Medicine for Year-End 2008: Physicians, Captive Insurance Companies and
Cash-Value Life Insurance
Captive insurance arrangements that are funded with
cash-value life insurance are the hot tax shelter for 2008. But serious
questions exist whether they work as the promoters promise they will do.
During the savings & loan crisis of the late 1980s and
early 1990s, the courts in which I then practiced as a young litigator used a
particular acronym to describe cases where a physician had made an obviously bad
investment in an oil & gas deal, and then sued to try to recoup their losses.
Such a case was known as a "DDC", which was short for "Dumb Doctor Case".
Some doctors have a habit of getting into deals that don't
make any sense. There's a saying that doctors will crawl on their bellies over
broken glass for a mile to get to a bad deal, but they won't walk across the
street to get to a good one.
These deals are usually like those that they think the big
boys on Wall Street are doing. So, they convince themselves (and their friends)
that they should be doing these deals too. Wheeler-Dealer-itis.
The more something looks like something that ExxonMobil or
Boeing are actually doing to save taxes, the more the average plastic surgeon in
Wichita wants to do it even if it makes absolutely no sense at all under the
Many of these deals are tax shelters. Doctors are drawn to
tax shelters like ants to a picnic, and there is no shortage of tax shelter
promoters who love selling to physicians.
Every year, October announces the start of tax shelter
season. Every year there is a hot tax shelter that it seems everyone is selling
Every year life insurance agents desire to boost their
year-end sales by offering some scheme, any scheme, whereby life insurance can
be funded with pre-tax dollars, thus giving their clients a fat year-end
And every year promoters come up with a slick idea to
provide clients with a new tax deduction, so that they can make a quick buck
selling tax shelters to physicians.
The 2008 Hot Tax
Shelter Involving Life Insurance
This year's tax shelter pitched by too many life insurance
agents is captive insurance.
To make money selling captives to physicians, promoters
have gone out to life insurance marketing organizations and stirred up life
insurance agents nationwide to go out and sell captive insurance companies
funded with cash-value life insurance.
Various promoters are giving seminars and teleconferences
telling life insurance agents, financial planners and others of the great
benefits -- particularly commissions -- that can be generated by selling
physicians captive insurance companies capitalized with cash-value life
The problem is that captive insurance companies rarely work
for small-practice physicians.
What is a Captive?
A captive is an insurance company that is formed by a
parent company to offer insurance policies to the parent’s subsidiaries. The
captive insures certain risks of its sister companies, which pay insurance
premiums to the captive and take a current-year deduction for the insurance
premium expense. Underwriting profits are retained by the captive, and not lost
to a third-party insurance company.
Captives are used as risk financing tools by many of the
largest corporations in America. It is difficult to find a major corporation
that does not have a captive. Many other entities such as universities,
for-profit and non-profit hospitals, and large religious organizations, also
The IRS contended for many years that captives were merely
(non-deductible) self-insurance programs, and unsuccessfully challenged captives
on these grounds. Eventually, the IRS gave up on challenging captives as
self-insurance programs, and instead recognized the concept of the captive and
published guidelines as to what constitutes a proper captive insurance
It is precisely because of these guidelines and existing
case law that captive insurance companies do not work in all but the rarest of
circumstances for physicians.
The attraction of a small captive is simple to understand.
A property and casualty insurance company with net premium income of less than
$1.2 million may elect under IRC Sec. 831(b) to be taxed only on its investment
income. This means it is not taxed on its insurance underwriting income. If an
insured is able to pay tax-deductible premiums of up to $1.2 million to its own
captive, which then pays no claims, the insured reduces its taxable business
income by $1.2 million and doesn’t pay tax when the captive earns that $1.2
million as premium income.
Why Captives Don't
Work for Physicians
The definition of 'insurance' for tax purposes goes back to
a 1941 Supreme Court opinion, which said that insurance basically had three
components: an insurance contract, risk-shifting and risk-distribution.
The Requirement of
an Insurance Contract
The requirement of an insurance contract means that a bona
fide insurance arrangement exists. If a claim under a policy arises, the claim
will be paid just as with any insurance company.
Promoters of bogus captive programs tell their clients that
if a significant claim occurs, the client will simply not make a claim against
the policy. "You don't make every claim on your State Farm policy, so you don't
have to make claims here either." While that might be true, not making claims is
strong evidence that the “insurance policy” is a sham.
The Requirement of
Risk shifting means that the business is actually shifting
a real insurance risk to the captive.
For instance, let's say that a manufacturer buys a products
liability policy from its captive. The manufacturer is in the business of making
products and faces the risk of having to compensate claimants for damages
resulting from the use of its products. The captive insurance company is
adequately capitalized so that it can pay claims as they arise. This constitutes
risk-shifting. Some portion of the manufacturer’s risk has been shifted to the
captive insurance company.
