Microcaptives
Microcaptives catch the eye of the IRS—again
The IRS has decided to revisit the world of captive insurance again, with another battle over microcaptives. Captive International investigates.
The IRS has decided to revisit the world of captive insurance again, with another battle over microcaptives. Captive International investigates.
“That’s why it’s in the Code to begin with, to facilitate the development of small insurance companies.”
Jeff Simpson, Womble Bond Dickinson
In April this year the Internal Revenue Service (IRS) announced that it had issued a document that contains proposed regulations relating to microcaptives.
The IRS document, titled “Microcaptive Listed Transactions and Microcaptive Transactions of Interest”, seeks to identify transactions that are the same as, or substantially similar to, certain microcaptive transactions as listed transactions, a type of reportable transaction, and certain other microcaptive transactions as transactions of interest, another type of reportable transaction.
If you read the above and felt a sense of déjà vu, you’d be right: this isn’t the first time that the IRS has had an issue with microcaptives (aka 831[b]s due to the 831[b] tax election aspect of their nature). Several years ago, the IRS attempted to label them as abusive transactions, which led to the captive insurance industry battling hard against what the IRS was proposing. The entire matter ended up not merely in litigation, but before the US Supreme Court in one case—which the IRS lost. The State of Delaware also brought litigation against the IRS on microcaptives, albeit unsuccessfully.
All this left microcaptives in the captive insurance industry’s collective consciousness—and with some seeking to better educate the market over just what a microcaptive is and how the 831(b) aspect of it works.
Jeff Simpson, attorney at Womble Bond Dickinson and counsel for Oxford Risk Management Group, told Captive International that an 831(b) isn’t really a type of captive, it is a tax election.
“A traditional captive, typically a pure captive, that covers the risks of a smaller business, avails itself of this election under the Internal Revenue Code, where it can be taxed only on its investment income, rather than also on its premium income. That, of course, is a big difference from the way insurance companies are typically taxed in the US, which is on their premium income,” Simpson says.
“An 831(b) makes it possible to have an insurance company that’s essentially a low-tax entity. A lot of businesses have found it helpful to take advantage of that election, to start an insurance company. That’s why it’s in the Code to begin with, to facilitate the development of small insurance companies and to help distressed industries and farmers protect themselves and cover the unique losses that affect their businesses.”
The tax code can be a complex thing to properly navigate and in fact one result of the perceived lack of understanding about how 831(b)s work has been the creation of the 831(b) Institute (www.831binstitute.org).
Nate Reznicek, an advisor for the Institute and the president and principal consultant at Captives.Insure, told Captive International that the 831(b) Institute was formed to cope with what he and the other advisers on the council believed to be challenges from a lack of education regarding what the 831(b) election is and what the captives taking the election are actually doing, so that local government representatives and the US Treasury Department can have a clearer picture of the reality of the situation.
This would allow the Treasury, for example, to more effectively target its enforcement efforts, which, Reznicek pointed out, is what the market has just seen here with the recent look at microcaptives being another round aimed at captives.
“NCOIL condemns fraud. But the way to combat that is not for the IRS to get into regulating the business of insurance.”
Tom Considine, NCOIL
Common misconceptions and other issues
“There’s a common misconception on this because of the tax election, the name of that tax election and the types of coverage is that a lot of these captives were writing,” says Reznicek.
“Also there were esoteric enterprise risk-like coverages that were heavily abused in the early days of captives from the tax election perspective by a number of promoters, some of them quite heavily, so everybody’s being painted with that bad brush.
“You take that election or not, but in reality the election has nothing to do the types of coverages that the captive writes, the way it operates its business, or any of the details of it that actually matter from a statutory and enforcement perspective or how our legislative bodies make their decisions based on how to enforce or not enforce, to expand or constrict the ability of these captives to operate in states,” he explains.
According to Reznicek, there is a definite higher likelihood of abuse in any transaction, whether it’s in an 831(b) or otherwise, when there is potential tax benefit to a taxpayer.
“Humans by nature will try to find some way to get blood from a stone and make a good thing even better and some individuals may be more nefarious than others and will move past the line of what could be right and appropriate,” he adds.
The problem with the 831(b) tax election as far as the IRS is concerned is that it has seen a number of transactions that have been failed tests for one reason or another, to not meet the requirements necessary for the IRS, Reznicek told Captive International.
“There is a benefit to the small captives market with such heightened scrutiny.”
David DiMayo, Oxford Risk Management Group
There are often laws in place, as was seen with the State of Delaware and the IRS’s suit against it, under which they are prohibited from sharing some of that information with federal entities, so the service is doing the best it can here. According to Reznicek, the latest IRS proposed regulation is a much better approach than in the past—it’s flawed, as he put it, but it’s much better than it was before, as it’s an attempt to get information and better identify transactions where there may be cause for concern so they can investigate enforceable rules.
“It’s a challenge,” Reznicek admits. “The IRS was handed a loss by the US Supreme Court although on a very limited basis with the ruling. In my opinion it was targeted because there are rules and procedures in place that everybody needs to follow, insurers as well as the IRS, and in the case that came before the Supreme Court the IRS did not follow those rules in order to push out that notice, and everything about it came out fast.
