Taxation of Captives

In general, the Internal Revenue Code permits property and casualty insurance companies certain deductions against taxable income, including premium income and investment income, which are not available to regular corporations.  As a result, an insurance company may have little to no taxable income from premiums received (see Section 831(b) Companies below).

Section 831(a) Companies

Section 831(a) imposes a tax on the taxable income of every insurance company other than a life insurance company.  The term "taxable income" means gross income as that term is defined in Section 831(b)(1), less the deductions allowed by Section 832(c).  "Gross income" includes the sum of "the combined gross amount earned during the taxable year, from investment income and from underwriting income..."[IRC 832(b)(1)]

Underwriting income is defined as "the premiums earned on insurance contracts during the taxable year less losses incurred and expenses incurred. " [IRC 832(b)(3)]  The deductions allowed, in addition to those available to all corporations, include an accrual based deductions for losses that are incurred, but not reported ("IBNR") [IRC 832(b)(4) and IRDC 832(b)(5)].

For example, when a new building is constructed and placed in service, construction defects may already have been incurred, for example, improper soil compaction, or defects in plumbing pipes.  Many of these defects may not be recognized (reported) for years to come.  Real estate developers often use captive insurance to set aside pre-tax dollars from development profits for future claims as defects are reported.

Section 831(b) Companies

Section 831(b) provides a very powerful tax advantage for qualifying small insurance companies.  If the company receives less than $1.2 million of premiums each year, it may elect to be taxed only on its investment income [IRC 831(b)(2)(a)].

Thus, premiums are not taxable income.

The Section 831(b) election may not be revolked onee it is made without consent from the Secretary of the Treasury.  Section 831(b) status does not affect the deductibility of premiums paid by the operating companies.  Under this structure, the significant advantage is that the company is able to accumulate surplus from underwriting profits free from tax.  While a Section 831(b) company pays no taxes on underwriting profit, its owners are taxed on dividends received from the company similar to large property and casualty companies.

State Taxes

State taxation of a captive is wholly dependent on state law and is usually not an ordinary income tax.  The most common types of taxing regimes are a premium tax and a direct placement tax.   A direct placement tax is usually imposed on transactions through in in-state broker with a non-admitted insurer in the state.  A premium tax is usually levied on the gross premiums received by the insurance company and applies only to admitted insurance carriers doing business in the state.

Kentucky charges captives a premium tax of 0.4% on the first $20 million and is capped at $5,000 for Section 831(b) captives.