Is it Time to Revisit Captive Insurance?
JEFF NEWMAN, CPA, JD
Many businesses use captive insurance companies to meet their risk management needs, control costs and reduce taxes. Recent developments have created new opportunities to take advantage of captives. At the same time, new restrictions designed to curb perceived abuses of micro-captives may require some companies to modify their captives’ ownership structures.
Captives can be structured in many ways, but essentially, they are insurance companies owned and controlled by those they insure. Benefits include stable premiums, lower administrative costs, the ability to cover risks that are unavailable commercially and participation in the captive’s underwriting profits and investment income. income.
Captives also offer significant tax advantages. For example, unlike self-insurance reserves, premiums paid to a captive are deductible. As an insurance company, the captive can deduct most of its loss reserves. Micro-captives—those with annual premiums of $1.2 million or less—enjoy even greater tax advantages. They may elect to exclude premiums from their income and pay taxes only on their net investment income, although they will lose certain deductions.
A captive can also be a powerful estate planning tool. By placing ownership of a captive in the hands of family members, business owners can transfer wealth to their heirs free of gift and estate taxes.
To provide these benefits, a captive must qualify as an insurance company for federal income tax purposes. Among other things, this means that premiums must be priced based on actuarial and underwriting considerations and the arrangement must involve sufficient distribution of risk.
There is no bright-line test for risk distribution, but the IRS has ruled that it exists when a wholly-owned captive:
- Insures the parent’s operating subsidiaries, none of which pay more than 15% of the premiums; or
- Receives more than 50% of its premiums from unrelated third parties.
According to the IRS, a captive that insures only the risks of its parent does not distribute risk.
Several recent Tax Court cases may create fresh opportunities for companies to establish captives. In the court’s view, risk distribution exists when there is a large enough pool of unrelated risks, regardless of the number of entities involved. In other words, a captive achieves risk distribution if coverage is spread over a sufficient number of employees, facilities, vehicles, products or services, even if they are all part of the same entity. However, it is not certain how the IRS will react to such arrangements.
Last year’s Protecting Americans from Tax Hikes (PATH) Act had a big impact on micro-captives. Beginning in 2017, the premium limit went from $1.2 million to $2.2 million, making this vehicle available to more companies. But, at the same time, this act also establishes a diversification requirement that will be monitored through annual information returns. To qualify, a captive must meet one of these two tests:
- No more than 20% of premiums come from any one insured; or
- Ownership of the captive mirrors (within a 2% margin) ownership of the insured business.
The first test may be difficult for smaller captives to meet. The second test essentially prohibits the use of a micro-captive as an estate planning tool.
Review Your Insurance Arrangements
The recent developments described above may open up captive insurance to more businesses. If you have ever considered establishing a captive, now is a good time to revisit this strategy. Generally, it takes several months to set up the captive properly and get all of the actuarial studies completed. If you are interested in exploring captive insurance companies for your business, please do not hesitate to contact me with any questions or concerns.
Partnerships: Get Ready for New Audit Rules to Claim Research Payroll Credits
ANITA WESCOTT, CPA
For partnerships, including limited liability companies taxed as partnerships, new audit rules are a game-changer. The rules apply to returns for partnership tax years that begin after December 31, 2017, including amended returns. The changes are not merely procedural and they substantially alter the taxation of partnerships by effectively imposing entity taxes on partnerships.
There is plenty of time to prepare for the new rules, but you should begin thinking about how they will affect you. If you are contemplating a new business venture that will be taxed as a partnership, it is a good idea to address the new rules in your partnership or operating agreement.
Tax on All Partnerships
The Bipartisan Budget Act of 2015’s new audit rules will affect all partnerships, regardless of size. However, certain partnerships with 100 or fewer partners will be able to opt out of the new rules, but this process involves additional reporting and disclosure requirements.
Under the new rules, the IRS will assess and collect taxes at the partnership level. This is a significant departure from current rules, under which the IRS generally assesses and collects taxes at the individual partner level. By easing the administrative burden associated with collecting tax from individual partners, the new rules will likely produce a dramatic rise in the number of partnership audits.
Tax Assessed at Highest Rate
The new rules do not just streamline the audit process. In some cases, they will actually increase the aggregate tax liability of the partnership and its partners. In an audit under the new rules, the IRS will determine any adjustments to the partnership’s income, gains, losses, deductions or credits and assess any additional taxes, penalties and interest against the partnership. Additional taxes will be determined by multiplying the net adjustment by the highest marginal individual or corporate tax rate for the audited year. The result is an imputed underpayment that the partnership takes into account in the adjustment year.
This approach will create several problems for partnerships and their partners. For example, because the new rules assess the tax at the highest marginal rate, partners lose the benefit of partner-level tax attributes that ordinarily would reduce their tax liability. To ease this burden, partnerships will be allowed to reduce their imputed underpayment by proving that a portion of it is attributable to tax-exempt partners, partners taxed at lower rates or income taxed at lower rates (such as capital gains). Compiling this information from all your partners may be time-consuming.
Tax Mistakes of Others
Since the new rules take additional taxes into account in the adjustment year, current partners may be liable for tax mistakes that benefited former partners. However, two exceptions will allow a partnership to shift the liability back to its former partners. Partnerships can reduce or avoid entity-level taxation by:
- Having the partners from the year under review file amended returns reporting their distributive shares of partnership adjustments and pay the tax within 270 days; or
- Within 45 days after the audit, make an election to provide partners from the year under review with adjusted information returns. Those partners would then take the adjustments into account on their individual returns for the adjustment year.
These exceptions allow you to avoid inequitable results, but meeting them could be a challenge.
No More Tax Matters Partner
By the time the new rules take effect, you will need to replace your tax matters partner with a partnership representative. This person can be a partner or non-partner and must have a substantial U.S. presence.
Choose your representative carefully. He or she will have broad authority to bind the partnership and its partners in dealing with the IRS and partners will no longer have the right to participate in a partnership audit. Now is the time to begin the process of selecting a partnership representative.
The IRS is working on regulations that will clarify and modify the new rules. In the meantime, familiarize yourself with the rules and determine whether or not you will be eligible to opt-out. If not, consider strategies for mitigating the impact, such as amending agreements to require partners to provide tax information and file amended returns in the event of an audit or indemnifying partners against unexpected tax liabilities.
Can You Opt-Out?
Partnerships with 100 or fewer partners may opt-out of the new audit rules by filing an annual small partnership election. However, before you jump to any conclusions about your partnership’s status, be aware that you can opt-out only if your partners are individuals, C corporations (including foreign entities that would be treated as C corporations, if they were domestic), S corporations or estates of deceased partners.
A partnership with just one non-qualifying partner does not qualify, regardless of its size. This means that tiered partnerships or limited liability companies generally will not be able to opt-out. Also, for any S corporation partners, each shareholder counts as a partner for purposes of the 100-partner threshold.
If you opt-out, in addition to filing annual elections, you will need to inform your partners of the choice to opt-out and provide certain information to the IRS about each partner, including shareholders of S corporation partners.