Regulatory scrutiny of captives continued over the past year with Washington state introducing legislation to increase taxation of captives and the IRS intensifying its crackdown on microcaptives.

While most commercial insurance buyers won’t be affected by the moves, the regulatory and legislative actions are causing some concern in the captive insurance sector, experts say.

Last month, a bill was introduced in Washington, which is not a captive domicile, that proposes a 2% captive premium tax on risks based in the state.

The bill follows four years of investigations into captives in Washington by the state’s insurance commissioner, Mike Kreidler.

After being challenged over the alleged nonpayment of premium taxes, various large captive owners, including Microsoft Inc. in 2018 and Costco Wholesale Corp. in 2019, paid back taxes and penalties to settle with Washington’s insurance department.

The actions in Washington are a concern for captive owners, said Nancy Gray, regional managing director-Americas at Aon PLC in Burlington, Vermont.

“It’s not just Washington state but what happens with the next state that starts coming after captives, basically increasing costs for organizations to self-insure in some cases,” she said.

Several other states are looking at the issue of captive taxation, said Chaz Lavelle, a partner at Dentons Bingham Greenebaum LLP in Louisville, Kentucky.

“Other states, while they haven’t taken the route of Washington — states like Oregon, Minnesota, New York, Texas historically — are looking at various aspects of how they can tax captive transactions, either from income tax or some version of premium tax,” he said.

Meanwhile, the IRS has stepped up its pursuit of microcaptives.

Over the past several years, the IRS has investigated alleged breaches of tax rules by owners of captives electing to be taxed under Section 831(b) of the Internal Revenue Code. The so-called 831(b) captives, which have a premium limit of $2.3 million, are taxed only on their investment income, not their underwriting income. Larger captives are usually taxed under Section 831(a) of the tax code.

The 831(b) captives are often used by small and midsize companies that are too small to establish conventional captives, but many observers say they have also been used by wealthy individuals, their family members and others to create the appearance of insurance coverage while being used to avoid taxes.

The IRS has won several tax court rulings concerning 831(b) captives and since 2019 has made various settlement offers to hundreds of captive owners.

The IRS added to its audit resources for 831(b) captives and expanded the number of owners it made settlement offers to last March, and in October it introduced a second settlement program. In addition, the IRS also began some investigations of captive managers.

“They are full court press out there,” said Chaz Lavelle, a partner at Dentons Bingham Greenebaum LLP in Louisville, Kentucky.

Captive owners that don’t take the 831(b) election should still be concerned about the IRS’ investigation of microcaptives, he said.

The IRS has a decades-long history of investigating captives and although captive owners have won most of the court challenges to larger captives, the IRS may not be finished, Mr. Lavelle said.

“Once they get done with developing the law for the small captives, they may again look at the large captives,” he said.

In addition, a lot of businesses that may have considered establishing microcaptives are hesitant to move forward until there is more clarity from the IRS, said Patrick Theriault, managing director at Strategic Risk Solutions Inc. in Burlington, Vermont. 

“The industry wants clarity on the analysis to achieve proper tax treatment and once you’ve done that whether you elect to be an A or a B should be a pure election based on the amount of premiums written,” he said.