Parts of this article are from the book published by John Wiley and Sons, Protecting Clients
    from Fraud, Incompetence and Scams, authored by Lance Wallach.

    September 24, 2010

    Herol Graham has turned defensive boxing into a poetic art. Trouble is, nobody ever got
    knocked out by a poem.
    —Eddie Shaw

    Every accountant knows that increased cash flow and cost savings are critical for businesses in
    2009. What is uncertain is the best path to recommend for garnering those benefits.

    Over the past decade business owners have been overwhelmed by a plethora of choices designed
    to reduce the cost of providing employee benefits while increasing their own retirement savings.
    The solutions range from traditional pension and profit sharing plans to more advanced strategies.

    Some strategies, such as IRS section 419 and 412(i) plans, used life insurance as vehicles to
    bring about benefits. Unfortunately, the high life insurance commissions (often 90 percent of the
    contribution, or more) fostered an environment that led to aggressive and noncompliant plans.

    The result has been thousands of audits and an IRS task force seeking out tax shelter promotion.
    For unknowing clients, the tax consequences are enormous. For their accountant advisors, the
    liability may be equally extreme.

    Recently, there has been an explosion in the marketing of a financial product called Captive
    Insurance. Small companies have been copying a method to control insurance costs and reduce
    taxes that used to be the domain of large businesses: Setting up their own insurance companies
    to provide coverage when they think that outside insurers are charging too much. A captive
    insurance company would be an insurance subsidiary that is owned by its parent business(es).
    There are now nearly 5,000 captive insurers worldwide. More than 80 percent of Fortune 500
    companies take advantage of some sort of captive insurance company arrangement. Now small
    companies can, too.

    These so-called “Captives” are typically small insurance companies designed to insure the risks
    of an individual business under IRS Code Section 831(b). When properly designed, a business
    can make tax-deductible premium payments to a related-party insurance company. Depending on
    circumstances, underwriting profits, if any, can be paid out to the owners as dividends, and
    profits from liquidation of the company may be taxed as capital gains. Single-parent captives
    allow an organization to cover any risk they wish to fund, and generally eliminate the
    commission-price component from the premiums. Jurisdictions in the United States and in
    certain parts of the world have adopted a series of laws and regulations that allow small non–life
    insurance companies, taxed under IRC Section 831(b), or as 831(b) companies.

    Captives can be a great cost-saving tool, but they can also be expensive to build and manage.
    Also, captives are allowed to garner tax benefits because they operate as real insurance
    companies. Advisors and business owners who misuse captives or market them as estate
    planning tools, asset protection or tax deferral vehicles, or other benefits not related to the true
    business purpose of an insurance company, face grave regulatory and tax consequences.

    A recent concern is the integration of small captives with life insurance policies. Small captives
    under Section 831(b) have no statutory authority to deduct life premiums. Also, if a small captive
    uses life insurance as an investment, the cash value of the life policy can be taxable at corporate
    rates, and then will be taxable again when distributed. The consequence of this double taxation is
    to devastate the efficacy of the life insurance, and it extends serious liability to any accountant
    who recommends the plan or even signs the tax return of the business that pays premiums to the

    The IRS is aware that several large insurance companies are promoting their life insurance
    policies as investments within small captives. The outcome looks eerily like that of the 419 and
    412(i) plans mentioned above.

    Remember, if something looks too good to be true, it usually is. There are safe and conservative
    ways to use captive insurance structures to lower costs and obtain benefits for businesses.
    Some types of captive insurance products do have statutory protection for deducting life
    insurance premiums (although not 831(b) captives). Learning what works and is safe is the first
    step an accountant should take in helping his or her clients use these powerful, but highly
    technical insurance tools.

    Lance Wallach, National Society of Accountants Speaker of the Year and member of the AICPA
    faculty of teaching professionals, is a frequent speaker on retirement plans, financial and estate
    planning, and abusive tax shelters.  He writes about 412(i), 419, and captive insurance plans.
    He speaks at more than ten conventions annually, writes for over fifty publications, is quoted
    regularly in the press and has been featured on television and radio financial talk shows
    including NBC, National Public Radio’s All Things Considered, and others.  Lance has written
    numerous books including Protecting Clients from Fraud, Incompetence and Scams published by
    John Wiley and Sons, Bisk Education’s CPA’s Guide to Life Insurance and Federal Estate and
    Gift Taxation, as well as AICPA best-selling books, including Avoiding Circular 230
    Malpractice Traps and Common Abusive Small Business Hot Spots. He does expert witness
    testimony and his side has never lost a case. Contact him at 516.938.5007, or visit or

    The information provided herein is not intended as legal, accounting, financial or any other
    type of advice for any specific individual or other entity.  You should contact an appropriate
    professional for any such advice.