Following a recent government victory in U.S. District Court in Texas, the captive insurance company industry stands generally on alert, viewing this case as a sign of a perceived increase in focus by the Internal Revenue Service on captive insurance companies. While the court ruling does not change the structuring requirements or potential advantages of captive insurance companies, it is an indication that the IRS is looking into captive insurance companies, particularly “micro” captives formed to take advantage of the benefits of Section 831(b) of the Internal Revenue Code, that appear to be designed for other than insurance purposes (for example, as estate planning devices).

Captive insurance companies need to satisfy the general requirements for status as insurance companies under the Code, including demonstrating adequate risk shifting and risk distribution aspects. Qualifying micro captives earning less than $1.2 million in annual premium income may elect under Section 831(b) of the Code to pay tax on only their investment income.

In the recent Texas decision, Salty Brine I, Ltd. et al v. United States, 111 AFTR 2d 2013-2308, the court determined that these basic requirements for insurance were not met, and concluded that the “insured” entity was therefore not entitled to a deduction for amounts paid for the purported coverage.

The IRS appears to be more closely scrutinizing captive insurance companies, with a potential focus on companies claiming the potential benefits for micro captives, to ensure that these companies meet the established industry standards. Taxpayers with captive insurance companies may want to examine their business rationale for the companies, and their adherence to the requirements for valid insurance under the relevant tax principles, to ensure compliance with these standards.