By Karen Hube

Soaring insurance costs for small businesses for everything from healthcare to flood and fire coverage are prompting more owners to pursue private insurance arrangements called micro-captives. Beware: The Internal Revenue Service is targeting them.

These structures enable business owners to save through lower premiums than they would find in the commercial insurance market along with tax deductions for premiums paid to the micro captive.

Different than self-insurance, which is simply setting aside assets to cover your own risks, a micro captive is a private insurance entity set up to cover a company's specific risks that can range from supply-chain disruptions to bird flu.

Business owners set these up by going to outside advisors or administrators who create diversified risk pools with other companies' micro captives. The premiums -- up to $2.85 million per business are allowed each year -- are invested in a portfolio managed either by the business owners or the advisors; taxes are owed on investment income and gains when they are realized.

Typically, business owners use micro captives alongside standard commercial insurance, says Kevin Doherty, an attorney at Dickinson Wright. "This can allow you to raise your deductibles on regular insurance and thereby reduce your costs. Then the regular insurance is there for catastrophic claims."

In areas prone to natural disasters where insurers have scaled back on coverage, micro captives are sometimes the only way for owners to insure their businesses for certain risks.

"With traditional insurance we see more and more exclusions for coverage and less replacement on buildings, which is a scary thing especially on the coastal parts of the country prone to flooding and fires," says Van Carlson, founder and CEO of 831(b) Admin, a company that administers risk pools for micro captives.

Carlson himself has a micro captive with audit risk coverage, which helped offset his business's roughly $300,000 in expenses during a two-year "hell and brimstone" IRS audit that wrapped up last year, with no notice of penalties or back taxes owed.

Interest in micro captives rose during the pandemic, when the risk of business interruption -- which can be pricey to cover through a commercial carrier -- was laid bare. Since then, natural disasters and increasing cyber threats have continued to fuel interest, Carlson says.

"We have over 800 clients, about double since 2020, and are on track to double that again over the next five years," he says.

It is critical for businesses to tread carefully before getting coverage from a micro captive. The IRS goes after those it regards as tax dodges rather than legitimate insurance providers.

"Micro captives have been a target of the IRS," Doherty says. "The IRS has always disliked them because some people have been using them as tax shelters."

Last month the Internal Revenue Service passed final regulations on micro captives and returned some of these structures to its watchlist of frequently abused strategies after being removed from the list in 2022. Under the new rules, the IRS requires anyone using a micro captive in which claims amount to less than 60% of premiums to disclose their entity when they file their taxes by using a Form 8886.

In a U.S. Tax Court ruling last year, a micro captive created by a married couple who own urgent care and rehabilitation facilities around San Antonio, was deemed illegitimate due to a few factors, such as they paid unreasonable premiums and deducted them. For example, they paid about $1.5 million for terrorism coverage one year, compared with the roughly $5,000 they could have paid through commercial insurance. The court ruled that the couple's deductions claimed for four years had to be unwound.

Defendants rarely win cases challenged in tax court, because the IRS chooses the cases very carefully, says Larry Kemp, an attorney at Holland & Knight.

"Most of the cases the government has chosen to litigate had facts that favored the government, so most decisions have fallen to the side of the government," Kemp says.

But when structured properly, micro-captives can be effective tools in an increasingly difficult insurance market, Doherty says.

Health insurance costs for businesses rose 33% over five years through 2023, and businesses with fewer than $600,000 in revenues paid higher premiums than those with more than $2.4 million in revenues, according to a 2024 study by JP Morgan.

For a micro captive to be legitimate, it must have a clear insurance purpose, and its risks must be pooled and diversified.

For example, if you live in Southern California and can't get adequate coverage to mitigate risks of fire damage, you can't simply pay premiums into a captive to cover your own damage, Kemp says. "That would be self-insurance."

To make that situation legitimate, the company would have to pool the micro captive with other companies' micro captives through an administrator or advisor.

The pooled risks must also be diversified, Kemp says.

"If you have five people on one square block all issuing against the same risk, is that diversification of risk? It's probably one risk," he says. "But if you have one person insuring against wildfires in California and another insuring for wildfires in North Carolina, those are different risks and it's hard to argue otherwise."

Signs of an illegitimate micro captives are when premiums are inflated and close or equal to the $2.85 million threshold and risks aren't pooled.

"You always want to have premium quotes so your premiums are in line with commercial ones," says Bill Smith, national director of tax technical services at CBIZ MHM. "It has to be set up legitimately for insurance reasons, not set up as a tax dodge."

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March 01, 2025 04:00 ET (09:00 GMT)

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