There are a lot of people who try to put together their own captive and mess it up pretty badly which exposes themselves and their businesses to unnecessary tax liability. Sadly, there are also many advisors out there who try to form captives but don't really understand what they are doing and end up botching it pretty badly. This article reviews some of the bad practices that we see when people bring us their captives to review.

Didn't Get the News About 501(c)(15)?

For whatever reasons, there still seem to be a few people who have not yet received the news the 501(c)(15) captive is effectively no more. While Congress did not abolish 501(c)(15) insurance companies outright, Congress instead created a $600,000 maximum limit for gross receipts of both the insurance company and other companies held by the same control group.

In other words, if the both the insurance company's income and the income of the owners exceeds $600,000 in a given year, then the 501(c)(15) limit has been busted and that exception can no longer apply. Since probably no business that would even consider a captive would have less than $600,000 in income by itself, the effect of Congress' change -- which became effective as of December 31 of 2003 -- is to have effectively eliminated 501(c)(15) in all but the rarest of circumstances.

Some tax professionals apparently did not get the news about this change, and have been blissfully advising their clients that 501(c)(15) is alive and well, although their clients are about to wake up to a horrible tax nightmare. Worse, some of these professionals have misconstrued the Determination Letter given to them by the IRS to allow in some way an "exception" to the gross receipts test, which is absolutely not the case. To the contrary, such letters only say that the captive is exempt only so long as it complies with 501(c)(15), which is no longer practically feasible. Malpractice per se.

The Single-Insured Captive

Another common error is the person who sets up an insurance company but then only uses it to underwrite the risks of his own company. Since there is no risk-spreading or risk-shifting, there is little chance that the IRS will consider the insurance company's activities to be that of insurance, and thus little chance that the IRS will consider the insurance company to be an insurance company for tax purposes even if it holds a nice, shiny license from somewhere.

Where people run adrift of this mud bar is where they have received bad advice from their Property-Casualty broker, and set up a captive to underwrite their business needs, thinking that because they have 11 or more single-member LLCs as subsidiaries, they meet the test for risk-sharing and risk-shifting. To the contrary, as the IRS recently announced in Rev.Ruling 2005-40, the IRS simply disregards the single-member LLCs and thus there is just one policyholder -- and no risk-sharing or risk-shifting.

There is one major Property-Casualty insurance broker who has (crazily) been advising its clients to set up these arrangements, and we would not be surprised to see significant litigation against this broker and some of its accommodating advisors who only thought that they understood the federal tax treatment of insurance companies.

The Sham Segregated-Cell Captive

This is a strategy being sold to doctors, whereby they act like they are making payments of medical malpractice premiums or disability income premiums to an offshore segregated-cell insurance company, but the insurance company after some period of time ends up paying out those premiums as "profits" to an offshore trust or similar arrangement that is controlled (directly or indirectly) by the physician. Sometimes these arrangements are designed so that they appear as offshore deferred compensation arrangements.

At any rate, what happens is about the same in all these schemes: The physician makes his premium payment to the segregated-cell captive, takes a deduction for it, and then gets his money back tax-free offshore.

There are four words which are applicable to this structure: Don't drop the soap. This is amazingly blatant criminal tax evasion, and the physician who doesn't fess up before being caught by the IRS will get to spend some quality time at Club Fed. This will be in addition to the huge fines and penalties that the physician will get to pay, in addition to the back taxes and interest.

One of these programs is being marketed by a law firm in the Bahamas, which has aggressively approached property-casualty brokers in the U.S. and even some financial planners to help them sell this scheme. Don't believe it. The Bahamas law firm claims that they have opinion letters and other stuff that will keep the physician out of jail when the time comes, but this scheme is so detached from tax reality that the physician caught up in it will not have a prayer when the IRS criminal investigation agents come knocking.

Offshore planning in general is a flame to which physician moths flock to and get burned. This segregated cell scheme is just another in a long line of abusive offshore strategies that will keep many physicians awake at night wondering whether they will be indicted, just as the abusive Irish or Barbados employee leasing schemes are doing to hundreds of physicians nationwide now.

The Lesson

Captive insurance company taxation is complex and changing. It is very easy to screw up and hit one of the many deadly tax landmines, leading to the entire captive arrangement being disregarded. While captive insurance is a very powerful tool, it must be accompanied by quality tax advice and counsel. If an arrangement sounds too easy or too good to be true, seek a second independent opinion from a qualified tax professional who has experience with insurance company taxation.