Each year the IRS publishes a list of the “Dirty Dozen” tax scams. The list is intended to warn taxpayers against common and trending tax scams. The complete list for 2015 can be found by clicking here.
The 2015 list includes the improper use of captive insurance companies to shelter income from the IRS.
Captive insurance companies, when used lawfully, can be a means of legitimate self-insurance. Basically, a parent company forms a wholly-owned subsidiary, which operates as a “captive insurance company.” The captive insurance company can be incorporated domestically, but is more often incorporated in an offshore venue, such as the Cayman Islands, the Bahamas, or the British Virgin Islands. The parent company pays insurance premiums to its captive subsidiary, which then provides insurance to the parent company, either through the reinsurance market or on its own.
The tax benefits can be obvious. All premiums paid to the captive company can be deducted as expenses by the parent. Since these expenses are being paid to a subsidiary, however, the joint owners of both parent and subsidiary benefit from the transaction.
In the Dirty Dozen list, the IRS identified two red flags to signal when captive insurance companies are being used improperly. First, the IRS identified situations where the risk being insured is an esoteric or implausible risk. In other words, the parent company is paying a large premium to its own captive subsidiary to insure against a risk that is never likely to happen. The insurance policy is being used as a ruse for sheltering income from taxes.
Next, the IRS identified situations where the total amount of premiums paid to the captive insurance company equals or comes close to the amount of deductions that a given business or entity needs to reduce its income for the tax year. The IRS might view this as more than a mere coincidence. Instead, this might be a sign that the captive insurance company was created, not as a legitimate means to provide insurance for the parent, but as a means to reduce taxable income for the parent.
If an employee knows about the use of a bogus captive insurance company, he or she may be entitled to a reward by reporting this information to the IRS through the IRS whistleblower program.