8178 / How can captive insurance be used as an estate planning tool in closely held businesses?

In the closely held business context, captives can play a valuable role in estate and business succession planning. If the captive is owned directly by (or for the benefit of) a business owner’s chosen beneficiaries, the business owner may transfer wealth without gift, estate, or generation-skipping transfer (GST) taxes.

Planning Point: For several years, the IRS has listed microcaptive transactions on its “dirty dozen” list and, more recently, the Tax Court has regularly challenged the legitimacy of captive insurance arrangements. Generally, in a captive arrangement, the parent entity is entitled to deduct amounts paid as insurance premiums to the captive subsidiary and the captive itself can elect to be taxed only on investment income so long as premiums do not exceed $2.2 million. The Tax Court has challenged several arrangements on the basis that premiums are artificially high to generate a larger deduction at the parent level. Because of this, while captives can be valuable in the estate planning context, companies using the captive strategy must be especially careful that the arrangement satisfies the IRS “risk shifting” and “risk distribution” requirements, rather than simply as a vehicle to transfer wealth and minimize taxes.

To avoid gift, estate, and GST taxation, the transfer of funds to the captive must be made in the ordinary course of business (meaning that the funds received by the captive are also deductible under IRC Section 162). When the transaction occurs in the ordinary course of business, it will be considered to have been made for adequate and full consideration.¹

If the captive qualifies as an insurance company, the premiums paid by the insured entity or entities will be considered insurance premiums, which are ordinary and necessary business expenses under IRC Section 162 (see Q 8173). If this is the case, gift, estate, and GST taxes will not apply to the transfer.

Planning Point: In the context of a closely held business, the use of captives can be part of an effective estate planning strategy. The business owners can form a captive entity to provide insurance for their business group and name children and grandchildren as the owners of that captive. Because all funds transferred to the captive will escape gift, estate, and GST taxes, the net underwriting profits of the captive will essentially have been transferred to the owners’ children and grandchildren transfer tax-free. The structure of the transaction is important in estate planning, so the business owner should seek professional advice from legal and tax advisors in forming the captive entity and transferring the premiums to that entity. To avoid transfer taxes, it is important that the owner have no retained interests in or control over the captive.

1.Treas. Reg. § 25.2512- 8.