Captive insurance has been around for a while, but micro-captive insurance structures are more recent in their invention and application.
As with any other financial planning vehicle generally, and insurance product in particular, whether or not something is right in a certain circumstance greatly depends on said circumstance. In other words, despite what a very persuasive insurance salesperson may say (even one with a very nice car and an expensive suit), no insurance product is right for every person and every situation. To take it a step further, if some insurance products are good, right and proper for about 30% of people (just picking a nice round number), I would venture that micro-captive insurance structures are appropriate for a MUCH, MUCH, MUCH lower percentage of people.
Wait, what is micro-captive insurance? Great question. I am not an expert in such things, not by a long shot. Thankfully, I have professional colleagues who are experts in these matters. One such expert is an accountant colleague named Jared Chatterton. I have several mutual clients with Jared, have worked extensively with him and have the utmost confidence in his knowledge and expertise. Accordingly, I have shared below a summary he has written. If you have questions about micro-captive insurance companies, please let me know, and I will be happy to put you in touch with Jared. So, without further adieu, here is Jared’s write-up on micro-captives.
December 11, 2017
To: Captive’s Attractives
From: Jared Chatterton
As a practitioner who specializes in tax planning for businesses and business owners, it has become the norm for me to field questions and offer advice on the concept of IRC 831(b) Micro‐Captive Insurance. Accordingly, in an effort to give a basic overview of the relevant issues, please see below:
Micro‐Captive Insurance – What is it?
The micro‐captive insurance structure, in a nutshell, is when a small‐business (the insured) pays and deducts insurance premiums paid on a policy to a “captive” insurance company (the insurer) that is also owned by the insured. The insurance company makes an election under Section 831(b) to exclude the net premiums from income so that the company only pays tax on its investment income.
This type of structure is easy to sell to a small‐business owner with consistently high profits that become the victim of a Federal tax rate of 39.6%. The world’s worst salesman could successfully convince a money-making-business owner to consider a captive arrangement. “Hey, Uh, Yah, so um… it looks like you’re making a lot of money again this year. So, umm…here are your options: (a) Pay $500,000 to an insurance company that you own 100% of so you get to keep the money; or, (b) Pay $198,000 of income tax to the US Treasury and keep $302,000 of the $500,000. So, um, which amount are you in the mood to retain this year ‐$500,000 or $302,000? Uh, yeah it’s legit, everyone is doing it, and there are companies dedicated to them…for a large fee…which is also tax-deductible. So, you in?”
A financial advisor, accountant, attorney, wealth planner, or promoter that is positioned correctly is motivated to pitch the simple concept to their high-tax-paying clients in anticipation of receiving fees and commissions derived from managing the funds inside the captive, establishing and maintaining the legal structure, advising and managing the insurance company, preparing income tax returns and other compliance documents.
The IRS’ Position
The IRS began its micro‐captive journey a few years ago when it placed micro-captive insurance structures on their annually published list of “Dirty Dozen” tax scams. Calm down promoters and lovers of captive arrangements; I acknowledge that being on the list does not, by itself, deem it to automatically be a tax scam. The list consists of various plans or transactions that are on the radar because of their potential to be implemented as abusive tax shelters. The list is informal and for the most part irrelevant and certainly without legal binding. No big deal. But wait…
The IRS took it a step further when, on November 1, 2016, they released Notice 2016‐66 officially designating micro‐captive arrangements as a “Transaction of Interest” as well as establishing disclosure reporting requirements for those entering into such transactions. The disclosure requirements impose a mandate for the insured, its owners and the insurer (captive insurance company) to complete Form 8886 (Reportable Transaction Disclosure Statement), along with the appropriate attachments and schedules. An S Corporation with three shareholders that pays premiums to a captive insurance policy would be required to file five separate Form(s) 8886 – one for each shareholder, one for the S Corporation and one for the captive insurance company (usually a C Corporation).
The information that is required to be disclosed on this form is quite officious and with attachments quite large, including:
- The name, tax identification number, and address of every individual and entity to whom you paid a fee concerning the transaction if that individual or entity promoted, solicited, or recommended your participation in the transaction, or provided tax advice related to the transaction.
- A description of the amount and nature of the expected tax treatment and expected tax benefits, including the facts and circumstances relating to each step involved and including the amount and nature of your participation in the transaction and all related transactions, regardless of the year in which they were entered.
- A detailed description of any tax result benefit concerning the transaction.
- An identification of all individuals and entities involved in the transaction that are related, including their names, tax identification number, address and a description of their involvement.
First ‐ the dirty dozen hot list. Next – Notice 2016‐66 labeling it as a transaction of interest and imposing reporting requirements, then… Congress passed the Protecting Americans from Tax Hikes (PATH) Act, effective January 1, 2017, establishing diversification and reporting requirements for new and existing captives.
