IRS Steps Up Attacks on Some Captive Insurance Companies – InsuranceNewsNet

Captive insurance companies are used to insure against a large number of commercial risks, mainly for commercial companies with certain types of large and complex risks. These insurers are owned by the insured or a related party and are governed by various provisions of the Internal Revenue Code of 1986, as amended, including IRC §831.

When discussing captives, it is essential to understand the difference between widely acceptable §831(a) captives and captives formed under §831(b), which are increasingly viewed by the IRS as tax avoidance and tax evasion schemes. Let’s take a look at these differences and explore the uses of captives.

Know the difference

There are distinct differences between the two main types of captive insurers: those who choose §831(b) to be treated as a small insurance company (i.e. microcaptives) and those who do not. do not and are administered pursuant to IRC §831(a) .

Those who choose to form a §831(a) captive do not face a limit on the amount of premiums that can be paid and there are no restrictions on the number of shareholders (participants) for the captive. On the other hand, the choice to form a §831(b) captive can only be made as long as the premiums paid are below $2.3 million (2022 limit – threshold adjusted annually). In both structures, the premiums paid are often tax deductible.

For §831(a) captives, underwriting income (the amount of premiums paid, less allowable reserves and expenses) is taxed while with a §831(b) captive, investment income, but not subscription, are taxed. Therefore, a company can, in effect, pay a deductible premium to its own captive insurance company without the captive paying tax on it. This appears to be a major distinction in the eyes of the IRS, along with the fact that underwriting and claims are arm’s length transactions in §831(a) captives administered by third parties and not conducted by related parties.

This premium deductibility, along with the lack of taxation on underwriting income, has led to abuse by taxpayers forming captive insurers as well as scrutiny by the IRS. Often, microcaptive owners and developers focus on tax benefits with little or no attention given to insurance benefits. This includes failures to properly underwrite cover, incorrectly priced cover, little or no claims paid, and limited or no risk shared with third parties (i.e. reinsurance).

This shows why the IRS frowns on §831(b) captives and examines them as potential vehicles for tax avoidance while §831(a) captives are not considered in this light. In 2014, the IRS added §831(b) captives to its “Dirty Dozen” list, calling such captives “abusive arrangements.” Then, in 2016, the IRS issued Notice 2016-66 in which the agency wrote that §831(b) captives had the potential for tax evasion or evasion.

As if the message about these forms of captives wasn’t strong enough, three recent US Tax Court decisions have given the IRS victories in §831(b) captive disputes. These cases addressed a number of issues:

  • Does the §831(b) captive insurer operate like an insurance company?
  • Is the captive §831(b) organized, operated and regulated like an insurance company?
  • Has there been a feasibility study demonstrating the need for captive insurance as opposed to existing commercial insurance?
  • Are the constitution, operation and coverages of the captive insurance company specifically tailored to the business needs of the insured operating company?
  • Is the §831(b) captive sufficiently capitalized?
  • Are the policies issued binding?
  • Are the premiums paid reasonable and have they been determined by an arm’s length transaction?
  • – Is there a claims payment history?
  • – Is there “risk shifting” and “risk spreading”? »

Last year, there was a notable negative ruling for §831(b) captives in Caylor Land & Dev. V. Commissionerwhere the court ruled that a §831(b) captive arrangement did not qualify as insurance for federal tax purposes.

More recently, on May 13, 10e The Circuit Court of Appeals issued a decision on a ratepayer’s appeal in Reserve Mechanical Corp. vs. Commissioner. The appeals court upheld the tax court’s decision upholding the IRS’ decision that the company was not eligible for tax-exempt status as an insurance company under section 501(c). )(15) and that the bonuses she received should therefore be taxed at a rate of 30% rate under section 881(a). As a result, Reserve Mechanical not only lost the deductibility of the premiums it paid to its captive, but its captive had to pay taxes on the money it received from Reserve Mechanical – effective double taxation on top of interest and penalties. due!

Uses of captives

The tax benefits of setting up a captive insurance company can be attractive. However, these benefits should be secondary to the need for the different types of insurance a captive can provide. Captive insurance arrangements can provide customized coverage while mitigating the costs associated with commercial coverage.

We live in a time of increasing cyberattacks, regulatory risks and supply chain disruptions (to name just a few growing threats) and we’ve just seen what a transmittable virus can do to cripple businesses. The protection that captive insurers can provide is increasingly important for business continuity. By emphasizing the provision of coverage through an arm’s length transaction and paying taxes, where applicable, §831(a) captive insurers have moved beyond the negative attention garnered by §831(a) captives. b).

Here are some examples of coverage provided by captive insurers:

Property related – resulting from equipment breakdowns, natural disasters, remediation and maritime and river incidents.

Work interruption – resulting from supply chain disruption, loss of contract, loss of key employee, cyber attack, communicable disease and strike or civil unrest.

Regulatory and legal – resulting from the defense of litigation, loss of license, regulatory change and government audit.

Additional – arising from excess liability, deductible coverage, gap coverage and difference in conditions.

Jay C. Judas, JD, M.Sc. is the CEO of Life Insurance Strategies Group, an independent life insurance consulting firm. Jay can be contacted at [email protected].

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Kristan F. Talley