Contrast this to a single-physician captive. The principal
risk that the physician faces is medical malpractice liability. Usually, the
physician doesn't want to move that coverage to the captive because (gulp!)
there actually might be a claim. Plus, hospitals may require a certificate of
insurance from a rated insurance company as a condition of extending hospital
privileges to the physician.
So, the physician wants the big deduction for a captive,
but doesn't want to give up their existing medical malpractice coverage. So what
does the physician have left that will support a six-figure premium payment to a
Thus, the promoters of physician captives gin up a melange
of inflated risks and charge an exorbitant premium to try to get the physician
to the desired fat deduction.
Tax shelter captives, as opposed to legitimate captives,
require the physician to purchase a variety of questionable insurance policies
that the physician likely would not purchase, but for the tax deduction and the
retention of the premium in the physician’s controlled captive
The Requirement of
Whereas risk shifting emphasizes the individual aspect of
insurance. (A pays B to assume A’s risk of loss), risk distribution emphasizes
the group aspect of insurance (Z is paid by A, B, C, etc. to take on their
risks, and the law of averages spreads the cost of that risk among the
insureds). The IRS has identified what amounts to a "safe harbor" for risk
distribution, which is that the insurance company insures at least 12 separate
Having 12 insureds for the captive is no big deal for a
Fortune 500 company with dozens of affiliates. Similaly, it is often not a big
deal to find 12 insureds for smaller captives affiliated with a real estate
developer, a hotel owner, a franchisee with multiple operations, etc., where
businesses are divided geographically and by business line.
So what does a physician have? The practice, maybe an
interest in a surgery center or physical therapy clinic, and perhaps an
investment property or two -- but rarely the dozen separate entities required to
meet the safe harbor for risk distribution. Thus, the promoters of physician
captives will look for other ways to achieve risk distribution.
Segregated Cell or
Protected Cell Captives
The most common form of tax shelter for physicians involves
what is known as a "segregated cell" or "protected cell" captive. Similar in
concept to a series LLC, a segregated cell company can be thought of as a group
entity wrapped around a number of individual sub-entities.
The physician pays premiums to the group entity. The
physician reports to the IRS that premium payments were made to the group
entity, and a deduction is taken for those premium payments. If challenged, the
physician will tell the IRS that the premium payment was deductible because
there is risk distribution within the group entity.
What the physician doesn't tell the IRS is that the money
paid to the group entity is then immediately dropped down into a segregated
account (a/k/a protected cell) that is owned only by the physician.
If there is a claim against the physician's policy, only
the money in the physician's own segregated account will be available to pay
claims. If, for example, somebody else in the group entity has a claim against
their policy, the physician's money will not be available to pay that claim.
In other words -- to put it bluntly -- segregated cell
companies are wink-wink-nod-nod affairs that are specifically designed to
deceive the IRS as to whether the physician's premium payment is deductible as a
payment for insurance, as defined by the tax law.
Even more troubling is how the physician gets the money out
of the segregated cell company. Some programs are designed so that the premiums
are refunded to the physician in later years, most likely when the physician is
in a lower tax bracket, which makes the program look like what it is: a
disguised deferred compensation program for the physician.
In other schemes, the group entity distributes premium
funds to an unreported offshore account or to a trust for the benefit of the
physician, or uses the premium funds to pay for an offshore life insurance
contract for the benefit of the physician. These deals go far beyond mere tax
shelters into criminal tax evasion schemes.
An alternative IRS "safe harbor" for meeting the risk
distribution requirement is for the captive insurance company to derive at least
50% of its premium income from unrelated third party insureds.
To create the appearance of third-party risk, a shady
captive promoter may establish a "risk pool." Each client of the promoter makes
premium payments for some questionable risk to an insurance company that is
owned or controlled by the promoter. The risk pool then buys reinsurance from
each client's captive, thus giving the appearance that each captive is deriving
at least 50% of its premiums from third-party risk.
These sorts of risk pools are a sham on several levels. The
purpose of a risk pool is to act as a conduit so that the client can deduct
outbound premium payments that he would not be deductible if paid to his own
captive, but for the so-called third-party risk intended to meet the 50% safe
The problem is that the same money is coming and going,
despite the promoter's (false) representations that the risk pool is unrelated
to the client and that the premiums paid to the client's captive constitute
third-party insurance. The physician would not make the initial purchase of
insurance from the risk pool unless it was understood that his premiums would
not be exposed to the claims of other clients.
In other words, there is no real risk distribution.
Sure, the IRS will be told that the premiums paid by the
physician will be at risk (wink-wink nod-nod). But would a reasonable business
person enter into such an arrangement if she really thought that she might lose
several hundred thousand dollars if somebody else in the so-called “risk pool”
has a substantial claim? Of course not.
