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 Adkisson's Captive Insurance Companies
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The Asset Protection Bestseller by Jay Adkisson and Chris Riser
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© 2008 by Riser Adkisson LLP. All rights reserved. No portion of these materials may be reproduced in whole or in any part without the express written permission of Adkisson Publishing Inc. Legal issues should be faxed to 877-698-0678.

 
Life Insurance and Captives

Closely-Held Insurance Company structures, known as "CHICs", are sometimes used to purchase life insurance outside the estate of the business owner with what amounts to pre-tax dollars.

This should not be the primary focus of the captive, but is something that can be done with a portion of the captive's accumulated assets. If the primary purpose of the captive is to buy life insurance, or act as the conduit for the pre-tax purchase for life insurance, or if life insurance becomes the significant asset of the captive, there is a risk that the arrangement will not be considered a bona fide captive arrangement but will instead be treated as a tax shelter.

Caution that there are significant potential issues related to the Corporate Owned Life Insurance (COLI) restrictions.

Beware Bogus Programs

There are some captive insurance promoters who attempt to persuade agents that they have special access to certain "approved" life insurance policies for captives. This is a totally false assertion. No state has "approved" a life insurance policy just for captives. Subject to the tax restrictions, a captive can invest in pretty much any life insurance policy from any company, so long as there is enough cash value in the policy to meet the reserve requirements -- taking into account all the other assets of the captive.

Likewise, some promoters have attempted to suggest to agents that only a life insurance policy with a high initial cash value and no surrender charges can be used with captives. This is another false assertion. It also implies that the promoter is going to put 100% of the assets of the captive into life insurance, which could trigger some very bad tax consequences including that the IRS might label the entire arrangement to be a "sham".

If life insurance is going to be used with a captive, it should only be a relatively small percentage of the captive's assets and certainly no where near 100%.

Beware overpricing of services. In addition to the formation fee, management fee, and a percentage of the life insurance commissions, some promoters will also charge a percentage of deposits and a fee for using a shared risk pool. These fees are not commonly charged within the captive industry and may be considered excessive.

 

ARTICLE
Bad Financial 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.

Background

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 surface

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 to doctors.

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 deduction.

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 insurance.

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 have captives.

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 arrangement.

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.[1]

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.[2]

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

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 captive? Nothing!

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 Risk Distribution

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 entities.[3]

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.

Risk Pools

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.[4]

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 harbor rule.

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 Variant

Some programs for physicians combine a captive with a risk retention group (RRG), which is a form of insurance company owned by its insureds.

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 third-party risk.

Bottom-Line on 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 Life Insurance

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.

Bogus Exit Strategies

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 Criminal

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.[5]

Summary

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 life insurance.

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.



[1] Of course, there would be tax to pay if the captive pays dividends, or if the captive is sold or liquidated.

[2] Helvering v. Le Gierse, 312 U.S. 531 (1941).

[3] Rev. Rul. 2002-90, Disregarded entities, such as single member LLCs and QSubs don’t count. See Rev. Rul. 2005-40.

[4] Rev.Ruling 2002-89.

[5] Superseding Indictment filed in U.S. v. Peggs, 1:07-CR-239 (March 6, 2008)

 

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Since its release in late 2006, Jay Adkisson's book on captive insurance companies has become the all-time captive insurance bestseller, providing a basic introduction to captives and related structures and how they are properly utilized within the context of the client's overall business and estate planning.

Available now from:

Amazon and Barnes & Noble

We assist prospective captive owners and their advisors in evaluating, designing, and implementing captive solutions. We also review existing captive structures and suggest ways that they can be used more efficiently. In addition to Mr. Adkisson's firms, we also have relationships with experienced and reputable insurance managers, actuaries, underwriters, and accountants who specialize in captive insurance arrangements.

You may contact Jay Adkisson for a telephone conference or for a speaking engagement by calling his scheduling assistant at 949.200.7753 or by e-mailing him directly to jay [at] risad.com (We serve clients nationwide).

 

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Riser Adkisson LLC

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GENERAL DISCUSSION AND NEWS
Discussion of news and general issues relating to captive insurance companies and alternative risk transfer and management issues. Most new posts will go here unless clearly bound for another category.
Calendar of Upcoming Events
A listing of upcoming events involving captive insurance companies and alternative risk management, including association meetings, educational forums, etc. Please send us your meeting information to add to our list!
 
