August 20, 2015

The Tax Investigation of Small Captives and Their Providers: Where is it Going?

Jay Adkisson

A captive insurance company is a risk-financing vehicle that is widely used by large enterprises worldwide to bring their insurance costs under control. Essentially, an enterprise forms and manages its own insurance company as a subsidiary, and the enterprise's other operating subsidiaries purchase insurance from the captive. 

In little more than a decade, captives have substantially changed the way that corporate America approaches insurance. In the past, American businesses would purchase their insurance from large commercial insurance carriers just like everybody else. Now, American businesses are increasingly using captive insurance companies to underwrite their insurance needs, and then having the captives go out into the worldwide reinsurance market to acquire excess or catastrophic coverage. The efficiency is thus gained by cutting out the "middlemen," i.e., the commercial carriers who themselves were setting off their losses through reinsurance – corporate America now retains those underwriting and investment profits themselves and accesses the reinsurance markets directly if at all. 

The key to a captive insurance arrangement is that the insurance company premium payments made by the operating subsidiaries are deductible to them, and the captive insurance itself can receive those premiums but mitigate the tax impact by creating long-term reserves, etc. But with anything that creates the potential for tax efficiency, comes the potential for tax abuse.

In the discussion that follows, it is important to keep in mind that the abuses of captive insurance companies as tax shelters are taking place almost entirely at the lowest levels of the business, being very small "mini-captives" formed for small-to-medium sized businesses. The large corporate captives should be unaffected by the measures that the IRS will likely take to combat these abuses, and so there is little reason for any concern on their part. 

Section 831(b) of the Internal Revenue Code allows a small insurance company, being one that receives less than $1.2 million in premiums, to completely avoid the tax on the premium income that the captive receives, so long as the captive timely makes the "831(b) election." This provision was originally enacted by Congress to benefit small, mostly agricultural mutual captives that had sprung up in the Midwest. So-called "831(b) companies" or "mini-captives" led an almost silent existence for many years without being a problem to anybody. 

Congress Takes Action

The change came in 2005, when Congress changed the rules relating to very small captives that qualified under Section 501(c)(15) of the Internal Revenue Code (micro-captives) which previously offered tax-free status for an insurance company which earned less than $350,000 in premiums. Quite a few 501(c)(15) companies at that time began taking in larger premiums, and making the 831(b) election so that they made the jump from micro-captives to mini-captives. 

Concurrently, the IRS was dealing with abuses in certain pensions and welfare arrangements, primarily those involving VEBAs, 412(i) plans, 419(e) plans, and 419A(f)(6) plans. Those plans were funded with life insurance, and had been popular tools for advisors seeking to sell life insurance to their clients on a pre-tax basis. Needing a sales tactic after the IRS deemed most of these deals to be abusive, these life insurance agents started turning to captive insurance companies. 

Tax planners, too, were reeling at the same time from the IRS closing many then-popular tax shelters with colorful but ill-advised names and acronyms, such as Son of Boss, BLIPS, CARDS, etc. Tax planners needed new sales tactics, and soon turned to 831(b) captives as their tool-of-choice to artificially generate annual deductions of $1.2 million per year, whether their clients had serious insurance concerns or not. 

Thus, starting in 2005, there was an explosion in the number of 831(b) captives that were created as a result of the confluence of all these factors, and the entry into the captive industry of a sizeable army of tax shelter promoters who had been driven by the IRS out of other areas of tax planning. 

Certainly, the pace of formation of the agricultural mutuals and legitimate small captives increased with the greater general awareness in the business community of captive insurance companies, keeping in mind that none of this affected the large and completely legitimate big corporate captives which were then proliferating for non-tax reasons. The vast bulk of new formations, however, were simply tax shelters that were disguised as legitimate insurance companies. 

There is reason to believe that upwards of 75 percent of new captives formed after 2005 were simply tax shelters where mere lip service was given to the captive's insurance function, but the true focus was generating an annual $1.2 million deduction to the client. 

The IRS's guidance in Rev. Ruling 2008-8 regarding captives formed as "Series Business Units" threw gasoline on the raging tax shelter fire. The advent of SBU captives allowed every doctor wanting to save as little as $50,000 in taxes to form their own "captive," and start socking away money on a pre-tax basis. Many of these companies were sold by unprincipled promoters as an alternative to traditional pension plans. 

The IRS Acts

Around 2010, the abuse of 831(b) captives became such a large blip on the IRS's radar screen that such captives could no longer ignore the potential of IRS scrutiny. The IRS started to examine certain captive insurance managers (i.e., companies that manage small captive insurance companies on a turnkey basis for their clients), and this culminated with the IRS in 2013 starting to warn groups, such as the American Bar Association's Committee on Insurance Taxation, that it was aware of the fact of the abuses and was starting to widely investigate 831(b) captives. 

