Microcaptives
A plague on 831(b)s
The IRS insists that microcaptives are havens for tax evaders, but advocates of the structure say they provide the perfect vehicles for providing the pandemic coverage that the commercial market has so spectacularly failed to provide. Captive International reports.
The Internal Revenue Service (IRS) has long been gunning for the microcaptives—aka 831(b)—industry. It has pursued a number of captives through the courts, securing victories against Avrahami in 2017 and Reserve Mechanical Corp in 2018.
Part of the IRS case against microcaptives, and a key point on which the Avrahami case was decided, was that they wrote coverages for years but no claims were made against them.
When the COVID-19 pandemic hit, advocates of the 831(b) structure were quick to seize on this point. A captive could have written pandemic coverage for decades without any claim being made—until 2020, the argument goes. Few would argue this invalidates this coverage as real insurance.
Emilie Gastley, director of marketing at Captive Alternatives, says: “The pandemic has proved many of the arguments against small captives wrong: small companies do face existential risks, they do have a right to mirror large company risk management techniques, and—although they may not have had losses in the past—it does not preclude the need for the purchase of coverage.”
As businesses and re/insurers grapple with COVID-19, the issue of pandemic coverage has become highly controversial. Pandemic risk is excluded from most commercial coverage, and even many captive insurance policies, leaving many businesses that thought they had coverage through business interruption policies with no claim.
While the issue is still being litigated in the US, the UK and elsewhere, this does not look likely to change. What’s more, “even stricter pandemic exclusions are likely going forward”, says Gastley.
The perfect vehicle
Some believe microcaptives could be a solution, offering a perfect vehicle to plan for this risk. “They are flexible risk management structures and therefore well suited to managing complex corporate risks,” explains Gastley.
“The nimbleness and flexibility of small captives, combined with the natural synergy with their underlying insureds, position captives as an optimal vehicle for the handling of emerging risks,” says Nate Reznicek, director of operations at CIC Services.
He argues that innovation in the insurance industry has long been led by captives, citing their role in developing innovative coverage for ride-sharing services and cyber as examples.
“Captives will play a vital role in how businesses manage their pandemic risk, regardless of how the insurance company may elect to be taxed,” Reznicek says.
“Small and mid-market businesses in particular look to insurance as a solution and often the most efficient tool they have available to fund these kinds of future losses is through a captive.”
Gastley points to Caribbean business owners that are using captive insurance vehicles and parametric insurance policies to carve out hurricane risk from their commercial property coverage as a precedent.
“This has led to significant reduction in the cost of their regular property coverage, and allowed them to make long-term, multi-year efforts to build resources to defend against catastrophic risks,” she explains.
In the case of pandemic coverage, the value of the programme would depend on the specific details of the coverage provided, notes Gastley, and whether the captive had capped limits or reinsurance protection. Using microcaptives to write coverage for pandemic risk will require business owners and captives managers to work in unison to develop coverages that meet the needs of small and medium sized businesses, says Gastley.
This coverage has to be affordable and provide some significant measure of mitigation when such an event occurs, she says.
“Businesses would be more comfortable employing a captive insurance strategy if the next legal battle goes in favour of the captive.”
Emilie Gastley, Captive Alternatives
Hurdles
“Captives will play a vital role in how businesses manage their pandemic risk, regardless of how the insurance company may elect to be taxed.”
Nate Reznicek, CIC Services
One factor that could prevent microcaptives being used this way is the reputational damage they have sustained as a result of the ongoing attention of the IRS. It is not only the court cases it has won: the IRS has included microcaptives in its ‘Dirty Dozen’ list of common scams for five years, essentially labelling them as a tax dodge.
In recent months the IRS has stepped up its efforts to collect the tax it believes it is owed by microcaptives. In September 2019 the IRS sent out 200 letters to microcaptives owners offering settlement terms to avoid further investigation for tax fraud.
In March 2020 it sent another batch of letters to more microcaptives requesting they review their filings and notify the IRS if they are no longer claiming deductions or other tax benefits for covered microcaptive insurance transactions.
All this has led to some potential microcaptives owners concluding these structures may be more trouble than they are worth. The appeal of an 831(b) captive structure is certainly diminished if owners believe it will invite scrutiny by the IRS, which can be highly disruptive even for the innocent.
