Captive insurance companies tax free income for farmers

A farmer creates a C corporation under Delaware law with the intention that it be regulated and taxed as an insurance company. The corporation offers specialized insurance to the farmer who pays big premiums to his C corporation insurance company. The premiums are never taxed to the C corporation but the farmer takes a full deduction for the premiums paid. Several companies are promoting this setup. Sound too good to be true? Well, yes and no. In 1986, Congress inserted a provision into Sec. 831 that opened up a significant planning opportunity for small insurance companies as described above. Under Sec. 831(b), if a property and casualty insurance company with gross premium income of $1.2 million or less (known as a mini-captive) makes an election under that section, it avoids tax on its premium income and owes tax only on its investment income. Some have suggested investing the proceeds in life insurance so as to minimize or eliminate investment income. There are a lot of requirements for a captive insurance company to operate, not the least of which is that it must be regulated by the Iowa Insurance Division. The IRS has issued a number of revenue rulings that provide guidance to captives (see, e.g., Rev. Rul. 2002-89). In addition, in Rev. Proc. 2002-75 the IRS stated that it would begin to issue private letter rulings on specific companies' risk distribution and risk shifting and whether the captives are true insurance companies. In a new Tax Advice Memorandum ("TAM") the IRS has concluded that a corporation didn't qualify as an insurance company under Code Sec. 501(c)(15) for the years at issue because the majority of its business wasn't related to insurance and it failed to achieve adequate risk distribution during those years. TAM 201517018. Section 501(c)(15) is the ancestor to Section 831(b), but all captive insurance companies must comply with the following three factors: (1) the arrangement involves the existence of an 'insurance risk'; (2) there is both risk shifting and risk distribution; and (3) the arrangement is for 'insurance' in its commonly accepted sense. The Harper Group v. Commiss'r, 96 T.C. 45, 47 (1991). The taxpayer in the TAM had only one policy. One policy does not allow any risk shifting or risk distribution. Therefore, the captive insurance company did not qualify for an exemption from taxation on the premiums received. The tax benefit of a captive insurance company is like the proverbial carrot dangled in front of the horse. No matter how hard the horse works for the carrot, he will likely never fully realize his ambition.

The material in this blog is not intended, nor should it be construed or relied upon, as legal advice. Please consult with an attorney if specific legal information is needed.