Risk Retention Group
Some programs for physicians combine a captive with a risk
retention group (RRG), which is a form of insurance company owned by its
An RRG provides certain types liability insurance to its
member-owners who engage in similar or related business. Federal law allows an
RRG to be charted under the laws of one state, but to engage in insurance
business in all states, subject to certain limitations. RRGs used properly are
valuable risk financing tools.
But an RRG used improperly is something like this: A
physician pays a grossly inflated medical malpractice insurance premium to the
RRG, and the RRG purchases reinsurance from the physician’s captive.
Again, the premiums are just going around the horn in an
attempt to make it appear that 50% of the captive’s premiums are derived from
third-party business. In truth, with that physician’s risk is the only risk
covered by the captive, half via RRG reinsurance and half directly.
As with risk pools, the RRG scheme is merely a conduit for
the physician's own money to make it into the captive while appearing to be a
Physicians and Captives
Physician “mini-captives” rarely work because the tax law’s
requirements for risk shifting and risk distribution cannot be met.
Unfortunately, many programs created for physicians to participate in small
captive programs are simply schemes that give the appearance of risk shifting
and risk distribution, although in fact the IRS tests are not met.
The Problem With
The hope of selling a large cash-value life insurance
policy with pre-tax dollars -- via the captive in this case -- has life
insurance agents ringing up their physician clients just as every pre-tax life
insurance scheme does.
The problem is that cash-value life insurance makes a
captive arrangement look and smell like a tax shelter.
Real insurance companies typically buy little, if any, life
insurance as an investment. Instead, they generally hold more traditional and
relatively liquid investments like stocks and bonds.
Owning a cash-value life insurance policy in a captive
reduces the captive’s liquidity, and thus its ability to pay claims as they
arise. It's just not something that a real insurance company would purchase as
its principal asset.
The fact that the IRS has never issued guidance that says
that a captive insurance company cannot invest in a cash-value life insurance
policy doesn’t mean that it’s not a bad idea. Captive owners have worked hard
over the years to gain the IRS’s begrudging acknowledgment of the validity of
legitimate captive insurance arrangements for tax purposes.
Using a captive as a device to buy cash-value life
insurance with pre-tax funds makes it look much less like a bona fide insurance
company, and much more like a tax shelter.
One thing is certain: the IRS has shown a strong distaste
for arrangements that end up with the pre-tax purchase of life insurance.
Captive-owned life insurance will be no different. Think 412(i) plans and
419A(f)(6) plans, and keep that Form 8886 handy.
Not merely content with the tax deduction for the
physician's premium payments to the captive, some promoters have developed
strategies involving (surprise!) life insurance arrangements which purportedly
allow the physician to extract funds from the captive without tax. These
strategies involve bogus valuations of the assets of the captive, and
complicated transactions that have no real economic substance. They are, in my
opinion, merely a tax sham wrapped in a tax shelter.
When Shelter Becomes
Some captive arrangements more easily cross the line into
the criminal. In a recent indictment in Michigan, the promoters had their
clients make payments for "loss of income" policies to the promoters' captive in
the U.S. Virgin Islands. The premiums were later returned to the clients in the
form of loans.
Anything that has the potential to save income taxes can,
and will, be abused by shady promoters. Captive insurance arrangements are not
immune to such abuse, which has gone into overdrive as a method to sell pre-tax
Don't be fooled by the promises of the promoters, and the
dubious opinion letters of their affiliated pals (remember: Son of BOSS had some
of the thickest and most detailed opinion letters of all, and it didn't help).
Captives for physicians rarely work because the physician
cannot meet the tax law’s requirements for risk-shifting and risk-distribution.
Many captive schemes currently being promoted to physicians
only give the appearance that the IRS guidelines have been met. These schemes
are worse than tax shelters. They are fraudulent and evasive tax shams.
With all the seminars about captives and life insurance,
and all the aggressive promotion of captive and life insurance by agents and
financial planners who are less-than-discreet, do you really think that the IRS
doesn't know of this shelter, or that the IRS will not eventually take action?
Finally, anytime somebody comes to you with the
latest-and-greatest scheme for the pre-tax purchase of life insurance, run!
Because if it hasn't blown up yet, it's just a matter of time.
Make a quick buck now, and spend the next three years
trying to dig yourself and your clients out.
Of course, there would be tax to pay if the captive pays dividends, or
if the captive is sold or liquidated.
v. Le Gierse, 312 U.S. 531 (1941).
Rev. Rul. 2002-90, Disregarded entities, such as single member LLCs and
QSubs don’t count.
See Rev. Rul.
Superseding Indictment filed in
U.S. v. Peggs, 1:07-CR-239 (March 6, 2008)