- Recent IRS and Congressional Focus on Micro-Captives
- May 15, 2015 | Authors: Jocelyn Margolin Borowsky; Hugh T. McCormick
- Law Firms: Duane Morris LLP - Wilmington Office ; Duane Morris LLP - New York Office
Captive insurance companies have been used for risk management purposes since the 1960s, when industrial corporations found insurance for their risks either challenging to find in the marketplace, or expensive. One solution was to form wholly-owned and controlled insurance companies (hence the term "captive") for risk management purposes. The primary benefits to captive owners are the ability to customize their risk management programs and to eliminate some of the overhead built into premiums charged by commercial insurers. Tax issues have also been a key consideration in the formation of captives, and they led to a long and tortured history of litigation between owners of captives and the Internal Revenue Service (the "IRS"). At this point, most of the contentious issues, primarily the deductibility of premiums paid to captives, and the tax treatment of the captives themselves, are largely settled. (Issues relating to captives have also been a matter of controversy in the insurance regulatory community. See, e.g., Highlights from the NAIC Spring Meeting on PBR and Captive Insurance Companies, April 16, 2015, and other Duane Morris Alerts cited therein.)
More recently, however, a number of advisors, accountants and estate planners have come up with a new use for captives. These advisors advocate the use of small captives (sometimes referred to as "micro-captives" or "section 831(b) companies") for tax and estate planning purposes. Although the risk management purposes of micro-captives is part of the presentation of the benefits of micro-captives, some have been structured so that the tax and estate planning aspects completely overwhelm their insurance aspects. Both the IRS and Congress have taken notice of the use of micro-captives for tax and estate planning purposes.
Recent IRS and Congressional Activity
On February 3, 2015, the IRS issued a release addressing "Abusive Tax Shelters on the IRS 'Dirty Dozen' List of Tax Scams for the 2015 Filing Season." The release noted the following:
Another abuse involving a legitimate tax structure involves certain small or "micro" captive insurance companies. Tax law allows businesses to create "captive" insurance companies to enable those businesses to protect against certain risks. The insured claims deductions under the tax code for premiums paid for the insurance policies while the premiums end up with the captive insurance company owned by same owners of the insured or family members.
The captive insurance company, in turn, can elect under a separate section of the tax code [section 831(b)] to be taxed only on the investment income from the pool of premiums, excluding taxable income of up to $1.2 million per year in net written premiums.
In the abusive structure, unscrupulous promoters persuade closely held entities to participate in this scheme by assisting entities to create captive insurance companies onshore or offshore, drafting organizational documents and preparing initial filings to state insurance authorities and the IRS. The promoters assist with creating and "selling" to the entities often times poorly drafted "insurance" binders and policies to cover ordinary business risks or esoteric, implausible risks for exorbitant "premiums," while maintaining their economical commercial coverage with traditional insurers.
Total amounts of annual premiums often equal the amount of deductions business entities need to reduce income for the year; or, for a wealthy entity, total premiums amount to $1.2 million annually to take full advantage of the Code provision. Underwriting and actuarial substantiation for the insurance premiums paid are either missing or insufficient. The promoters manage the entities' captive insurance companies year after year for hefty fees, assisting taxpayers unsophisticated in insurance to continue the charade.
The IRS has been aware of the aggressive use of section 831(b) companies for some time: Reports in the trade press indicate that numerous audits of section 831(b) companies are ongoing.
Also in February, the Senate Finance Committee considered a legislative proposal that would increase the limitation on premiums from $1,200,000 to $2,200,000, but that would have significantly restricted the uses of section 831(b) companies by limiting to 20 percent the percentage of premiums that could be received from any one policyholder (or group of related policyholders), as well as prohibiting section 831(b) companies from assuming reinsurance. However, the restrictive provisions were met with opposition and did not survive a voice vote of the Committee.
On April 14, 2015, Senator Orrin Hatch introduced S. 905, a bill that would, as did the earlier proposal, increase the premium limitation for section 831(b) companies from $1,200,000 to $2,200,000, with an inflation adjustment for future years. S. 905 does not directly address the restrictive provisions in the earlier proposal, however; rather, it would direct the Secretary of the Treasury to submit to the Senate Finance Committee a report on the abuse of captive insurance companies for estate planning purposes "so Congress can better understand the scope of this problem and whether legislation is necessary to address it." This report, which would be due no later than February 11, 2016, is to contain legislative recommendations for addressing abuses.
