Captive Taxation
The tax treatment of insurance companies in general and captive insurance companies in particular is different from that of any other enterprise. Any domestic captive qualifying as an insurance company is taxed under IRC Subchapter L. Generally, insurance companies can defer the unearned portion of gross premiums and can also deduct reserves for unpaid losses, including a reserve for incurred but not reported claims. If the captive is a qualified insurance company, the premium payments made by the parent and affiliates should be treated as ordinary and necessary business expenses under IRC section 162.
Sometimes, the IRS determines that premium payments are not deductible, claiming a captive is an insurance company in form, but not in substance. The IRS may maintain that the risk of loss has not been shifted and premiums paid to the captive are nondeductible reserves for self-insurance. In such instances, any payments from the captive would be treated as a dividend to the parent to the extent of the captive's available earnings and profits. Payments to other affiliates would be considered dividends to the parent and capital contributions to the affiliates. Any losses actually incurred by the parent or its affiliates would be deductible under IRC section 165 as a loss not compensated for by insurance to the extent that the risk of loss was retained by the captive and not reinsured with an independent company. Essentially, the captive in these circumstances would not be considered a separate corporation, but rather a division of the parent.
