Microcaptives: recent developments and a look at what the future may hold

In Reserve Mechanical v Commissioner, the US Court of Appeals for the Tenth Circuit agreed in May 2022 with the Internal Revenue Service (IRS) that purported insurance premiums received by a taxpayer were taxable because the taxpayer was not engaged in the insurance business.

The decision represents the first appellate court win for the IRS in a case against a microcaptive, a commonly used term for a captive insurance company writing less than $2.45 million in premiums and making a section 831(b) tax election.

A properly structured captive insurance company making this tax election is not taxed on its underwriting income (only investment income), creating a permanent tax benefit for the captive owner. Given this, let’s look back to see how we got here and what the future may hold.

A look back

Section 831(b) was created as part of the 1986 tax reform. The original intent was to help certain groups within the agricultural sector weather the liability crisis of the mid-1980s and compete effectively with their larger counterparts.

After including microcaptive transactions on prior lists of “Dirty Dozen tax scams”, the IRS identified them as “transactions of interest” in 2016, citing their potential for tax avoidance and tax evasion (more on IRS notice 2016-66 below). The IRS included microcaptives on its list of most prevalent tax scams again in 2022.

Since 2019, the IRS has been offering a settlement programme for taxpayers under audit for microcaptive transactions. While the programme had an 80 percent acceptance rate during its first year, several cases have gone to court over the past five years. In those cases, the IRS argued that the taxpayer could not deduct insurance premiums paid to its captives because the captives were not bona fide insurance companies for federal tax purposes.

In the Reserve case, the court had two grounds for deciding that Reserve was not an insurance company. First, it determined the risk distribution was inadequate. Virtually all the risk resided with one insured, a company that had the same ownership as Reserve itself. To attempt to distribute risk, Reserve entered an insurance pool with other insurance companies, each owned by an affiliate of its insured. The court decided that this arrangement lacked substance and the pool itself did not distribute risk.

Second, the court determined that the policies issued by Reserve were not insurance in the commonly accepted sense. For example, the premiums were not the result of arm’s-length transactions and were not reasonable, and Reserve did not operate as a legitimate insurance company.

The court identified the following flaws in Reserve’s operations as not following the common tenets of insurance company operations:

• The premiums were unreasonable, without basis, and overinflated for the risks covered
• The third-party insurance arrangements were deemed to have been arranged solely for tax purposes and lacked substance
• There was no supporting documentation accompanying the sole claim notice
• Those responsible for captive governance were judged to have poor knowledge of captive operations
• The captive’s domicile lacked business substance

In March 2022, CIC Services, a captive insurance advisor, successfully challenged the validity of IRS Notice 2016-16 under the Administrative Procedures Act. The district court initially ordered the IRS to return to taxpayers and material advisors (including but not limited to CIC) all documents and information it collected pursuant to the notice.

The court amended its order in June 2022, with Judge Travis McDonough of the US District Court Eastern District of Tennessee, commenting: “CIC is ultimately the only plaintiff in this action. As a result, the court should not have ordered affirmative injunctive relief that extends to nonparty taxpayers and material advisors.” In essence, the IRS must return documents and information to CIC associated with the vacated notice, but not to other parties.

While definitely an interesting ad hoc addition to a court case decision, it is important for market participants to understand the court’s focus and the aim of the decision. Bottom line: the decision applies to CIC, not the broader market.

A look ahead

Per Notice 2022-118, the IRS noted on June 7, 2022 that the Reserve “court decision upholds the IRS’s long-standing position regarding abusive microcaptive insurance transactions”.

“In many of these cases,” the IRS continued, “microcaptive insurance transactions lack economic substance and that when transactions are held to lack economic substance, then a 20 percent penalty (40 percent if undisclosed) will automatically apply, and it cannot be waived or reduced by the IRS or the courts.”

The IRS has increased enforcement in this area, adding 12 new examination teams in 2020 to handle increased IRS audits of microcaptives. Additionally, the IRS expanded its microcaptive “Dirty Dozen” listing by adding Puerto Rico-domiciled structures to the list, expanding IRS’s scope of the transactions being looked at. With regulatory pressure, the prospect of IRS audits and potential legal action, where does this leave the microcaptive industry?

The Reserve case (in addition to other cases such as Avrahami and Caylor Land & Development v Commissioner) highlighted deficiencies in captive insurance company operating procedures. It’s important therefore to consider best operating practices for captive insurance companies. These include, but are not limited to:

• A necessary business purpose behind the insurance provided by the captive
• Captive premiums supported by actuarial loss forecasting or, if unobtainable, comparable to supportable market rates
• Identifiable, robust claims-handling methodology and procedures (claims should be paid)
• Adequate capitalisation accompanied by necessary liquidity to pay claims and expenses
• Strong captive governance by the captive board of directors, for example, minutes of meetings held in the captive domicile

Neither the Internal Revenue Code nor the Treasury Regulations define the term “insurance”. However, case law has developed a four-prong framework that must be present for insurance to exist:

1. The arrangement must involve the presence of an insurance risk
2. There must be risk-shifting
3. There must be risk distribution
4. The arrangement must be insurance in the commonly accepted sense

Exhibiting insurance as defined above and evidencing best captive insurance company practices are essential for all captive insurers, but especially those planning to make a section 831(b) tax election.

In addition to the specifics of insurance and best practices, it may be helpful to think about the original market-oriented purpose of section 831(b). Is the primary purpose of the insurance company to meet a business need, to finance risks that would be otherwise difficult or expensive to obtain in the insurance market? If the answer is no, the potential captive owners should stop there.

A tax benefit of the election was and is a by-product of prudent and appropriate business planning. Small captives remain a viable risk-financing option if structured and purposed correctly. In Notice 2016-66 the US Treasury and the IRS note: “The Treasury and the IRS recognise that related parties may use captive insurance companies that make elections under §831(b) for risk management purposes that do not involve tax avoidance.”

Taking that into account, it’s vital for electing captives and their owners to understand the regulatory, risk and insurance tax landscape to ensure regulatory, tax and legal compliance. Having capable insurance, accounting, tax, and legal advisors will help guide prospective captive owners based on their individual facts and circumstances.