Captives in General
In order to understand the issues raised by micro-captives, here is a brief overview of the U.S. federal income tax treatment of captives. When captives were originally formed—mostly in offshore jurisdictions—the expectation was that the captive arrangements would be treated much the same way as commercial insurance arrangements; i.e., the premiums paid to the captives by their owners and affiliates would be deductible as ordinary and necessary business expenses, and the captive would be treated as an insurance company. Contrary to these expectations, the IRS took the position that most captive insurance arrangements did not constitute "insurance" for tax purposes because they did not meet two key requirements: They did not provide for shifting of risk from an insured to an insurer and they did not spread the risk of each insured over a pool of risks from other insureds (this is referred to as "risk shifting" and "risk distribution"). The result of the IRS's position was that the premiums paid to a typical captive were not deductible expenses; rather, the premiums were treated as contributions to the capital of the captive, and payments from the captive were treated as distributions to the parent. The parent would be allowed deductions for losses only when permitted under its accounting method (but without reduction for payments from the captive, as the payments are not "insurance"). The IRS also concluded that because the relationship between the parent and the captive was not insurance, the captive did not qualify as an insurance company.
After many years of litigation, many (but not all) of the IRS's litigation positions were repudiated by the courts, and the IRS eventually modified its views. With respect to a parent-subsidiary relationship, the IRS ruled that risk transfer and risk distribution requirements can be met if at least 50 percent of the risk assumed by the captive comes from unrelated parties. See Rev. Rul. 2002-89, 2002-2 C.B. 984. In the brother-sister context, the IRS has ruled that when a parent establishes a captive, but the risks being transferred are those of 12 subsidiaries of the parent, the risk transfer and risk distribution requirements can be met. See Rev. Rul. 2002-90, 2002-2 C.B. 985.
Section 831(b) Companies
As previously noted, section 831(b) of the Internal Revenue Code provides that when an insurance company (other than a life insurance company) has net written premiums, or if greater, direct written premiums, of not more than $1,200,000 (determined on an affiliated group basis) in a taxable year, the company will be treated as a "small" insurance company and can elect to be taxed on investment income only. Once made, the election to be treated as a section 831(b) company is revocable only with the consent of the IRS. Thus, in contrast to most property/casualty insurers, which are taxed at the corporate income tax rate on net income that consists of premiums and investment income, plus or minus changes in allowable reserves and minus claims for losses and other expenses, a section 831(b) company determines its tax by simply multiplying its investment income by the corporate tax rate.
The benefits of this election will depend on the situation of an individual company, but in general, the losses and expenses of the company would have to be high before the benefit of the election would be lost. Using a simplistic example, if a company that had made the election received $1,000,000 in premiums, earned $50,000 in investment income, had losses and loss adjustment expenses of $75,000 and general expenses of $25,000, it would pay tax on the $50,000 of investment income. Otherwise, tax would be imposed on the net income of $950,000. On the other hand, if the company had losses of more than $1,050,000, it would still be required to pay tax on the $50,000 investment income even though no tax would be due had the election not been made.
The potential benefit of the election is compounded by the fact that if the requirements for treatment as insurance are met, the owner of the captive is permitted a deduction for the premiums as ordinary and necessary business expenses. Thus, in a properly structured captive situation, the owner can transfer up to $1,200,000 on a tax-deductible basis to the captive. Each annual premium, plus investment income, minus taxes and expenses and losses, can be accumulated inside the captive, with the only tax cost at the federal level being the tax on the investment income. The accumulated amounts will be subject to tax only when amounts are actually distributed to shareholders—presumably at favorable rates.
In light of their wealth accumulation potential, it is not surprising that tax advisors advocate using section 831(b) companies for tax and estate planning purposes—something with no relationship to the original purposes of the law. As can be seen from the example above, however, an inherent tension can exist between the risk management and wealth accumulation uses of section 831(b) companies, as insurance losses diminish the economic return of the captive.
Advisors have addressed this problem by advising that the captive should be used to insure exposures with a low probability of occurrence. Low probability events can be insurable—earthquakes and similar relatively rare events (at least in certain locales) can be covered by commercially available insurance. The key question in the micro-captive world becomes: Is the actual risk to be covered a reasonably insurable risk? Can one reasonably use a captive to insure against terrorist risk in a dental office in California? (Reportedly, a court answered this question affirmatively). Or, as an IRS attorney reportedly said in a conference, tsunami risk in Nebraska? A cautionary Internet posting on section 831(b) companies notes that: "The risks insured themselves must be valid risks faced by the company, not exaggerated risks with no real chance of occurring."
