Gallagher hit with class action over 831(b) captive business

Arthur J. Gallagher & Co. faces a class action lawsuit alleging its captive management unit promoted the use of 831(b) captives that resulted in captive owners illegally reducing their taxes.

The suit against Gallagher and its Artex Risk Solutions Inc. unit was filed in federal court in Arizona on Friday on behalf of a group of Arizona-based businesses who allege that they had to pay back taxes, penalties and interest to settle IRS investigations over their use of 831(b) captives, also known as microcaptives.

The plaintiffs in Dimitri Shivkov v. Artex Risk Solutions Inc., which seeks class action status, allege violation of the Racketeer Influenced and Corrupt Organizations, or RICO, Act and are seeking actual and punitive damages.

According to the 140-page suit, Artex fraudulently induced clients into the 831(b) transactions and charged captive management fees for advice and services. “The receipt of those fees was the primary, if not sole, motive in the development and execution of the captive insurance strategies,” the suit alleges.

Artex “knew or should have known that these purported tax-advantaged captive insurance strategies were, in reality, nothing more than illegal and abusive tax shelters,” court papers say.

Among other things, Artex should have known that the IRS would disallow the strategy due to the lack of business purpose and economic substance of the transactions, the circular flow of funds and the lack of risk distribution, the complaint says.

The brokerage said in a statement Tuesday that the suit “appears to be related” to a previously disclosed IRS audit of its captive operations and “has no merit,” and that in the past it has “successfully defended individual claims involving similar allegations.”

Gallagher has disclosed in its U.S. Securities and Exchange Commission filings for the past several years that its microcaptive advisory services were the subject of an IRS investigation.

“We have been disappointed with the IRS’s position on 831(b) captives. 831(b) captives are important insurance vehicles that have been provided for by Congress for decades. Gallagher and Artex have diligently and consistently striven to comply with 831(b) in forming and managing captive insurance companies,” the Gallagher statement said.

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

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 create the appearance of insurance coverage while being used to avoid tax. Some 831(b) captives, including the one under dispute in Benyamin Avrahami and Orna Avrahami v. Commissioner of Internal Revenue, have been subject to unfavorable IRS rulings.

Arizona roots

Several of the businesses in the suit against Artex were clients of Mesa, Arizona-based Tribeca Strategic Advisors LLC, which Gallagher acquired through Artex in 2010, court papers say.

According to the suit, some of the businesses were insured by Provincial Insurance PCC, an insurer owned by Tribeca founder Karl Huish and his family. Provincial then ceded the risks to the captives owned by the insured businesses under a reinsurance arrangement.

The reinsurance was placed in two layers: a facultative placement representing an individual captive’s exposures, which equaled 49% of the original premium paid and the reinsurance premium ceded; and a quota share layer, which was pooled among dozens of captives and represented 51% of the original premium paid and the reinsurance premium ceded to the captives participating in the pool.

By allocating 51% of premium to the quota share policy, the captives could claim that the arrangement met regulatory rules governing risk distribution in captives, the suit says.

“By the end of the insurance year, Provincial held no insurance premiums,” court papers say.

The Provincial reinsurance pool was established in 2002 but had paid no claims through 2010, the suit alleges. In 2011, there were 197 participants in the pool with 940 policies and total premiums paid of $51.7 million, and the pool paid a single claim totaling $8,274. Each captive in the pool had to pay less than $100 to settle the claim.

In 2012 there were 245 participants, $63.8 million in premiums and claims totaling $210,615; and in 2013 there were 246 participants, $79.2 million and claims of $1.1 million.

“Notwithstanding the 51% allocation of reinsurance premiums to the quota share layer, the overpriced, vague, and defective policies carried little possibility of potential coverage for any valid claims,” the suit alleges.