The high cost of insurance is an issue for most companies. A strategy used by 90% of Fortune 500 companies to help control the cost of insurance is to form a captive insurance company (captive). Generally used to augment existing commercial policies and provide insurance for risks not covered by traditional insurance, a captive is an insurer wholly owned by a parent company that provides insurance to its parent and related companies.

Captives can cover everything from general and umbrella liability to workers’ compensation, regulatory changes and legal defense. Some companies use captives to fund employee benefit programs, such as life and disability insurance, retirement and healthcare benefits. Other types of insurance captives offer include:

• employment practice liability;
• contractor liability;
• director/officer/employee liability;
• contractual liability;
• property damage and business interruption;
• fiduciary liability;
• equipment; and
• protection against pollution, mold and other environmental claims.

Generally, any type of definable and measurable risk can be covered by a captive provided the state or country in which it is domiciled (i.e. incorporated, licensed, managed and operated) allows the line of business to be underwritten. Contractors can custom tailor insurance policies to cover their specific needs. Captives can also be used to decrease the cost of commercial policies. Contractors can elect to reduce premiums by increasing deductibles and then have the deductible paid through the captive.

In order to qualify as an insurance company for tax purposes, the captive must have adequate risk shifting and sharing; similarly, it must operate and regulate itself as an "actual" insurance company with sufficient capital to allow for risks. The company must be a U.S. taxpayer, either domiciled in the United States or offshore. The captive must also elect and qualify under Section 953(d) to be taxed as a U.S. insurer. The gross premium income for the tax year in question must be $2.3 million (for taxable years beginning in 2018) or less, with the premium cap subject to inflation adjustments. This premium threshold applies to all insurers included in a single consolidated tax filing.

In the past, captives only made sense for companies with at least $100,000 in insurance premiums and more than $10 million in revenue. Today, it is possible for smaller contractors to form their own captive due to declining capital requirements and operating costs. Ideal candidates are businesses with:

• $500,000 or more in profits;
• multiple entities;
• risk currently uninsured or under-insured; and
• interest in protecting assets while possibly minimizing tax obligation.

A properly structured captive offers both added insurance coverage and numerous tax-planning opportunities, including but not limited to:

• tax deductions on insurance premiums paid to the captive;
• lower income taxes; and
• possible tax-saving options on shareholder dividends.

Smaller, or “microcaptives,” may qualify to be exempt from federal income tax on operating income. Under Internal Revenue Code section 831(b), a captive with a gross premium income of $2.3 million or less that makes an election under that section is not taxed on premium income but is taxed on investment income. In other words, if the captive is established according to IRS guidelines, it may qualify to receive up to $2.3 million in premiums from its parent company, tax free. The parent or affiliate company can then take a deduction for the amount paid to the captive as a legitimate business expense.

The captive can make a profit if claims are less than the premium paid by the company. A portion of the profits can then be reinvested to avoid ordinary income taxation. Or, the funds could be disbursed to the company’s shareholders as a qualified dividend which would be taxed at a lower rate. Even so, there is always the risk that claims against the company could be higher resulting in a loss. Therefore, it is important to consider what risks to insure under the captive instead of a commercial policy.

Many contractors join a group captive, in which a number of businesses come together to form their own insurance company, or an association captive, which is established by a trade group for the benefit of its members. Participating in either a group or association captive allows members to share, to some degree, the collective risks, as well as the benefits—such as potential investment earnings and profits from premiums paid in excess of claims. Since group members make a commitment to minimize risks, participation also serves as a risk management tool.

It should be noted that the IRS has included microcaptives on its "Dirty Dozen" list of tax scams to avoid for many years. According to the IRS, insurers that qualify as small insurance companies can elect to be treated as exempt organizations or to exclude limited amounts of annual net premiums from income so that the captive insurer pays tax only on its investment income. In certain microcaptive structures, owners of closely-held entities are encouraged to participate in schemes that do not qualify as insurance.

As with any business strategy a contractor should consult with legal counsel, as well as accounting, insurance and other professionals before establishing a captive. Contractors need to be fully aware of compliance and funding requirements, as well as IRS regulations. It is important to carefully consider all costs, risks and benefits to ensure and confirm that a establishing a captive is the most viable strategy for a business.