In 2014, the extent of the IRS's interest in abuse of 831(b) captives became apparent, as the IRS launched so-called "promoter audits" of at least a half-dozen of the captive managers that it believed may have been involved in the sale of abusive tax shelters disguised as 831(b) captives. The promoter audits required the target captive managers to turn over their client lists to the IRS, and their clients were served with document requests from the IRS. To say that these promoter audits roiled the previously calm waters of the mini-captive sector would be a substantial understatement. 

This brings us to 2015, when the IRS issued the following warning about the abuses of 831(b) captives: 

Captive Insurance

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 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.

Shortly after this warning was issued, the U.S. Senate Finance Committee convened to consider whether the $1.2 million limit for 831(b) captives should be substantially increased. This increase has long been the desire of Iowa Senator Charles Grassley, so as to further the agricultural mutuals that were making the 831(b) election. Senator Grassley has proposed increases to the 831(b) limit every year for the last decade, but the increases always failed (including in the many years when he was the powerful Chair of Senate Finance) because no offsetting revenue could be found – and it will likely die in 2015 for the same reason. 

What is new this year is that the Treasury Department has proposed certain limits on 831(b) captives so as to deter abuses. While those limits were not adopted by the Senate Finance Committee (which limits Senator Grassley was relying upon to create offsetting revenue), Senator Grassley formally requested that the Treasury Department study and report to the Committee about abuses with 831(b) captives. Whether this was an impromptu request, or as some Senate-watchers believe, the theatrics for which Congress is so famous, the bottom line is that Treasury is now formally preparing a report to the Committee which will presumably describe the widespread abuses of 831(b) captives and suggest statutory remedies. 

Of course, in the present political environment, whether Congress will end up doing anything – good, bad, or indifferent – is subject to considerable doubt. That in any case Treasury, through the IRS, will take matters into its own hands through tax shelter enforcement and additional "guidance" is all but a certainty. 

Here, we must recall that the vast majority of captives will be utterly unaffected by any of this, including the many legitimate captives that have made the 831(b) election. The large corporate captives have no reason for concern, and the agricultural mutuals have little reason for concern. But that still leaves literally thousands of 831(b) captives with a potential target on their back. 

The IRS’s Focus

So what is the IRS most concerned about? At this point, with Treasury just beginning to undertake its study, it is unknown as to whether the IRS itself even knows with certainty what it is most concerned about. However, the IRS has told us, formally through the aforementioned warning and informally through the off-the-record statements from those in the IRS general counsel's office, and of course through the promoter audits themselves, what it seems to be focused on, at least presently. 

First, we can tell from the documents requested by the IRS in the promoter audits that it is concerned about captives that have been marketed and sold not as true insurance vehicles, but for purposes of generating deductions and wealth transfer. It is routine when clients are evaluating the cost-benefit analysis of a captive arrangement that the captive manager will prepare what can best be described as an "illustration" of proposed benefits. These illustrations can demonstrate that the captive was never intended to serve as an insurance vehicle. 

For instance, illustrations for abusive captives will show no or few anticipated claims. You have to keep in mind here that insurance premiums are largely derived from the following formula: Premium = Anticipated Claims + Anticipated Expenses + Reasonable Profit - Investment Returns. 

Very simply, if anticipated claims are zero or very small, then the premium should accordingly be zero or very small. Yet in illustrations for abusive captives, anticipated claims will be zero or very small, while premiums will be very large. 

Here, you will sometimes hear the argument that "commercial carriers often have large profits," and this is true in the abstract; but when you have a captive, this argument doesn't hold water, since a captive is in a close relationship with its insureds, and large profits are indicative of artificial deduction creation and wealth transfer. 

Second, the IRS is looking for arrangements where the captive owner has designated the amount of deduction that it desires, and the captive manager has "backed in" premiums to try to reach that amount. While no captive owner or captive manager will admit to such a practice, this is a pervasive practice among abusive captives, and can be established by other proof – largely meaning e-mail trails and the like, keeping in mind that captive managers are not law firms and have no attorney-client privilege as to the process by which premiums and policies were developed. 

Third, the IRS is looking for speculative risks. Much like the late Potter Stewart's definition of pornography, what constitutes a speculative risk is not easily stated, but "I know it when I see it." The classic example is a business in Omaha, Nebraska, purchasing hurricane insurance. While there is a possibility that a hurricane could adversely affect such a business, the likelihood of a hurricane occurring in Nebraska is so small that probably no business in Omaha would seriously consider purchasing such insurance. 