Moreover, assuming a risk is insurable, is the premium being charged sound, or is it excessive in light of what a commercial insurer would charge for the risk? It is important to note that the payment must be an "ordinary and necessary" business expense. Returning to the example discussed above, is a $1,000,000 annual premium for a risk that runs at about $75,000 per year reasonable? Is a premium of $600,000 reasonable when a commercial insurer would charge $5,000 for the same coverage? One may contend that the insurance is intended to cover future spikes in the risk, but that ultimately could be an argument with the IRS. Pricing should be determined by a qualified actuary—preferably independent of the captive or the manager.
Another issue to consider is risk distribution. A captive with one or a small number of insureds may not provide for risk distribution, unless sufficient outside risk is brought in so as to meet the requirements of Rev. Rul. 2002-89—but outside risks can raise significant issues. In the early days of industrial captives, some companies suffered significant unexpected losses because captive managers assumed unrelated risk without understanding the nature of the risks they were taking on. Advisors in the section 831(b) company market have addressed that issue by creating risk pools that are intended to satisfy the outside risk standard by requiring that each company in the pool assume a ratable share of 51 percent of each claim filed by other companies in the risk pool and 49 percent of each company's own claims. Some pools, however, reportedly have provisions ensuring that the participants will ultimately be responsible for only their own risks—something that could potentially destroy risk distribution.
In addition to pricing and risk transfer and distribution concerns, other signs of an aggressive captive structure include the following:
- Captive managers do not possess meaningful experience and professional credentials in the business of insurance.
- Captive managers are paid a percentage of premiums rather than a flat fee to form or manage the captive.
- The sale of life insurance inside the captive is promoted.
- Claims payments are subject to caps, deductibles or reimbursement fees paid by the claimant that are inconsistent with ordinary insurance practice.
- Premiums are paid on the last day of the year or are based on the events of the past year.
- Few or insignificant claims have been paid in the company's history.
The Captive Insurance Companies Association ("CICA"), a trade association representing the captive insurance industry, has issued a statement on section 831(b) companies with cautionary language:
The traditional captive insurance company industry and CICA are extremely concerned about the misuse of small captives utilizing the IRC 831(b) election and the attendant publicity about "captives" being a tax avoidance device. Although there is nothing wrong with the utilization of the 831(b) election when a small captive insurance company is truly engaged in insuring the risk of its parent company/owner(s), the traditional captive insurance industry strongly opposes the utilization of small 831(b) captives primarily for tax sheltering purposes.
In simple language, do 831(b)s right or don't do them at all!
In short, it is possible to structure a micro-captive to function as a risk management vehicle that also has tax and estate planning benefits, but it is important to note the real likelihood of IRS scrutiny of the micro-captive. Failure to structure the micro-captive to meet the "insurance" criteria set out in cases and rulings can lead to an expensive dispute with the IRS. Prospective owners of micro-captives may want to focus first on risk management needs, and only after they have been properly addressed, should the focus turn to tax and estate planning.
1. The latter reference is to section 831(b) of the Internal Revenue Code of 1986, as amended (the "Code"), which, as discussed in more detail below, provides tax benefits for non-life insurance companies that qualify as "small" insurance companies.[T]he proposal imposes additional restrictions intended to narrow the application of section 831(b). Specifically, for a property and casualty insurance company to be eligible to make the section 831(b) election, no more than 20 percent of its net written premiums (or if greater, direct written premiums) for a taxable year can be attributable to any one policyholder. For this purpose, all policyholders that are related or are members of the same controlled group are treated as one policyholder. Attribution rules relating to family, partner, and stockholder relationships (which apply for other purposes under the tax law) are applied to determine whether policyholders are related. Compliance is enforced through reporting rules. In addition, the proposal requires that the company assume or otherwise take on no risks through reinsurance.
2. The Congressional Joint Committee on Taxation described the original Senate Finance Committee proposal (known as the "Chairman's Mark") as follows:
Staff of the Joint Committee on Taxation, "Description of the Chairman's Mark Relating to Modifications to Alternative Tax for Certain Small Insurance Companies," JCX-21-15 (February 9, 2015).
