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Microcaptives continue to come under fire from tax authorities as the IRS aggressively audits captive insurers that take advantage of long-standing rules that allow captive owners to reduce their tax bills.
The IRS is emboldened by two key tax court victories over the past 18 months and continues to demand more information from captives that elect to be taxed under Section 831(b) of the tax code, which are taxed only on investment income, captive experts say.
As a result, fewer 831(b) captives were formed over the past year as prospective owners wait to see how other cases involving microcaptives are resolved, they say.
Meanwhile, at least one captive manager faces a class action lawsuit from 831(b) captive owners alleging its promotion of 831(b) captives resulted in captive owners illegally reducing their tax bills.
831(b) captives, which are formed under laws passed in the 1980s, have become increasingly popular over the past 10 years. While many have been formed to cover warranties offered by auto dealerships, others have been formed in U.S. and offshore domiciles to cover a wide range of risks. The limit on premiums for the captives is $2.3 million.
A big advantage of captives electing to be taxed under Section 831(b) of the Internal Revenue Code is that they are taxed only on their investment, not their underwriting income, effectively lowering their tax liabilities compared with other captives and commercial insurers.
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, their family members and others to create the appearance of insurance coverage while being used to avoid tax.
In 2017 and 2018, the IRS won two key tax court victories in the so-called Avrahami and Reserve Mechanical cases, where they argued that the captives were not established for legitimate insurance purposes. The Reserve Mechanical case is being appealed and rulings in three other key cases are pending.
In addition, the IRS has singled out 831(b) captives in various documents that raise concerns about potentially abusive tax structures, has demanded more information from organizations involved in the formation of the captives and has stepped up its audit of the captives.
Also, a group of microcaptive owners in December filed a lawsuit seeking class action status against Arthur J. Gallagher & Co. and its captive management unit Artex Risk Solutions Inc., alleging they were fraudulently induced into 831(b) transactions and now face paying penalties, back taxes and interest to the IRS. Gallagher says the case has no merit, and it is due to file its response by early March.
The increased scrutiny has hit 831(b) formations over the past year, several experts say.
Captive formations have slowed in general, but the increase in IRS audits of captives making the 831(b) tax election appears to have deterred companies from establishing 831(b) captives in particular, said Steve Kinion, director of Delaware’s Bureau of Captive and Financial Insurance Products, based in Wilmington. More than 50% of Delaware’s captives make the 831(b) tax election, he said.
However, formation of all types of captives has slowed in recent years, Mr. Kinion said.
Not all domiciles report 831(b) captives in Business Insurance’s annual survey, but the number of captives worldwide excluding lowing a 3.7% decline in 2017.
Tennessee has also seen a slowdown in 831(b) formations, said Michael Corbett, director of captive insurance for the Tennessee Department of Commerce and Insurance based in Nashville.
“The average size of captives in Tennessee are around $8 million in premium. Most of our captives do not fall in (the 831(b)) category, but, yes, we have seen some slowdown,” he said.
“The IRS is clearly emboldened by the decisions in Reserve Mechanical and Avrahami, and I don’t expect that to change anytime soon. When a captive case is won by a taxpayer, we may see a change then, but I don’t expect the IRS posture to change until that happens,” said John Dies, Houston-based managing director of tax controversy at tax consulting firm Alliantgroup LP.
While the tax victories for the IRS and the increased audits is deterring owners from forming new 831(b) captives, the structures themselves are not inherently problematic for captive owners, tax experts say.
831(b) captives that were entered into primarily to achieve tax benefits are encountering problems, but “most of the 831(b) captives that I’ve seen are true insurance arrangements, so just because the IRS is going through all this scrutiny does not mean that they are all bad,” said Sheryl B. Flum, a tax expert and managing director at KPMG LLP in Washington.
“The IRS is trying to separate the captives that lack good insurance characteristics and appear to be entered into without intending to use them for a true insurance reason from captive insurance companies that are exactly that — captive insurance companies,” she said.
Mr. Dies said almost all 831(b) pooling arrangements are differently structured, and he is advising clients that have what they believe to be a valid captive not to concede to the IRS if it challenges them.
In addition, as the Avrahami and Reserve Mechanical cases focus on captives that were formed more than a decade ago, captives being challenged today are often structured differently, he said.
“Many of the issues that you see raised in these cases don’t even exist for captive insurance providers anymore. The industry has grown and advanced, and a 2018 insurance pool looks very different to the pools that Avrahami and Reserve Mechanical were dealing with,” Mr. Dies said.
The cases that have been ruled on so far include captive programs that likely won’t be mirrored in other microcaptives, said Charles Lavelle, senior partner in the tax and employee benefits department of Bingham Greenebaum Doll LLP based in Louisville, Kentucky.
“Avrahami had a stand-alone terrorism pool, and there are probably few other stand-alone terrorism pools, and the court had some harsh statements for some of the Avrahami facts, which might not be present in a lot of the other programs used by companies electing section 831(b),” he said.
“Broadly, the conversation among my peers has been that those have been anomalies,” said Mr. Corbett at the Tennessee insurance department.
“We’ve looked very carefully at those captive management firms and captives that we’re aware of in the state of Tennessee that are 831(b)-type captive managers, and have worked very hard with them to make sure that some of the trip points that Avrahami and Mechanical (had), which we think were glaring, are not issues for some of the 831(b) captives that we’ve seen here in the state,” he said.
The remaining three 831(b) rulings will likely further clarify the position of the tax court, said Mr. Lavelle.
“There are three other tax court cases that have been tried that will present their own fact situations … We’ll know a little bit more about what the court thinks about that tax situation and see whether or not they make broader statements that may relate to brother-sister arrangements or domestic captives,” he said.
Going forward, captive managers and the captive industry are adapting to the tax rulings, experts say.
The Captive Insurance Companies Association released a document on commonly accepted practices in late January that addresses issues raised by the Reserve Mechanical decision on risk pooling, premium calculations, quota share reinsurance arrangements and other issues (see related story).
The release of the document is “a clear effort by the industry” to explain how captives are legitimate risk-financing vehicles, said Mr. Dies.
The legal disputes over 831(b) captives will likely play out over several years, in the same way that legal battles over other types of captives took place in the 1970s, 1980s and 1990s when the IRS won some initial cases but captive owners went on to win other cases, Ms. Flum said.
“I think the same thing will happen on the microcaptive front. There will come a time when the IRS overreaches and tries to find a problem with a captive that is more likely than not going to pass muster and win a court case. Once the tide starts turning, there will be an easier way to differentiate the wheat and the chaff,” she said.
Gloria Gonzalez contributed to this report.
The reduction in the U.S. corporate tax rate has had the most impact on 831(b) captive insurers to date, but the effects of other provisions of the 2017 tax overhaul are less clear as industry stakeholders await key guidance from the IRS and possible legislative fixes from the U.S. Congress to mitigate the law’s unintended consequences.