Controlling a Group of Captives That Is Not A Controlled Group
By Randall Beckie
For U.S. tax purposes, under which separate entity treatment applies to each series insurance
business unit within a series LLC captive or to each cell insurance business within a protected
cell company, it may be practical for a person to control more than one insurance company.
There are no limits to the number of insurance companies that a person can control. However,
there are limits to the extent of captive insurance tax exclusions for which one owner may be
eligible. This article reviews those limits and how potentially to work around them.
Background: why form multiple captives
U.S. taxation of insurance companies comes in four flavors:
1.
Under §501(c)(15), a non-life insurance company’s income (including underwriting
income and investment income) is exempt from corporate income tax if gross receipts do
not exceed $600,000 and more than 50% of gross receipts are insurance premiums. The
gross receipts limitation applies to a controlled group of which the insurance company is
a member.
2.
Pursuant to an election under §831(b), a non-life insurance company’s underwriting
income is excluded from corporate taxable income if gross or net written premiums
(whichever is greater) for the year do not exceed $1.2 million. The $1.2 million premium
limitation applies to a controlled group of which the insurance company is a member.
3.
Under §806, a life insurance company may claim a special deduction that offsets as much
as 60% of the company’s first $3 million of taxable income, although the special
deduction phases out as income approaches $15 million. The phase-out is calculated by
aggregating insurance company income among all insurance companies within a
controlled group. Furthermore, to qualify for the special deduction, assets may not
exceed $500 million for a controlled group of which the insurance company is a member.
4.
Failing eligibility for exclusions from corporate income tax recognition under
§501(c)(15), §831(b), or §806, an insurance company’s net income would be subject to
corporate income tax.
In all cases, insurance companies are treated as corporations for tax purposes. An insurance
company cannot have tax treatment as an S corporation, partnership nor sole proprietorship.
For closely-held business owners, captive insurance planning often involves qualifying for an
exclusion under §501(c)(15), §831(b), or §806. One practical constraint is that the tax benefit
of these exclusions is relatively small. For example, a captive with $500,000 in premiums and a
40% loss ratio would net $300,000 of underwriting income. Via §501(c)(15), the captive could
avoid approximately $100,000 of corporate tax on $300,000 of income. It is not uncommon for
a small captive to incur $100,000 in annual administrative costs from its service providers,
although owners would be inclined to wind down captives whose G&A costs consistently
outweigh the tax benefits. First, owners look for ways to increase tax benefits by increasing
premiums.
An increasingly popular solution involves enabling the closely-held business owner’s family to
own multiple §501(c)(15) or §831(b) captives. This approach has become administratively
feasible thanks to the series LLC captive regime in Delaware or under protected cell company
statutes in other captive domiciles. In Delaware, for example, $250,000 of minimum capital that
would be needed to form a traditional pure captive can instead capitalize a series LLC captive
with multiple series business units. The aggregate administrative costs for the series business
units could be just marginally more than for a traditional pure captive.
In situations where the closely-held business could justify paying multi-million-dollar premiums
to a captive insurance arrangement if only the arrangement could manage to exclude the
underwriting income from corporate taxation, forming multiple captives may be appealing. This
approach gained validation on September 14, 2010 when the U.S. Treasury Department
published proposed regulations in line with Rev. Rul. 2008-8, regarding separate entity tax
treatment of series captives and cell captives.
Which brings us to confront the limits of possibility: namely, the controlled group aggregation
rules. A single person owning two captives each with $600,000 of premiums (and no other
income) could not qualify either captive under §501(c)(15), for each would exceed the $600,000
limitation on a controlled group basis. (In this example, each captive could qualify under
§831(b) because controlled group premiums do not exceed $1.2 million.)
Definition of a controlled group
A brother-sister controlled group is defined to include C corporations more than 50% of which
are owned by five or fewer persons, counting only their overlapping ownership percentages.
Proposed Treasury regulation §1.1563-1(a)(1)(ii) would expand the definition of a controlled
group to include S corporations. The preamble to the proposed regulation asserts that current
law should be interpreted to mean that controlled groups include S corporations, although this
position seems out of context with current Treasury regulations that specifically exclude S
corporations from controlled groups. Some §501(c)(15 ) captives are under common ownership
with S corporations. If the proposed regulations are adopted, the consequence would be to
disqualify such a captive from §501(c)(15) because the S corporation’s gross receipts exceed
$600,000.
Constructive ownership attribution rules apply, such as:

Ownership by one spouse is attributed to the other spouse.

Ownership by a child under age 21 is attributed to the parent.

Stock options count as stock ownership.

Indirect ownership (beneficially through another entity) counts as ownership.
On the other hand, the ownership attribution rules leave room for planning. Example: Father
owns 100% of Captive A; Son aged 21 owns 100% of Captive B; Father and Son each own 50%
of Captive C. None among Captives A, B or C are members of a controlled group, for no
combination of captives is owned more than 50% by the same five or fewer owners (counting
only their overlapping ownership percentages).
The more adults in the family, the more 50/50 captives can be owned by two related adults. In
essence, every adult can own 100% of one captive plus 50% of each additional captive that is coowned by a different adult family member. However, beware co-ownership of a captive by
spouses, for ownership by one spouse is attributed to the other spouse even if direct ownership is
50% each. Also, if each spouse wants to own a captive separately, ownership will not be
attributed from one spouse to the other spouse if the spouses stay out of each other’s business:
e.g., husband must avoid being a director, employee or shareholder in wife’s captive and vice
versa.
If a family were to use all the leeway in the constructive ownership rules, the resulting
arrangement might resemble a syndicate of cell captives all underwriting portions of the same
risk pool. The tax issue becomes: What characteristics distinguish the cell captives from one
another so that the IRS cannot recast them as a single unitary business? Under section 845 the
IRS can recast reinsurance transactions where (among other justifications) the tax benefits are
disproportional to the insurance risk. In a family-owned syndicate of cell captives, perhaps the
cell captives would be prudent to operate as direct insurers rather than as reinsurers. It would
fall on the captive manager to coordinate all this – literally controlling a group of cell captives so
as not to be a controlled group, as defined for tax purposes.