Of these coverages, the most abused have been terrorism insurance and the utterly ephemeral "business interruption" insurance. While it is possible that some businesses in some locales have legitimate terrorism risks, many abusive captives include this coverage, although the realistic possibility of a captive owner having such a loss are about in the range of the business being destroyed by an asteroid strike. Similarly, "business interruption" policies are often so vaguely worded that it is unclear what they do or do not cover, and thus it is unlikely that a commercial insurer would even offer such a policy in the real markets or that a business would be comfortable buying such a policy. But here we see the same phenomenon of all tax shelters, which is trying to dress up something that is vaguely similar to something which is commercially available, so as to conceal the true primary and impermissible tax purpose of the captive. 

Fourth, the IRS is concerned about premium amounts that bear little relationship to either reality or what is charged for comparable policies in the real insurance marketplace. Take the example of our Omaha business buying hurricane insurance, or maybe a garment business in New Mexico buying terrorism insurance. Sure, there might be some risk that those bad things will occur, but what would the correct premium be? Maybe $100 per $1 million in coverage? With an abusive captive, the premium will be so far detached from market reality that it belies any true insurance purpose – it is certainly not $250,000 for $1 million in coverage, but that is what the abusive captive will charge the related business. 

But it doesn't have to be outlandish coverages where an absurd premium is charged. Consider the case of directors’ and officers’ insurance, which is a standard policy underwritten by many captives large and small. The abusive captive will charge something like $50,000 for $1 million in coverage, though similar insurance is available on the open market for more like $800 per $1 million in coverage. 

Here, the promoters of abusive captives will say something like, "But our policies cover deductibles and exclusions that are not covered in traditional commercial policies." While that may be true, how much does that really affect the premium amount? Does it increase the premium by $500 or $2,000? Maybe, but it certainly doesn't justify the large premium amounts charged by the abusive captive. 

This is as good a place as any to mention a truism in the captive world, which is that "you don't act unless you talk to the actuary first." This means that whether a premium amount charged by a captive is defendable before the U.S. Tax Court hinges upon if it was reasonably determined by an accredited actuary. 

The problem is that the captive world has seen an influx of actuaries that do not undertake a technical analysis of the premium amount, but rather ask, "What sort of number do you want?" and then back into it with their analysis. Doubtless the IRS is aware of this as well, as very likely the same actuaries show up in relation to the same group of abusive captives. 

Fifth, the IRS is looking at who is selling the captive arrangement to the business owner. If the captive arrangement was promoted by a property and casualty agent, then the captive is likely benign from a tax viewpoint. But if the captive is promoted to the business owner by a tax professional or financial services professional, that might tell the IRS a different story. 

Sixth, the IRS is concerned about "notional" risk pools that give the appearance of risk distribution, where none is taking place. It is here that we digress and note that the term "insurance" is not defined in the Tax Code, but rather was defined by the U.S. Supreme Court in Helvering v. Le Gierse, 312 U.S. 531 (1941), where that Court stated, “Historically and commonly, insurance involves risk shifting and risk distributing. . . .” 

The element of "risk shifting" is satisfied by having a bona fide insurance contract that the parties honor, and the insurance company has sufficient capital so that it has substantial "skin in the game" of its own and is not simply relying upon premiums to pay claims should loss history turn bad. 

But it is the element of "risk distribution" that requires the most technical tax analysis. That is where the arrangement may run aground, because of the insurance being deemed self-insurance (which is not "insurance" at all for tax purposes, and thus premiums paid are not deductible to the operating business), as opposed to captive insurance, which allows the affiliated operating business to properly take a deduction for reasonable premiums paid. 

The IRS has identified what amounts to two safe harbors for risk distribution.

  1. The captive insurance company can insure at least 12 insureds, with the risk of loss distributed more-or-less evenly among the insureds. Most large corporate captives fall into this safe harbor for risk distribution, as they frequently have the numerous operating subsidiaries that can suitable as insureds.
  2. The captive insurance company can meet risk distribution if at least 50 percent of its premiums derive from third-party sources. Most small captives are forced to meet this test, since they don't have enough affiliated operating businesses to meet the 12 insureds safe harbor. The problem is that captive insurance companies have limited insurances licenses that allow them to underwrite the risks of only affiliated businesses or other insurance companies (by way of selling the latter reinsurance). 

To attempt to remedy this problem, many captive managers have created their own insurance companies that act as "risk pools," so as to convert what would be non-qualifying direct insurance from the operating business into qualifying third-party reinsurance. In theory, the risk pool "mixes" the risks of numerous operating businesses owned by the captive manager's clients into a large single pool, and then each client's captive reinsures that pool to get to 50 percent of its premiums. 