There haven’t been any announcements declaring all captive arrangements as tax scams, and it would appear, given the lack of precedence on the subject, that they can be done correctly under the right circumstances. The IRS implies abusive structures to be those that lack many of the attributes of genuine insurance.
Some examples of potentially abusive structures would be:
- Coverages that insure implausible risk and/or fail to duplicate the taxpayer’s commercial coverages.
- Premium amounts which are unsupported by underwriting or actuarial analysis and geared towards the desired deduction amount or significantly higher than premiums for comparable commercial coverage.
- Policies that contain vague, ambiguous or deceptive terms.
- Claims administration processes which are insufficient or altogether absent.
- Insured fails to file claims that are seemingly covered by the captive insurance.
- Captive invests in illiquid or speculative assets or loan/transfer capital to or for the benefit of the insured or its owners
- Captive formed to advance inter‐generational wealth transfer objectives to avoid estate and gift taxes.
United States Tax Court 149 T.C. No. 7 August 21, 2017
The first United States Tax Court case involving an 831(b) captive involved Ben and Orna Avrahami who owned a retail jewelry store and commercial real estate properties in Phoenix, Arizona. The taxpayers claimed deductions on their 2009 and 2010 income tax returns under Section 162 for insurance premiums paid by their pass‐through entities to a captive insurance company which they wholly owned.
The taxpayers argued that they relied on the advice of their trusted professionals when the captive policy was established in 2007 – Craig McEntee, a CPA with over 25 years of experience; Neil Hiller, an estate planning attorney with more than 30 years of experience; and, Celia Clark, a New York attorney with more than 35 years of experience who specializes in small insurance companies and formation and maintenance of captive insurance companies with more than 75 captive insurance clients.
The captive was established, and the taxpayers paid and deducted $1.1 million in 2009 and $1.3 million in 2010 to their captive insurance company to insure their multiple businesses. There were no claims made on the company’s policies and with the money flooding in and none going back in claims the captive company accumulated a surplus of more than $3.8 million by the end of 2010.
The Court held that the amounts paid to the captive are not insurance premiums and not deductible under IRC Section 162. They held further that the IRC Section 831(b) election is invalid for 2009 and 2010.
This was a decisive win for the IRS and significant in terms of being the first real guidance coming out of Tax Court. Former IRS Commissioner, Steven T. Miller, who is now the national director of tax at AlliantGroup, a Washington D.C.‐based tax consulting firm, believes the ruling will give the IRS a stronger hand – “There’s nothing in this opinion that will limit the IRS’s activity in any way,” he said. “If anything, it will embolden them.”
I browsed the entire 105‐page Court opinion, and the Court did not criticize 831(b) captives. It did, however, criticize the facts of this particular case and determined that their captive was not operating as an insurance company and lacked adequate risk distribution.
Where they went wrong:
- Despite the formation of the micro‐captive company, each of the entities owned by the Avrahamis continued to buy insurance from third‐party commercial carriers even after contracting with their captive company for insurance.
- The actuary employed to determine appropriate premiums for varying levels of risk was inadequate at applying industry standard factors, and the premiums were not determined at arm’s length.
- The captive insurance company borrowed money to Mr. Avrahami who executed a promissory note with an LLC owned by his children and used to purchase real property assets in Snowflake, AZ. The captive company failed to seek approval from its regulators who often raise their eyebrows at related‐party dealings like this.
- Several of the captive’s policies included uninsurable risks, and it failed to distribute risk because of an insufficient pool of insureds which risk was not shifted because of their incapacity to meet its obligations.
The general concept appears to be that if it doesn’t look, smell and act like an insurance company, it isn’t an insurance company.
Typically, amounts paid for insurance are deductible under section 162(a) as ordinary and necessary expenses paid or incurred in connection with a trade or business. (See Reg. Sec. 1.162‐1(a). However, neither the Code nor the regulations define “insurance” so we must rely on case law when determining whether insurance exists for federal income tax purposes.
In Helvering v. Le Gierse, 312 U.S. 531, 539 (1941), the Supreme Court stated that insurance is a transaction that involves “an actual insurance risk” and that “involves risk‐shifting and risk-distributing.”
The Supreme Court identified four nonexclusive criteria that the insurance the arrangement must meet:
- Involve risk‐shifting;
- Involve risk‐distribution;
- Involve insurance risk; and
- Meet commonly accepted notions of insurance.
There have not been enough cases litigated to establish which micro‐captives will survive court scrutiny moving forward. What we do know is this: The IRS has been auditing captives and there appears, there are more court cases in the pipeline, and there is a great deal of friction between the captive industry and the IRS. I suspect there will be much more case law in the near future and as a result a narrower definition of what is deemed appropriate.
Until then, we watch people ride the captive wave.