Davis Smith, Bradley
15 May 2020Accounting & tax analysis

How captives can help fill pandemic coverage gaps

The outbreak of COVID-19 has caught many businesses off guard and in need of cash. Some hope their business interruption insurance policies will provide coverage for a loss of income suffered from a slowdown or suspension of operations. However, since business interruption insurance commonly requires damage to property (such as a building damaged by fire), it is possible the policy language will not address shutdowns due to an insured implementing prudent COVID-19 precautions.

This has led to frustrations among the business community with traditional carriers. New York, Ohio, Massachusetts, New Jersey and potentially the federal government are contemplating legislation to require insurers to retroactively cover losses from COVID-19, despite policy language to the contrary.

“Businesses must avoid the temptation to access capital held by their captives without observing important insurance company formalities.”

Where business interruption policies do not cover losses from COVID-19, a captive would be a great vehicle to address this coverage gap—if the affiliated businesses had the foresight to place such coverage with their captive prior to the outbreak. For businesses with captives in place, the temptation may be to pay a claim for business interruption from the captive, even when it is questionable whether the captive policy provides such coverage.

This temptation to disregard the captive’s policy language could have adverse tax consequences.

If structured properly, captives can be tax-efficient vehicles for companies to use to fill coverage gaps in their commercial policies. The premiums paid to an affiliated captive may be deductible against federal income taxes if the transaction qualifies as insurance under a four-prong test:

  1. Insurance risk must be present (as opposed to business risk);
  2. There must be a transfer of the risk of loss from the insured parent/affiliate to the captive in exchange for the premium;
  3. The captive must sufficiently distribute this risk to the point where an actuary can reasonably price the premiums; and
  4. The transaction must be insurance in the commonly-accepted sense.

In addition, if a section 831(b) election is made and annual premiums are less than $2.3 million annually (the premium cap in effect for tax year 2020), the captive is not taxed on the receipt of the premiums. The combination of risk management and tax advantages offered by captives has been a factor in their growth over the past several years. However, this growth has also caught the attention of the Internal Revenue Service (IRS).

Tax focus

The IRS has committed significant resources to audit and attack captive insurance structures that it believes do not qualify as insurance for federal income tax purposes. These activities have borne fruit, as evidenced by the IRS’s victories in a few recent Tax Court cases involving captives that have made the section 831(b) election.

In light of the intense focus by the IRS on certain small captives, businesses must avoid the temptation to access capital held by their captives without observing important insurance company formalities as required by the fourth prong of the insurance tax test.

Federal tax law requires that a captive operates with the formalities of an unrelated insurance company, in contrast to an affiliate that merely acts as a freely-accessible deposit account for the parent and other affiliates. The IRS has successfully attacked a lack of formalities in small captives in recent Tax Court cases.

For example, failure to have a formal claims-handling process was one factor the Tax Court relied upon in Avrahami in holding against the taxpayer. The Tax Court has also identified the circular flow of funds between a captive and an insured affiliate as problematic, particularly when premiums are paid and lent back to the insured soon thereafter. Finally, the policies issued by the captive did not look and function like a traditional commercial insurance contract.

The lack-of-formalities factor was also present in one form or another in subsequent Tax Court cases in which the IRS was victorious.

Make a claim

If your business has a business interruption loss that is not covered by your traditional commercial policies, you should proceed with a formal claims submission process with your captive before simply causing the captive to transfer funds to the parent or affiliates’ bank accounts.

The first step is to review your captive’s policy language for coverage. Captives policies are often manuscripted, meaning the policy language has been drafted to fit the particular needs of the insured. If the captive insurance policy has broad enough language to offer coverage for the loss resulting from the pandemic, then formally submit a claim to the captive using procedures described in the policy.

The captive should acknowledge receipt of the claim submission and proceed with a formal review of the claim to include setting reserves, investigating and documenting the claim, determining the cause of loss, liability and loss amount, and then settling the claim through either a payment of the loss or denial of the claim.

If it cannot be reasonably determined that the captive policy covers the claim, there are reasonable alternative methods for accessing the captive’s funds. For example, the captive can issue dividends to its owner. This may result in the owner being subject to capital gains tax on receipt of the fund, but that may be a small price to pay for access to the capital.

Again, it is important to follow through with all necessary corporate formalities in declaring and paying the dividends, as well as complying with state captive insurance laws, which typically require the consent of the department of insurance before any dividends are paid.

The captive may also make loans to the parent or affiliates, as long as the terms are reasonable, and the necessary approvals are obtained from regulatory authorities. Regardless of whether dividends or loans are used to access the capital, the captive will still need to maintain capital and surplus at levels that an actuary would opine are sufficient to meet the reasonable needs of the policyholders.

A captive can be a useful tool in a business’s arsenal when the unexpected strikes. But the captive owner must follow corporate formalities to prevent the IRS coming back and disallowing prior tax deductions for premiums paid to the captive.

Davis Smith is a partner at the law firm Bradley. He can be contacted at: dhsmith@bradley.com