Have you
ever heard of a “captive” insurance company?
They have
become quite cachet. They have also drawn the IRS’ attention, as people are
using these things for reasons other than insurance and risk management.
Let’s walk
through this.
Let’s say
that you and I found a company manufacturing sat-nav athletic shoes
COMMENT: Sat-nav meaning satellite navigation. That’s right: you know you want a pair. More than one.
We make a
million of them, and we have back orders for millions more. We are on the cover
of Inc. magazine, meet Jim Cramer and get called to the White House to
compliment us for employing America again.
Sweet.
Then tax
time.
We owe
humongous taxes.
Not sweet.
Our tax
advisor (I am retired by then) mentions a captive.
LET’S EXPLAIN THIS: The idea here is that we have an insurable risk. Rather than just buying a policy from whoever-is-advertising-during-a-sports-event, we set up our own (small) insurance company. Granted, we are never going to rival the big boys, but it is enough for our needs. If we can leap through selected hoops, we might also get a tax break from the arrangement.
What risks do
you and I have to insure?
What is one
of those shoes blows out or the satellite-navigation system shorts and
electrocutes someone? What if it picks up contact from an alien civilization –
or an honest political journalist? We could get sued.
Granted, that
is what insurance is for. The advisor says to purchase a policy from one of the
big boys with a $1.2 million deductible. We then set up our own insurance
company – our “captive” – to cover that $1.2 million.
We are
self-insuring.
There is an
election in the tax Code (Section 831(b) for the incorrigible) that waives the income
tax on the first $1.2 million of premiums to the captive. It does pay tax on
its investment income, but that is nickels-to-dollars.
You see that
I did not pick the $1.2 million at random.
Can this get
even better?
Submitted
for your consideration: the You & Me ET Athletic Shoe Company will deduct
the $1.2 million as “Insurance Expense” on its business return.
We skip
paying tax on $1.2 million AND we deduct it on our tax return?
Easy,
partner. We can still be sued. We would go through that $1.2 million in a
heartbeat.
Is there a
way to MacGyver this?
Got it. Three
ways come quickly to mind, in fact:
(1) Let’s make the captive insurance
duplicative. We buy a main policy with a reputable insurance company. We then buy
a similar – but redundant - policy from
the captive. We don’t need the captive,
truthfully, as Nationwide or Allstate would provide the real insurance. We do
get to stuff away $1.2 million, however – per year. We would let it compound.
Then we would go swimming in our money, like Scrooge McDuck from the Huey, Dewey
and Louie comics.
(2) A variation on (1) is to make the
policy language so amorphous and impenetrable that it is nearly impossible to
tell whether the captive is insuring whatever it is we would submit a claim
for. That would make the captive’s decision to pay discretionary, and we would
discrete to not pay.
(3) We could insure crazy stuff. Let’s
insure for blizzards in San Diego, for example.
a. Alright, we will need an office in San
Diego to make this look legitimate. I volunteer to move there. For the team, of
course.
The tax
advisor has an idea how to push this even further. The captive does not need to
have the same owners as the You & Me ET Athletic Shoe Company. Let’s make
our kids the shareholders of the captive. As our captive starts hoarding piles
of cash, we are simultaneously doing some gifting and estate tax planning with our
kids.
Heck, we can
probably also put something in there for the grandkids.
To be fair,
we have climbed too far out on this limb. These things have quite serious and
beneficial uses in the economy. Think agriculture and farmers. There are instances
where the only insurance farmers can get is whatever they can figure-out on
their own. Perhaps several farms come together to pool risks and costs. This is
what Section 831(b) was meant to address, and it is a reason why captives
are heavily supported by rural state Senators.
In fact, the
senators from Wisconsin, Indiana and Iowa were recently able to increase that
$1.2 million to $2.2 million, beginning in 2017.
Then you
have those who ruin it for the rest of us. Like the dentist who captived his
dental office against terrorist attack.
That nonsense
is going to attract the wrong kind of attention.
Sure enough,
the IRS stepped in. It wants to look at these things. In November, 2016 the IRS
gave notice that (some of) these captive structures are “transactions of
interest.” That lingo means that – if you have one – you must file a disclosure
(using Form 8886 Reportable Transaction Disclosure Statement) with the IRS by
May 1, 2017.
If this describes
you, this deadline is only a few months away. Make sure that your attorney and
CPA are on this.
Mind you,
there will be penalties for not filing these 8886s.
That is how
the IRS looks at things. It is good to be king.
The IRS is
not saying that captives are bad. Not at all. What it is saying is that some people
are using captives for other than their intended purpose. The IRS has a very
particular set of skills, skills it has acquired over a very long career.
Skills that make the IRS a nightmare for people like this. If these people stop,
that will be the end of it. If they do not stop, the IRS will look for them,
they will find them, and they will ….
Ahem. Got
carried away there.
When this is
over, we can reasonably anticipate the IRS to say that certain Section 831(b) structures
and uses are OK, while others are … unclear. The IRS will then upgrade the unclear
structures and uses to “reportable” or “listed” status, triggering additional tax
return disclosures and potential eye-watering penalties.
In the old
days, listed transactions were called “tax shelters,” so that will be nothing
to fool with.
