8177 / How does the tax-exempt status of the captive’s owner affect the captive?

IRC Section 501 permits many organizations to operate on a tax-exempt basis, but it also contains a specific provision limiting the ability of these organizations to engage in commercial insurance activities.¹ An organization will not qualify for tax-exempt status if any substantial portion of its business involves providing commercial-type insurance.²

The IRC excludes the following insurance-related activities from the definition of “commercial insurance”: |

1. Insurance provided at a substantially reduced cost to charitable recipients;
2. Incidental health insurance provided through a health maintenance organization of a kind customarily provided by such organizations;
3. Property or casualty insurance provided by a church organization for the benefit of that church organization;
4. Retirement or welfare benefits provided by a church organization for its employees or beneficiaries of its employees;
5. The use of charitable gift annuities.³

If the insurance activity of the tax-exempt organization does not fall within one of these exclusions, the insurance profits of the captive will be taxed to the organization as unrelated business taxable income (UBTI).⁴

Further, because of the state taxes that may apply to the premiums paid to a captive insurance company, the tax benefits of qualifying as an insurance company may not be sufficient to offset the additional taxes applied in the case of an entity that is operating on a tax-exempt basis. See Q 8181 and Q 8173.

Planning Point: While captive arrangements may be especially attractive to tax-exempt organizations because of the types of risk they may encounter, proper structuring is important to ensure that the tax liabilities do not exceed the benefits of the captive arrangement. Hospitals and school districts, for example, may find captive arrangements useful in insuring against malpractice and workers’ compensation risks. If properly structured, the use of captive structures can greatly reduce the cost of insurance for these organizations.

1.  IRC § 501(m).