“This latest regulatory notice is partly an attempt to do it the right way. The IRS acknowledged in this last statement that it is not going to challenge the fact that it didn’t give a proper notice and comment period—the things they were supposed to be before—which they are very clearly doing this time around,” he explains.
“Where the IRS has a particular concern is that some of these captives are structured in a way where the IRS thinks they’re covering things that the IRS views as not real risks. The IRS thinks that some of these captives are planned to never have losses and to take this premium that would otherwise be ordinary income in the operating company and convert it into a lower tax thing, like dividends coming out of the captive.”
According to Simpson, where we see a risk management opportunity, the IRS believes that many people who take the 831(b) election are only pretending to be engaged in insurance, but are actually engaged in a tax arbitrage.
“That’s what the IRS is worried about. But what’s really happening for the most part, in my experience, is that businesses are using the 831(b) election to cover things that they wouldn’t otherwise be able to cover, because the election makes it more efficient to cover those things.”
“More captives are being formed for taking advantage of the same tools that larger entities have done.” Nate Reznicek, Captives.Insure
Additional scrutiny and a lack of surprise
Tom Considine, chief executive of the National Council of Insurance Legislators (NCOIL), told Captive International that it is not uncommon for the IRS to try to use its regulatory authority under the tax code to get into areas that it doesn’t have any legislative authority to get into. And insurance is one of those areas.
Considine is not a supporter of the IRS’s initiative. “I was the state commissioner of banking and insurance in New Jersey and whenever the staff came in with proposed rules, I would point them to the legislative code and ask ‘where is the specific authority for this regulation?’,” he says.
“When they’d say ‘well, you have the inherent equitable authority to propose these’, I’d say ‘no, you know the legislature grants us authority to do things but doesn’t want us willy-nilly making things up’.
“In this instance, the McCarran Ferguson Act says that the business of insurance shall be regulated by the states, unless Congress acts otherwise. NCOIL condemns fraud. But the way to combat that is not for the IRS to get into regulating the business of insurance.”
David DiMayo, chief executive of Oxford Risk Management Group, pointed out to Captive International that it’s been 10 or so years since the IRS started to focus its attention on captive insurance companies which elect 831(b) tax treatment as being potentially abusive. During that time the IRS been successful in the Tax Court’s identifying some abusive structures.
However, that does not mean that every captive insurance company that’s electing alternative tax treatment under 831(b) is abusive and not truly engaged in the business of insurance, he says, adding that there is a benefit to the small captives market with such heightened scrutiny.
“For years, we have seen seeing the buyers of such insurance take the care and time to educate themselves,” DiMayo says. “They understand that the scrutiny is real and want to move ahead only if there is a legitimate risk management need for the insurance.”
The IRS’s decision to have another try at regulating microcaptives did not catch too many people by surprise, Reznicek pointed out. “Many folks, like me, expected this to happen. The IRS was told ‘hey, you did this wrong but that doesn’t mean you can’t do it—you need to go through the appropriate channels in order to try and implement something’. That’s what I believe this attempt is trying to do,” he says.
However, he reiterates, from an educational perspective there’s there misunderstanding of what an 831(b) means and what it doesn’t mean. Simply, taking a tax election does not mean that the captive is an abusive transaction. Far and away, Reznicek says, most 831(b) captives are going to be legitimate insurance companies.
“Many of the insurance companies that are creating small captives are taking risk in the same way that large captives are, from the changes in the hard market. Small captives are reinsuring their workers’ compensation exposure, general liability or property exposures directly from the rated and admitted carriers that issue these policies, in the same way as Fortune 500 captives that may have millions of premiums every year.
“These are smaller mid-market businesses with the premium threshold—it is now north of $2 million—that meets the eligibility requirements for the previous election.
“That’s still quite a sizeable business at that point in time, if you have more reinsurance premium into the captive to no longer qualify for the election,” Reznicek adds.
“It’s not necessarily volcano insurance in South Dakota, or hurricane insurance in Iowa or something along those lines—more captives are being formed for taking advantage of the same tools that larger entities have done. They’re just taking a small captive tax election because it’s available to them.”
In the meantime, there’s the issue of what the IRS will decide to do on the issue. As this edition went to press the IRS held a public hearing on microcaptives and their proposed regulation, with a wide range of speakers making prepared comments at the hearing. The IRS has stated that it will take all views into account when making its decision.
Considine concluded that the IRS might find its way back before a court of law. “The IRS is having a public hearing on this matter in July and then, we would hope, amend or withdraw this regulation. They would have to amend it significantly, in our view, to narrow it, and certainly make it non-retroactive,” he says.
According to Considine, there’s a fair likelihood that the IRS will make some changes. However, he wouldn’t give it a high likelihood that they’ll be substantial enough to make the issue go away. So, he thinks, this will probably end up in the courts.
“I think someone will challenge the legitimacy of the IRS rule,” he says. “I don’t know if that’ll be a taxpayer, or a captive company, or a group of captives that seek to challenge the law in advance in a declaratory judgment action, seeking to declare the rule null and void.
“But I don’t want to put the cart before the horse, because the optimist in me has remained hopeful that the IRS will significantly amend its proposal.”
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