Formation and Licensing
Discussion of issues relating to the insurance license application, the issuance of the license, capitalization, etc.
Cell Captives and Rent-A-Captives
Discussion of segregated cell captives and similar arrangements that are primarily designed for businesses that are too small to economically justify a captive.
Group Captives and Association Captives
Discussion of large group captives and captives serving associations.
Risk Retention Groups
Discussion of insurance companies formed under the Federal Liability Risk Retention Act of 1986.
 
Risks and Policies
Discussion of the insurance risks for businesses and the policies that can be developed to cover those risks
Workers Compensation
Discussion of workers compensation insurance, including fronting arrangements and reinsurance.
Healthcare and Benefits
Discussion of moving employee healthcare insurance and other employee benefits into a captive or similar arrangement.
Medical Malpractice
Discussion of the use of captive and other alternative risk transfer strategies for medical malpractice liability. Includes discussion of tax scams sold to physicians involving medical malpractice premiums paid to offshore insurance companies.
 
TAX ISSUES
Tax Issues Generally
Discussion of tax issues relating to captives and other alternative risk transfer and management issues other than those listed in one of the forums below.
Federal Risk Shifting and Insurance Contracts
Discussion of the federal tax law requirements for "insurance" as they relate to the shifting of risks and what constitutes a valid insurance contract as opposed to an economic hedge.
Federal Risk Distribution
Discussion of the federal tax law requirements of risk distribution, including what does and does not qualify for the 12+ affiliate safe harbor, and attribution issues.
Federal Excise Taxes on Insurance
Discussion of the federal excise taxes on insurance premiums paid, including premiums paid to offshore captive insurance companies
831(b) Election
Discussion of the 831(b) election for insurance companies whose annual net premium income does not exceed $1.2 million per year.
501(c)(15) Exempt Insurance Companies
Discussion of insurance companies qualifying for exempt treatment under IRC section 501(c)(15) for gross receipts not exceeding $600,000 per year of which at least half those receipts are premium income.
State Income Tax and Independently Procured Tax Issues
Discussion of state income tax issues for alternative risk management transactions and captives, including whether out-of-state captives are subject to state income tax and whether a state may assess a premium tax or independently procured tax to premiums paid to captives.
 
UTILIZATION OF THE CAPTIVE'S ASSETS
Captive Investments
Discussion of appropriate vs. inappropriate investments for captive insurance companies, permitted asset rules, and regulatory preferences.
Loanbacks
Discussion of the practice of having the captive loan money back to an insured or the parent company and the effect of loanbacks on the tax treatment of the captive arrangement.
 
DOMICILES - STATES
Arizona
Hawaii
Kentucky
Montana
Nevada
South Carolina
Utah
Vermont
Other States Not Listed
 
DOMICILES - OFFSHORE
Bermuda
British Virgin Islands
Cayman Islands
Other Offshore Domiciles Not Listed
 
CAPTIVE SERVICE PROVIDERS
Accountants and Auditors
Listing of accountants and auditors who provide bookkeeping services and/or have been admitted by an insurance commissioner to perform audits of captive insurance companies.
Attorneys
Listing of attorneys and law firms that provide services to captive insurance companies and similar alternative risk transfer arrangements.
Actuaries
Listing of actuaries who provide actuarial services to captive insurance companies.
Managers
Listing of captive insurance managers who have been admitted in one or more jurisdictions to administrate captives.
Other Service Providers and Consultants
Listing of service providers to captives not otherwise listed above and consultants to captive insurance companies and alternative risk transfer structures.

 

 

 

LEGACY PAGES

Benefits

Wealth Transfer

Concepts

Types of Captives

Rent-A-Captives & Segregated Portfolio Companies 

Taxation

Formation & Licensing

Policies & Risks

Workers Compensation Captives 

Domiciles

Captives Taxation Overview

Stupid Captive Tricks

501(c)(15) Exemption

831(b) Election

1563 Control Group Rules

IRM 7.25.15.1

RevRul 2001-31

RevRul 2002-89

RevRul 2002-90

RevRul 2002-91

Notice 2003-34

Notice 2003-35

RevRul 2005-40

RevRul 2008-8

1989 - Humana

1990 - Gulf Oil

1992 - Amerco

1992 - Sears, Roebuck

1993 - Ocean Drilling

1995 - Malone & Hyde

1997 - Kidde Industries

2001 - UPS

State Taxation of Captives

Dow Chemical

Arizona

Hawaii

Kentucky

Montana

South Carolina

Utah

Vermont

Bermuda

British Virgin Islands

Cayman Islands

Captive Scams

Contact Information

Free Newsletter & Updates

About the Captive Book

Warnings & Legal Information