Insurance has been in existence for literally thousands of years. Since the 1950s, captive insurance has provided businesses with an alternative risk financing tool. In the 1980s, the Internal Revenue Service (IRS) added section 831(b) to the Internal Revenue Code (IRC), paving the way for “micro captive” small insurance companies to make a tax election. Micro captives are helpful for certain qualifying businesses, but they aren’t for everyone.
What Is a Captive?
A captive is a licensed insurance company owned and operated by those it insures. A single company or a group can own it. The captive exists to pay for insurable losses the owner or owners experience.
Organizations that have difficulty obtaining appropriate coverage for unique risks, feel unrewarded by insurance markets for their excellent loss histories or want a more effective way to finance their risks often find that establishing a captive insurance program is advantageous. They may benefit from customized insurance policies, enhanced protection, direct access to insurance markets, and improved cash flow, among other things.
Various captive structures are available to help a parent company achieve its key objectives. To learn more about types of captives, read “What Is Captive Insurance?”
What Is Section 831(b) of the Internal Revenue Code?
Internal Revenue Code Section 831 b was established in 1986 as part of a U.S. tax overhaul. It is a tax exemption that initially was meant to benefit small, mostly agricultural-based mutual insurance companies that had sprung up in the Midwest and were struggling. It allowed for the underwriting profit of the captive to not be taxed at a federal level.
What Is a Micro Captive?
Also commonly called an 831(b) captive or a small captive, a micro captive is an insurance company whose owners elect to be taxed on the captive’s investment income only, not on its underwriting profit. To qualify for this tax treatment, micro captive insurance companies must not collect premium dollars above the set threshold for a given tax year. The threshold for calendar year 2023 is $2,650,000. This amount is updated annually to account for inflation.
How Do Micro Captives Work?
A micro captive, like other types of captives, is a traditional captive that is wholly funded and controlled by its owners. Creating the captive gives the owners an alternative to purchasing insurance on the open market and allows them to tailor the coverage to their insurable operational risks.
The micro captive must abide by the regulations set forth by its captive domicile, which is the state, country or territory that licenses it. A micro captive has some additional and unique considerations:
- A micro captive insurance company can’t be a life insurance company.
- A micro captive must elect to be taxed under IRC 831(b).
- A micro captive’s annual premiums can’t exceed the established threshold for a given year.
- A micro captive must meet the IRS’s diversification requirements, which among other things, specify that each policyholder can’t contribute more than 20% of the micro captive’s annual premiums.
- If the micro captive is defined as a “transaction of interest” by the IRS, it is subject to additional reporting requirements around such things as its assets, claims and how premiums were set.
What Are the Benefits of a Micro Captive?
The benefits of a captive insurance company, including a small captive that makes the 831b election, typically include the following:
- A captive can provide coverage when traditional insurance carriers are unwilling to or are demanding exorbitant premiums.
- Captive insurance company owners gain greater visibility and control over premiums and claims and have direct access to additional insurance and reinsurance markets.
- Captive owners gain greater access to and can tailor coverage types and limits that address their specific—and often unique or problematic—risks.
- If the captive is structured correctly, captive owners may earn investment income on their premium reserves, enhancing cash flow.
- Overall, captive owners can gain more control over their risks and potentially reduce insurance costs.
What Are the Drawbacks of a Micro Captive?
Forming any captive may be riskier than purchasing traditional insurance because the captive owners’ money is on the line. Owners must capitalize the insurance company up front, and that money remains captive throughout the company’s life cycle. Other considerations include the following:
- Owners of captive insurance companies sometimes assume more risk. They must set aside enough reserve to pay any claims, which may be more than initially estimated, despite actuary reports and history.
- Owners must actively manage the captive insurance company throughout its life, which means regularly interfacing with captive managers, insurers, regulators, tax specialists and lawyers to stay in compliance.
- Closing a captive isn’t as simple as just shutting it down. It is a complex process that can be time-consuming and expensive. Therefore, captive formation is not a short-term strategy.
IRS Scrutiny of 831 b Captive Companies
As noted earlier, 831(b) tax election captives have existed for more than 30 years. They are a helpful financing tool when managed to insure the owners’ risks. However, not all captive managers have used them appropriately.
The IRS has been closely examining the operations of micro captives within the last decade. Listed as part of the “Dirty Dozen” tax scams (a list of common scams taxpayers may encounter) consistently from 2014 to 2019, micro captives have been placed under a microscope due to the “potential for tax avoidance or evasion,” according to the IRS.
Though micro captives were removed from the Dirty Dozen list in 2020, the IRS has continued scrutinizing them. Soft-warning letters have been issued to thousands of taxpayers involved in captives making the 831(b) election, informing them of increased examination and the potential resulting penalties. And while certain groups under audit were offered settlements in 2019, scrutiny continued into 2021, when the IRS established a new office dedicated to addressing the abusive micro/small captives.
Many captives that make the 831(b) election are still legitimate business structures, yet organizations are looking for a less volatile solution. Instead of exiting the captive, converting the tax election from an 831(b) to an 831(a) is a simple solution that still yields the benefits of a captive. To learn the difference between an 831a and 831 b micro captive, read “Micro Captives Under a Microscope: Converting Your 831(b) to an 831(a).”
Is a Micro Captive Right for your Business?
If a company seeks an alternative to traditional insurance to insure its risk, self-funding or forming a captive may be an attractive solution. If the organization meets the IRS premium threshold and diversification guidelines, it may benefit from forming a micro captive.
While those who form a legitimate captive and make the 831b election will receive captive insurance tax benefits, they must always remember to operate their small captive compliantly as a legitimate insurance company. A micro captive is not a tax shelter.
Working with the Right Captive Manager
Any organization considering forming a captive and electing 831(b) should work with someone who has a vetted process for helping it understand whether doing so is in the company’s best interests. The advisor should have deep experience structuring and implementing these alternative risk financing solutions. Award-winning Hylant Global Captive Solutions helps organizations that feel their better-than-average claim history isn’t being rewarded in the traditional market or have difficulty obtaining certain types of coverage explore alternative risk-financing solutions. If a captive is appropriate, the team customizes a structure, implements, operates and services the captive-related insurance program throughout its lifecycle. Executives and their stakeholders benefit by strengthening the organization’s financial performance while protecting its assets.
Learn more about Hylant Global Captive Solutions here.
The above information does not constitute advice. Always contact your insurance broker or trusted advisor for insurance-related questions.