Parts of the industry are fighting back. In January 2020, CIC Services petitioned the US Supreme Court to hear its lawsuit against the IRS regarding IRS Notice 2016-66, which designated certain captive insurance transactions as “transactions of interest”, imposing onerous filing obligations and record-keeping requirements. In May the Supreme Court agreed to hear the case, which is expected to go ahead later in the year.
Reznicek argues that the captives industry as a whole has a shared interest in eliminating bad actors and ensuring that captives are formed and operated in a legitimate fashion. He rejects the IRS’s implicit assumption that microcaptives are a haven for large numbers of tax evaders with no real interest in obtaining insurance services.
Explaining the rationale for the lawsuit, he says: “Although the true intent may never be known, the manner in which the Notice was implemented could appear to some as an attempt to allege systemic impropriety within the industry and scare current and prospective captives owners with burdensome, costly, and duplicative reporting requirements.”
Reznicek describes the upcoming case as “an important battle in a larger fight” but admits it will not end the IRS’s interest in microcaptives, even if CIC wins.
“Ultimately, if the IRS really wants to collect the information at hand it will find a way to do it,” he says. However, he adds: “There are signs that the IRS is open to ideas on how to collect this information more efficiently, thereby reducing the burden on both Treasury and the taxpayer.”
Follow the rules
Reznicek says it is not only captives managers that should be following the rules.
“It’s important to remember that rules and proper process exist not only for the regulated, but the regulators as well,” he says. “There are long-established processes that the IRS is supposed to follow when enacting procedures like those included in Notice 2016-66,” he explains.
“The actions of the IRS are considered by some to be an attempt to circumvent constitutionally established means of creating law by instead implementing regulation that hides behind unappealable penalties that the service would argue are a tax.”
Early in the case the IRS did not argue that it did not follow established procedure and ran the periods for notice and comment simultaneously, notes Reznicek.
“As such, the outcome of this case goes beyond just the captive insurance industry and is of importance to all US taxpayers. This is probably one of the reasons that the Supreme Court has agreed to hear the case.”
Reznicek is confident about CIC’s chances in the case. While the IRS has won its most recent cases, it chose to fight those cases precisely because it had strong chances of winning them, he argues. This time CIC has taken the fight to the IRS and Reznicek believes he has precedent on his side.
Bigger issues
The question is what will change after the case has been heard. One US lawyer Captive International spoke to drew a clear distinction between issues of substance around microcaptives and issues of process.
The upcoming court case between CIC and the IRS is about process but does not change the substance of whether the IRS is justified in believing microcaptives are a tax dodge, the lawyer says.
“The bigger issues are not being discussed,” the lawyer adds. “Even if the cover is real there are questions about the implementation. There is often no negotiation, no due diligence.
“The 831(b) tax deduction is based on the amount of premium, so there is an incentive to have the highest premium possible.” Gastley is optimistic that CIC will prevail, but agrees the outcome will not resolve lingering questions around the viability of microcaptives, or their utility. A ruling in favour of CIC might make the ongoing management of 831(b) captives less onerous and unpredictable, but the core requirements of a good captive programme will still exist, she stresses.
In this sense, the verdict should not have much material impact on whether 831(b)s are used as a way to provide pandemic coverage to small and medium-sized businesses, she says.
However, she concedes that a victory for CIC could change the mood music around the industry.
“I do think businesses would be more comfortable employing a captive insurance strategy if the next legal battle goes in favour of the captive,” says Gastley.
Reznicek agrees that the captives industry will move on regardless of what happens with the IRS, and is bullish about the future for microcaptives.
“Independent programmes now exist that allow small captives to act as reinsurers for A-plus rated carriers, household names, at surprisingly low premium levels—approximately $250,000,” he says.
“By issuing property, general liability and other ‘standard’ casualty classes, captives that participate in these programmes have the support of carrier pricing models, policy forms, wordings, limits, etc.”
This, he argues, eliminates many of the standard arguments that the IRS has used against the industry.
“As word of these new programmes begins to spread to brokers and captives managers, the only real distinction between small captives and larger insurance companies will be premium size,” he concludes.
