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Looming court cases to determine future of microcaptives: Experts

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BOCA RATON, Fla. — Courts cases that are due to be heard over the next year should provide clarity on legitimacy of so-called 831(b) captives and determine how they can be used to cover commercial exposures, despite the Internal Revenue Service’s skepticism over the alternative risk transfer vehicles, a captive lawyer said.

While the IRS appears to view the use of microcaptives as a “scam,” courts hearing cases over their alleged misuse will likely clarify how 831(b) captives can be used, said Charles J. Lavelle, senior partner at Bingham Greenebaum Doll L.L.P. in Louisville, Kentucky, speaking during a session at the 26th annual World Captive Forum being held this week in Boca Raton, Florida.

Captives electing Section 831(b) are taxed only on their investment income, not their underwriting income. The limit of premiums for the structures was raised to from $1.2 million a year to $2.2 million this year.

The 831(b) captives are often used by small and midsize firms that are too small to establish conventional captives, but many observers say they have also been used by wealthy individuals and others to avoid tax. 

In a notice last November, the IRS stated it believes 831(b) transactions have “a potential for tax avoidance or evasion.” 

“The IRS thinks they’re all scams,” Mr. Lavelle said. “The thing that’s going to change the dynamic are these cases that are coming, and they are going to say what the courts think … the courts may back up the IRS, they may say, ‘Yeah, they’re all scams,’ but my guess is they won’t say that.”

One of the most closely watched cases is Avrahami v. Commissioner in U.S. Tax Court where the IRS alleges that the 831(b) for a jewelry business in Phoenix that ostensibly covered terrorism risks was really being used for estate planning. A ruling is expected in the case later this year.

Companies considering setting up an 831(b) should review carefully their reasons for establishing a captive, said Arthur Koritzinsky, managing director in the captive solution group at Marsh L.L.C. in New York.

Like all insurers, 831(b) captives should have a business plan, a business purpose and an internal and external governance process, he said.

“First and foremost, what’s the reason for its being? If the first word out of anyone’s mouth is ‘tax,’ you’re off to a bad start,” Mr. Koritzinsky said.

Instead, prospective captive owners should have an understanding of the risks that the captives will write and have a process in place to determine what risks should go into the captives, he said.

And captive managers should review plans for 831(b) captives in the same way they review larger captives and determine what risks are being covered and review the prospective owners’ existing insurance programs, among other things, Mr. Koritzinsky said.