3. The Senate Finance Committee Report that accompanied S. 905 noted that the limitation of $1,200,000 had not been increased since 1986, and that the revised amount was to reflect inflation from that date. S. Rep. No. 114-16, 114th Cong., 1st Sess. 2 (April 14, 2015).
4. The Senate Finance Committee Report cited in footnote 4 noted only that the proposal to narrow the eligibility to make the section 831(b) election in order to curb abuses was not included in the current bill because "it may cause problems for certain States."
5. Early captives were mostly established offshore because the regulatory environment in Bermuda and other jurisdictions was more favorable than in the United States. As a result, many captives were not subject to current U.S. taxation on their net income, but in some cases, the owners could be subject to tax on the captive's insurance income under the controlled foreign corporation ("CFC") rules in the tax law. In addition, the premiums paid to captives that were not themselves subject to U.S. taxation could be subject to a 4-percent federal excise tax for direct insurance, or a 1-percent tax for reinsurance. Prior to changes in law enacted in 1986, captives with multiple owners could avoid CFC status, but since that time, there are few tax benefits for organizing captives offshore, which led many states to enact laws encouraging the formation of domestic captives. For example, at the end of 2014, Vermont ranked third in the world's domiciles for captives, and Utah and Delaware are in the top 10 worldwide.
6. The risk shifting and risk distribution requirements for treatment of an arrangement as insurance originated with the U.S. Supreme Court case Helvering v. LeGierse, 312 U.S. 531 (1941), and have been embodied in cases and rulings since that time. The basis of the IRS's argument was that the parent and its affiliated companies were part of an "economic family," and that the risk of loss transferred from the parent or affiliates remained inside that family—in other words, the "insured" loss would ultimately come back to rest on the parent's balance sheet. See Rev. Rul. 77-316, 1977-2 C.B. 53. See also, Carnation Company v. Commissioner, 71 T.C. 400 (1978), aff'd, 640 F.2d 1010 (9th Cir. 1981).
7. Rev. Rul. 77-316 stated that "both the Internal Revenue Service and the courts have long held that amounts set aside by a taxpayer as a reserve for self-insurance, though equal to commercial insurance premiums, are not deductible for Federal income tax purposes as 'ordinary and necessary expenses paid or incurred during the taxable year.'"
8. See section 165(a) of the Code.
9. Companies that qualify as insurance companies are taxed under special provisions of sections 801, et seq. (for life insurance companies) and 831 et seq.(for non-life insurance companies) of the Code. A key feature of these provisions is that insurers are allowed deductions for reserves, including estimates of losses that have been incurred but not reported.
10. In Rev. Rul. 2001-31, 2001-1 C.B. 1348, in response to losses in the courts, the IRS announced that it was abandoning the economic family doctrine, but would continue to pursue cases based on the facts and circumstances of individual cases.
11. In Rev. Rul. 2002-89 the IRS stated that "No court has held that a transaction between a parent and its wholly-owned subsidiary satisfies the requirements of risk shifting and risk distribution if only the risks of the parent are insured. However, courts have held that an arrangement between a parent and its subsidiary can constitute insurance because the parent's premiums are pooled with those of unrelated parties if (i) insurance risk is present, (ii) risk is shifted and distributed, and (iii) the transaction is of the type that is insurance in the commonly accepted sense (citations omitted)." Case law would allow 30-percent outside risk.
12. In this ruling, the risks were described as being "homogeneous." In Rev. Rul. 2002-91, 2002-2 C.B. 991, the IRS concluded there was insurance when a group captive had fewer than 31 insureds, but each insured represented less than 15 percent of the total risk insured. Conversely, when an insurer (whether related to the prospective insureds or not) assumes all or most of its risk from a single insured, although the risk transfer requirement may be met, the risk distribution is not. See Rev. Rul. 2005-40, 2005-2 C.B. 4. This ruling also states that subsidiaries that are "disregarded entities" for income tax purposes will not be counted as separate insureds.
13. This example is based on one found in an Internet posting that discussed estate planning techniques for captives.
14. Although the accumulated earnings tax could be applicable, state and other taxes are not taken into account.
15. The special treatment of small insurance companies under section 831(b) was implemented in 1986 to replace complex rules that had previously applied only to small mutual non-life insurers. In the 1986 legislation, Congress noted that it was appropriate to eliminate prior-law distinctions between small mutual and small stock insurers by extending the election to both stock and mutual companies. It is generally understood that the purpose of these rules was to allow small insurance companies to accumulate surplus against future losses.