Captive Insurance Audit for Business Owners

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Tax season is over. Now, many business owners are anxious about the future and waiting to see if an audit might be in their future.

Businesses that have used a form or self-insurance called captive insurance might feel more nervous, particularly with some commentators misleadingly stating that captives are nothing but abusive tax shelters perpetrated only if bad actors.

Captive insurance is a legal, tried and true form of self-insurance that has existed for more than three decades. It was created by Congress in 1980s and further expanded by Congress during the Obama administration.

Section 831(b), which allows businesses to establish their own insurance entities (known as captives) to mitigate risks not covered by commercial insurance. For the premiums that they pay to captives, businesses can receive a tax deduction.

This is often a win-win situation, especially for small businesses who are not covered by commercial insurance or don’t have the resources to manage those risks. Many business owners have had to confront the limitations of their traditional business insurance. They often lose their claims for losses due to the pandemic.

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Captives can also have a tax benefit. There are always those who want to make it more. However, this shouldn’t discourage businesses from using legal self-insurance which could help reduce risk and provide tax breaks.

A good tax advisor’s job is to help clients keep more money in their pockets within the spirit of the law. This money could be used to increase their retirement savings or invest in their business. However, it is important to follow the law. It is not an open-ended system.

How to use captives safely without being spooked

Assess risk using a third party

It doesn’t make sense to pay premiums for terrorist attacks and then claim those premiums as a tax deduction if you are a dentist. There are who have done it. If you’re a business owner working in highly regulated industries, you can protect yourself against the negative effects of changes in the law. You can also insure against a social media attack that causes a loss of business if your business requires high levels of trust.

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It all begins with ensuring that the premiums you pay are in line with legitimate business risks. This includes both what those risks are as well as how much premiums.

A third party can provide an assessment to help you prove to the IRS that your captive payments are legitimate risk mitigation.

Bad actors often exploit captives by increasing their premium payments each year, currently at $2.3million, and then claiming the entire amount when it comes to tax time. They create phony risks like the terrorist attack example.

One rule of thumb: If your losses exceed 20% year after year, it is possible that you are insuring non-existent or phony risks.

A third-party assessment will help you determine which risks you are actually facing and what premiums you should be paying to protect them. While you might not reach that limit, it is possible to do so with legal authority.

Do your research on captive vendors

As you wouldn’t do due diligence before signing on with a vendor, why would you do the same with a captive manger?

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Self-insurance has been a part of my business for many years. I can tell that I went through numerous vendors before finding the one I currently use. Some promoters of captives are not good actors. They inflate the risks and try to backdate licenses. Or they behave in fraudulent ways.

However, you should not listen to general misstatements without supporting evidence regarding the entire captive insurance risk management sector or any state insurance regulator or department. Perhaps you will find your best option is a vendor based in Puerto Rico. This domicile has the highest risk rating from AM Best. Perhaps Bermuda, Vermont, or another domicile with a special market or focus on financial or other markets is your best choice.

Talk to your advisors and your team about potential vendors and use the same critical lens as you would for anything with major tax implications.

Other forms of self-insurance are available

After you have reviewed your financial records, spoken to an advisor, done due diligence, and received your assessment, it is possible that the 831b captive option may not be right for you. However, this doesn’t mean that you cannot self-insure your business and still potentially receive tax benefits.

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Captives were first codified in 1980. Many other private and self-insurance options, such as risk retention and risk buying groups, followed. Now, there are many newer options, including catastrophe bonds.

Bottom line, you have the right to reduce any risks that may affect your business. You can use 831(b), or any other self-insurance with confidence.