TAX PLANNING

A Compliant Framework for Tax Efficiency: Understanding the Mechanics of IRC §831(b)

A properly structured and managed micro-captive insurance company that makes an election under Internal Revenue Code §831(b) offers significant tax planning advantages. However, it is imperative to state that these tax benefits must be an outcome of a legitimate risk management strategy, not the primary motivation for the captive's formation. The IRS and the Tax Court have consistently rejected arrangements that lack a bona fide, non-tax business purpose.

The tax efficiency of a compliant micro-captive arises from the interplay of three distinct components of the Internal Revenue Code. The structure's unique power also stems from its status as a C-corporation, a separate legal and taxable entity from its owners. This structural separation is the very source of its utility for asset protection and advanced estate planning, a feature that is enabled by, and runs parallel to, its tax treatment.

THE THREE CORE TAX COMPONENTS

Deductibility of Premiums (Practice Benefit)

The operating medical practice pays premiums to its captive for bona fide insurance coverage.
These premiums are deductible as a business expense under IRC §162.
This allows the practice to fund future potential losses using pre-tax dollars.

Exclusion of Underwriting Income (Captive Benefit)

Deductibility of Premiums (Practice Benefit)

Gross written premiums for the year that do not exceed the annually adjusted statutory limit ($2.8 million for 2024) are not subject to federal income tax.
This allows surplus to accumulate within the captive on a tax-free basis.

Taxation of Net Investment Income

Deductibility of Premiums (Practice Benefit)

Taxation of Net Investment Income

The 831(b) election does not eliminate all tax for the captive.
The captive must still pay federal income tax at standard corporate rates on its net investment income, which is the income earned from investing its capital and surplus.

TAXATION OF DISTRIBUTIONS FROM THE CAPTIVE

Qualified Dividends

When the captive's board of directors decides to distribute accumulated surplus to its shareholders, these distributions are typically treated as qualified dividends.
For the shareholders, qualified dividends are taxed at the more favorable long-term capital gains tax rates, which are significantly lower than ordinary income tax rates.

Liquidation

Qualified Dividends

Should the captive be dissolved at some point in the future, any final distributions of its accumulated value to the owners may also be taxed at long-term capital gains rates.

Key Compliance Points for Favorable Tax Treatment

To secure these favorable tax outcomes, the captive arrangement must be meticulously maintained and compliant. The IRS requires that:

The captive must be a legitimate U.S. taxpayer. This means it must either be domiciled in a U.S. state or, if domiciled offshore, make a valid election under IRC §953(d) to be treated as a domestic corporation for tax purposes.

The premiums paid to the captive must be actuarially sound and reasonable for the risks being covered. They cannot be artificially inflated to maximize the tax deduction.

The entire arrangement must satisfy the four-part judicial test for what constitutes "insurance," demonstrating genuine risk shifting and risk distribution.2

Failure to adhere to these principles can result in the IRS disallowing the premium deductions, taxing the captive on its premium income, and assessing significant penalties