services (the "Service") through its website (the "Website") as well as through other sources. Our policies with regard to data collection and use of personal information of users of the Service, regardless of the manner in which users access the Service, and visitors to the Website are set forth in this statement ("Policy"). By using the Service, you signify your acceptance of this Policy.

Information Collection and Use by JD Supra

JD Supra collects users' names, companies, titles, e-mail address and industry. JD Supra also tracks the pages that users visit, logs IP addresses and aggregates non-personally identifiable user data and browser type. This data is gathered using cookies and other technologies.

The information and data collected is used to authenticate users and to send notifications relating to the Service, including email alerts to which users have subscribed; to manage the Service and Website, to improve the Service and to customize the user's experience. This information is also provided to the authors of the content to give them insight into their readership and help them to improve their content, so that it is most useful for our users.

JD Supra does not sell, rent or otherwise provide your details to third parties, other than to the authors of the content on JD Supra.

If you prefer not to enable cookies, you may change your browser settings to disable cookies; however, please note that rejecting cookies while visiting the Website may result in certain parts of the Website not operating correctly or as efficiently as if cookies were allowed.

Email Choice/Opt-out

Users who opt in to receive emails may choose to no longer receive e-mail updates and newsletters by selecting the "opt-out of future email" option in the email they receive from JD Supra or in their JD Supra account management screen.


JD Supra takes reasonable precautions to insure that user information is kept private. We restrict access to user information to those individuals who reasonably need access to perform their job functions, such as our third party email service, customer service personnel and technical staff. However, please note that no method of transmitting or storing data is completely secure and we cannot guarantee the security of user information. Unauthorized entry or use, hardware or software failure, and other factors may compromise the security of user information at any time.

If you have reason to believe that your interaction with us is no longer secure, you must immediately notify us of the problem by contacting us at In the unlikely event that we believe that the security of your user information in our possession or control may have been compromised, we may seek to notify you of that development and, if so, will endeavor to do so as promptly as practicable under the circumstances.

Sharing and Disclosure of Information JD Supra Collects

Except as otherwise described in this privacy statement, JD Supra will not disclose personal information to any third party unless we believe that disclosure is necessary to: (1) comply with applicable laws; (2) respond to governmental inquiries or requests; (3) comply with valid legal process; (4) protect the rights, privacy, safety or property of JD Supra, users of the Service, Website visitors or the public; (5) permit us to pursue available remedies or limit the damages that we may sustain; and (6) enforce our Terms & Conditions of Use.

In the event there is a change in the corporate structure of JD Supra such as, but not limited to, merger, consolidation, sale, liquidation or transfer of substantial assets, JD Supra may, in its sole discretion, transfer, sell or assign information collected on and through the Service to one or more affiliated or unaffiliated third parties.

Links to Other Websites

This Website and the Service may contain links to other websites. The operator of such other websites may collect information about you, including through cookies or other technologies. If you are using the Service through the Website and link to another site, you will leave the Website and this Policy will not apply to your use of and activity on those other sites. We encourage you to read the legal notices posted on those sites, including their privacy policies. We shall have no responsibility or liability for your visitation to, and the data collection and use practices of, such other sites. This Policy applies solely to the information collected in connection with your use of this Website and does not apply to any practices conducted offline or in connection with any other websites.

Changes in Our Privacy Policy

We reserve the right to change this Policy at any time. Please refer to the date at the top of this page to determine when this Policy was last revised. Any changes to our privacy policy will become effective upon posting of the revised policy on the Website. By continuing to use the Service or Website following such changes, you will be deemed to have agreed to such changes. If you do not agree with the terms of this Policy, as it may be amended from time to time, in whole or part, please do not continue using the Service or the Website.

Contacting JD Supra

If you have any questions about this privacy statement, the practices of this site, your dealings with this Web site, or if you would like to change any of the information you have provided to us, please contact us at:

- hide
*With LinkedIn, you don't need to create a separate login to manage your free JD Supra account, and we can make suggestions based on your needs and interests. We will not post anything on LinkedIn in your name. Or, sign up using your email address.