In other words, 50 percent of the premiums paid by a captive owner go directly from the operating business to the captive insurance company. The other 50 percent are paid into the risk pool, and then pass as reinsurance (less the claims of the pool) to the captive insurance company. 

The problem is that many, if not most, of these risk pools are simply conduits through which money passes and is retitled from "first-party insurance" to "third-party reinsurance," without any real mixing of risk. Indeed, most of the risk pools have few or no claims, and certainly not enough loss history to justify the premium amounts being paid to them. Many risk pools are simply a facade that gives the appearance that risk is being mixed, when in actuality, money is merely taking a detour for the purpose of bamboozling the tax authorities. 

Indeed, many captive clients form their own insurance company for the very purpose of taking their insurance destiny into their own hands, and the last thing they want is to actually risk losing money on somebody else's policy. 

The IRS is as aware of the problem with "notional" risk pools as anybody else, and is also aware that those notional risk pools present fat targets for audits. If the IRS can blow up the risk pool as to any one insured, it can probably take down the risk pool (and thus defeat the captives) as to everybody in it. From the viewpoint of the IRS, such action is much more efficient than attempting to randomly hunt down abusive captive arrangements. 

The flip side of that is the risk to the captive owner – being in a risk pool means risking having the pool invalidated as to somebody else, with the consequences being to you too. Indeed, the promoter audits launched by the IRS so far seem to be focused primarily on captive managers with no- or low-claim risk pools who are also somewhat touting the tax benefits of a captive and with only lip service being paid to its true insurance risk management function. 

Seventh, the IRS is concerned about captive arrangements where the promoters have told their clients not to submit or pay claims. This practice is nothing short of tax fraud, since not paying claims of course belies the true, supposedly arm's length nature of the captive insurance arrangement. 

These are the concerns that have been identified by the IRS. These concerns are not without their critics and others who believe that they have good defenses against possible IRS challenges. 

Other Views

Among these defenses, it has been suggested that so long as the captive insurance company qualifies with the requirements of state insurance regulators, that should be the end of the analysis from a tax perspective. The problem, of course, is that state insurance regulators are not tax professionals, and have no duty to ensure that the captive arrangement is tax compliant. What may be acceptable from a state regulatory viewpoint might simply fail to pass muster under tax law. 

Moreover, in the attempt by jurisdictions to compete for captive formations, state regulators have demonstrated that they are not above looking the other way when it comes to captive arrangements that are questionable from a tax perspective. There can be little doubt that, in an attempt to grow their own jurisdiction's captive business (and thus their office's prestige), some state regulators have been willing accomplices in abusive captive schemes. 

That a captive complies fully with state regulation is only one relatively minor factor. What happens with the captive complying with the demands of insurance regulation only helps to establish that the captive arrangement is facially valid, but that compliance is not conclusive as to the tax issues. 

Where all of this will shake out remains to be seen. All we know now is that the IRS is conducting promoter audits of those it believes may have be involved with abusive captive insurance transactions, and Congress has shown an interest in the subject. For those who have proper captives, none of this should be of much concern; but for those with potentially abusive captives, remedial action could be forthcoming.

Additional Resources

For other materials on this topic, please refer to the following.

Business Law Today

Our Mini-Theme: Captive Insurance
February 2014
By Jay Adkisson

A Growing Multidisciplinary Practice: Captive Insurance and Wealth Planning
February 2014
By Edmond M. Ianni

Current Tax Issues with Captive Insurance Companies
February 2014
By Beckett G. Cantley, F. Hale Stewart

Choice of Domicile in Captive Insurance Planning
February 2014
By Dana Hentges Sheridan, Jay Adkisson

Observations on Captive Insurance Companies: 10 Worst and 10 Best Things
February 2014
By Jay Adkisson 

ABA Web Store

Why Clients Across the Spectrum are Increasingly Using Captive Insurance Risk Management
Date: Tuesday, June 17, 2014
Credits: 1.50 General CLE Credit Hours

This webinar will examine some of the practical uses of captive insurance in the current market and its applications in the business and wealth management spaces.  We also will discuss some recent developments and guidelines to help you better connect with and serve your clients (and prospective clients) in this expansive frontier.

Hot Topics in Captive Insurance and Risk Pooling Arrangements
Date: May 21, 2014
Credits: 1.50 General CLE Credit Hours

Jay Adkisson

Founding Partner, Riser Adkisson LLP

Jay Adkisson is a founding partner at Riser Adkisson LLP in Newport Beach, California.