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Mark Lubin Published in The Legal Intelligencer
With careful planning, substantial tax liability can often be avoided in making a former captive’s assets available to meet future business needs of related entities
Businesses often manage property and casualty risk through captive insurance companies. Details of captive arrangements vary, but in closely held situations, it is common for captive insurers to be owned by the owners of entities they insure.
For various reasons, a business that has managed risk through captive insurance may decide that the arrangement is no longer beneficial and choose not to continue it. Certain federal income tax considerations regarding the termination of captives are discussed below. Although many of them have broader applications, this discussion is limited to domestic captives that have not been subject to or settled an IRS audit and that have one or more individual owners that directly hold the insured business through a single entity. It is also assumed that the owners have legitimate need for the captive’s assets (or if they are sold, from the proceeds) in the insured business.
Structural Background
Captive insurers are generally C corporations for federal income tax purposes. Because captives can be formed with relatively small amounts of capital, it is common for their owners to have a tax basis in their captive stock that is much smaller than the value of the captive’s net assets. In that situation, liquidation of the captive can result in substantial taxable gain to the owners.
Insured businesses come in a variety of structures, and they can include one or more entities (including LLCs) that are treated as C corporations, S corporations, partnerships or some combination of them. Again, this article assumes that the insured business has been conducted by a single entity.
Preliminary Aspects
Insurance companies are subject to regulatory supervision, which is designed to ensure sufficient reserves to satisfy claims and otherwise protect policyholders. Thus, regulatory approval is required for various actions by insurance companies, including those contemplated in this article. Also, outside management companies typically have control over captive operations and transactions. Because outside management usually is not required or desired after a captive ceases insurance activities, owners typically will want to end their management company relationship.
Ending a captive’s regulatory oversight and management relationship is typically straightforward, but owners of captives that have been organized as LLCs may face a potential tax hazard. Under the IRS “check-the-box” regulations, insurance companies are automatically treated as corporations for income tax purposes. However, when an LLC captive ceases to be considered an insurance company, it will generally become a “pass-through” for tax purposes unless it elects to be treated as a corporation. Where it becomes such a pass-through, the IRS will generally treat the former captive C corporation as having completed a taxable liquidation, which can subject the owners to substantial tax cost.
A similar concern is presented regarding captives structured as “series” LLCs, although the process for avoiding adeemed liquidation of those captives is more complicated because a series LLC is not a separate legal entity. The solution is generally to reconstitute the series LLC as a corporation (or an LLC treated as such for tax purposes) before winding down the captive. That can usually be accomplished through a qualifying “type F” reorganization under the Internal Revenue Code, although reorganizations are subject to a variety of requirements, and care must be exercised to ensure that they are satisfied.
The remainder of this discussion assumes that the captive is structured as a separate legal entity that is taxable as a corporation.
Common Structuring Options
Subject to obtaining the necessary regulatory approvals and satisfying any associated conditions, the owners will need to decide how to make the captive’s assets available to the business following termination. Potential approaches include:
- Distributions from the former captive followed by recontributions to the business entity.
- Preserving the former captive as a separate entity that lends funds to the business entity.
- Preserving the former captive as a separate entity that makes equity investments into the business entity.
- Preserving the former captive as a separate entity that directly owns and conducts new business activity.
- Combining the former captive with the business entity.
These approaches and some associated tax considerations are discussed generally below. Each approach raises technical and practical issues that would need to be addressed.
Dividends or liquidating distributions from the former captive are generally unattractive because they typically trigger substantial tax liability for the owners. Also, owners may need to sell the former captive’s illiquid assets to fund such distributions, which can result in additional corporate-level tax liability to the former captive. (Similar treatment would apply to the extent assets of the former captive are sold under other approaches.)
Making loans from the former captive to the business is generally unattractive because of the tax treatment of interest payments (which the IRS can treat as present even with interest-free or low-interest loans). If the former captive remains a C corporation, interest received will generally incur corporate income tax and either shareholder-level tax (if distributed) or “personal holding company” tax (if retained). If the former captive elects S corporation status, it will likely incur an “excess net passive investment income” tax, and S corporation status may be terminated if significant passive income persists for three consecutive taxable years.
These problems can often be avoided by having the former captive make an equity investment in the operating entity. This approach tends to be most feasible where the business is or can be held through a partnership (or an LLC treated as such for tax purposes), in which situation the former captive may receive “nonpassive” income that does not attract personal holding company or excess net passive investment income tax liability.
Repurposing the former captive as an operating corporation to conduct new business activities is sometimes favorable. If pass-through tax treatment is desired, the former captive can elect subchapter S status, but converting it to a partnership or disregarded entity held by individuals may trigger a taxable deemed liquidation. Moreover, this approach may be undesirable if the new and existing activities will operate as a single business or if one generates losses that might otherwise offset the other’s profits. If the existing business is held in a C corporation, combining the two corporations into an “affiliated group” that files consolidated federal tax returns can address those issues.
A more straightforward approach, which is likely to be available where the existing business is conducted by a corporation, is to combine the businesses in a tax-free reorganization. As indicated above, reorganizations are subject to a variety of requirements, all of which must be satisfied for tax-free treatment. Often, the former captive will need to be the surviving entity in the transaction. Where the operating entity is not conducted through a corporation, it may be possible to contribute the existing business to the former captive and have it conduct both the new and existing businesses. If desired, the former captive could prospectively make an S election.
Conclusion
With careful planning, substantial tax liability can often be avoided in making a former captive’s assets available to meet future business needs of related entities.
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Reprinted with permission from the June 6, 2024, edition of The Legal Intelligencer © 2024 ALM Media Properties, LLC. All rights reserved. Further duplication without permission is prohibited, contact 877-257-3382 or reprints@alm.com.