Unsure how to set up your captive insurance company structure? Luckily, there is a typical structure to follow. Even though there is a typical structure, there is a saying in the captive business “If you have seen one captive, you have seen one captive”.
As a reminder, a captive insurance company is an insurance company that a business owner or owners sets up to insure their own risks. Although the businesses and policies they write are varied, most captive insurance companies are structured in a similar way. Captive insurance companies are nearly always set up as a calendar year, C corporation (C-corp). They may also be an LLC that is taxed as a C-corp. A C-corp is a legal structure for a corporation in which the owners, or shareholders, are taxed separately from the entity.
According to the IRS, a captive insurance company must be a separate legal entity from the business it insures. A captive insurance company is a business whose reason for existence is to issue insurance policies and cover the risk of a business. Broken down further, a typical capture insurance structure looks like this:
The business (on the left) , pays premium to the captive insurance company (middle). When the captive distributes dividends, it goes to the shareholders of the captive insurance company. In the vast majority of captive scenarios, the shareholders of the captive are identical to the shareholders of the insured business.
The PATH Act
The rules around captive insurance company ownership has changed within the last few years. The Protecting Americans from Tax Hikes (PATH) act was legislation issued in 2017. This law changed how captive insurance companies could be structured. Before the PATH Act, the owners of the business and the owners of the captive did not have to be similar. The following example, although not common by any means, was common enough to have the IRS petition Congress to change the rules. Let me set the stage- you have a patriarch or matriarch owns a business. They do not need any more money and desired to get money to the next generation without using any of their gift tax exemptions.
In this scenario, the business owner parents may have the captive owned by the children (or trusts for the children). The business, owned by the parents, paid tax-deductible premiums to the captive that was owned by the children. The end result was this allowed the parents to get money past the estate and gift tax line to their children. This was even promoted by some captive managers specifically to skirt estate and gift taxes.
It is not surprising the IRS did not accept this as a legitimate means of intergenerational wealth transfer. The PATH Act effectively ended this practice. Under the PATH Act, the shareholders of the captive insurance company have to be the same as the insured business with regard to spouses and lineal descendants. There is a 2% de minimis exception, meaning the spouses or lineal descendants can own up to 2% of the captive.
New captive structures are being created every day, and diversity in approach will be beneficial to the whole industry. In the end, however, any structure will need to reflect the information above.