August 01, 2019

For many medium-to-large-sized businesses, forming a captive insurance company can be a great business and tax strategy.  A captive insurance company is a wholly-owned subsidiary that is formed to insure the parent company against certain risks.  So long as the risks are legitimate and insurable,[1] the parent company can deduct the costs of insurance premiums paid to its captive and keep those insurance dollars "in house" rather than paying a third-party insurance carrier to provide the same coverage. 

Captives are, in essence, a formalized system of self-insurance bestowed with certain tax benefits.  Not surprisingly then, they face constant scrutiny from the IRS and must navigate numerous state regulatory hurdles.  It would be understandable then for the parent company to decide to simply "unwind" its captive and relieve itself of the compliance burden.  But what becomes of a former captive?  What new issues lie ahead for the parent and the subsidiary in a post-captive world?

The Corporate, Regulatory, & Tax Structure of Captive Insurance Companies

To form a captive, the parent incorporates a new subsidiary corporation in a particular state.  The captive then must meet the applicable legal and regulatory hurdles to receive its insurance license from that state, and the subsidiary must operate as a C corporation for tax purposes.[2] 

The taxation of insurance companies is governed under Subchapter L of the Internal Revenue Code.  Life insurance companies are taxed upon their own unique definition of taxable income,[3] but nonlife insurance companies (e.g., property and casualty insurers) are taxed as regular corporations under Section 11.[4]  For the parent, premium payments to the captive are deductible as ordinary business expenses. For the captive, premiums and investment earnings constitute gross income.

However, if the nonlife insurance company is small enough, it can elect to be taxed only on its investment income (and exclude its premium income).[5]  The tax benefits of the captive structure quickly become clear: the parent receives deductions for expenses it would otherwise pay, the captive gets to hold and invest the parent's money for a rainy day, and part of the captive's earnings might avoid taxation.[6]

The Immediate Effects of a Captive Unwind

For purposes of this article, the captive at issue is assumed to be a nonlife insurance company that insures the parent against certain property and casualty risks.  For whatever reason, if the captive were to lose its state insurance license, suffer an adverse ruling by the IRS, or have its parent company simply abandon the venture, the captive is no longer an "insurance company" for purposes of the Internal Revenue Code.[7]  The parent can no longer claim a deduction for premiums paid, and the captive is now subject to the full corporate tax on all its earnings – dividends, interest, gains from property dispositions, etc.  

Like any good insurance company, the captive would have taken its income earned from premiums and invested it wisely to build assets from which any future claims from could be drawn upon.   Once its status as a captive insurance company is terminated, the subsidiary is treated an investment holding company of the parent. 

There is no indication in either the Code or the Regulations that this change in status from an insurance company to a non-insurance company (i.e., a regular corporation) triggers any deemed liquidation that might otherwise produce a taxable event.  This is supported by the plain logic of Section 831, which already taxes all nonlife insurance companies in the same manner as regular corporations under Section 11 (except for those electing small insurance companies discussed above).  So the only immediate tax consequences of a transition from a captive insurance company to regular non-insurance company are (1) the loss of the Section 831(b) election, and (2) the loss of the parent company's deduction for insurance premiums paid.

Tax Issues Facing the Resulting Investment Holding Company

Now, as a corporate holding company, other potential tax issues arise including the accumulated earnings tax, and the imposition of the personal holding company (PHC) tax.[8] Both are taxes levied on corporations in addition to the corporate tax imposed under Section 11.  The accumulated earnings tax does not apply to personal holding companies, and can be easily avoided by making sufficient annual shareholder distributions.  However, the PHC tax is a different animal, and its avoidance is trickier.  The policy behind both is to prevent taxpayers from shielding income inside a "corporate wallet" and avoiding the shareholder-level tax by not making routine distributions. While the application of the accumulated earnings tax is fairly subjective (i.e., an accumulation of profits beyond a corporation's reasonable needs), determining if the personal holding company tax will apply is objectively formulaic.  

A "personal holding company" is any corporation meeting certain stock ownership and income tests imposed by the Code.  These tests can generally be described as ownership (through attribution) by five or fewer individuals and income predominantly derived from sources such as dividends, interest, royalties, and gains from the sale of sock or securities.[9]  For our former captive, if the parent company is very closely-held, it most likely would meet the definition of a PHC.

To avoid paying the additional PHC tax, [10] the former captive either needs to repurpose itself as a business entity (taking on different sources of income) or it needs to shed its investments.  The problem, however, is that a disposition of assets by a C corporation generates two levels of tax – one at the subsidiary level and a second when the proceeds are distributed to the parent. 

Dissolving the subsidiary is one solution, but it is not without its caveats.  In general terms, a parent-subsidiary liquidation is "tax free" under Section 332 and Section 337 of the Code.  The subsidiary dissolves and its assets transfer to the parent, with the parent taking a carry-over basis in those former subsidiary assets.  Only a later disposition by the parent of the underlying assets will trigger the corporate tax.  So while it cannot be avoided, the tax can at least be deferred.

But if the parent is an S corporation that doesn't pay a corporate level tax, the result is a little different (and more favorable).  To foreclose an otherwise fortuitous loophole, Section 1374 imposes a built-in gains (BIG) tax on assets acquired by an S corporation from its dissolved C corporation subsidiary. The parent S corporation will have to track, recognize, and pay an additional corporate-level tax on any former captive assets it disposes of within the next 5 years.[11]  While not an immediate solution, it is a better result in that it at least limits the time period that the corporate tax would apply to any disposition of those assets.[12]

Conclusion

Having shut down its captive, the parent most likely wants to retrieve its corporate assets in the most tax efficient manner possible.  However, a captive insurance company cannot be unwound without some tax consequences to deal with.  In the immediate aftermath, the parent corporation loses the generous tax benefits of the captive structure.  Maintaining the subsidiary to hold investment assets raises the risk of additional corporate taxes being owed.  Dissolving the captive can mitigate the risk of the accumulated earnings or the PHC tax, but the assets still face taxation on later disposition.  Compared to C corporations, S corporation parents are in a better position with respect to their dissolved captives as they can wait 5 years and avoid the BIG tax on those transferred assets.  When it comes to unwinding a captive insurance company, the key is to understand the resulting corporate and tax realities after the captive designation is removed, and to wisely approach the timing and further disposition of the former captive's assets.

This Insight is intended only to provide an overview of the matters addressed herein and does not constitute legal advice.  If you have any questions regarding a specific issue, please seek appropriate legal counsel.

[1] See Harper Group & Incl. Subs. v. Comm., 96 T.C. 45 (1991).

[2] Insurance companies are ineligible to elect "S" corporation status.  IRC § 1361(b)(2)(B).

[3] IRC § 801(a).

[4] IRC § 831(a).

[5] IRC § 831(b).

[6] There is also an exemption from income taxes for certain small insurance companies under Section 501(c)(15); however, to simply the analysis, this article does not delve into the effects of such exemption.

[7] Treas. Reg. § 1.801-3(a).

[8] IRC §§ 531; 541.

[9] IRC §§ 542(a); 543(b)(1).

[10] Parent and subsidiary corporations filing a consolidated return can aggregate their income in calculating the total amount of PHC income attributable to the entire group.  Therefore, consolidated corporations have an easier road in avoiding the PHC trap.

[11] IRC § 1374(d)(7).

[12] Instead of dissolving the subsidiary, the S corporation parent could elect to treat the former captive is a qualified subchapter S corporations (QSub).  However, the election itself is treated as a parent-subsidiary liquidation so the BIG tax and 5-year taint on the captive's assets still applies.  Treas. Reg. § 1.1361-4.