Why the IRS Scrutinizes Captive Insurance

Captive insurance is touted as a way to self insure that avoids rising premium costs, provides more control and increases profits. While many of these benefits are worth investing in, it is important that it is set up correctly. Many companies specialize in setting up captive insurance, but those that don’t consult or follow best practices run the risk of being investigated and penalized by the IRS.

What Makes Captive Insurance Different?

Captive insurance is insurance that is owned by the insured. They can be set up by any business or practice provided they have the means and the knowledge. The largest benefits of a self-owned insurance entity are cost and control. With “traditional” third-party insurance, the expenses paid for a premium (though they can be deducted) are never returned. Captive insurance allows owners to keep and invest the premiums contributed to it. They can also customize their insurance plans and choose coverage in detail.

With those benefits one might wonder why traditional insurance is still prevalent, however, it is important to remember that not every company can afford to invest resources in setting up a captive. In general, a practice or business will need to have good risk management practices and financial stability before they can consider setting up a captive.

Why Does the IRS Scrutinize Captives?

Captives by their nature have the potential for abuse. According to the IRS’s 2018 list of ‘Dirty Dozen’ tax scams, micro-captives can be tax abusive if they are used improperly. If they believe that a captive does not meet the qualifications for insurance they can and will prosecute. Warning signs the IRS might look for in a captive include extravagant premiums, “circular flow of funds”, premiums paid for illegitimate expenses, improper distribution of risk etc. They want to make sure that it is really being used for insurance and not for estate planning with tax deductions.

Captive insurance, when done legitimately and properly, provides many benefits over traditional insurance. They allow for greater freedom and return on investment. However, because of their nature, the IRS scrutinizes them closely. A business or practice considering a captive should be strongly encouraged to consult with a specialist, but neither should they be afraid. If they comply with industry standards and choose a good company to help set it up they can provide better and more profitable insurance for their business.