An Open Letter To Congress And The Senate Joint Committee On Taxation Regarding The IRS’s Unlawful Harassment Of Small Captive Insurance Companies
The Joint Committee on Taxation is currently considering whether to expand the limits under Internal Revenue Code Section 831(b), the provision that makes it economically feasible for small businesses to engage in responsible risk management activities. I urge you to support this expansion, and more importantly to take this opportunity to thwart the IRS’s current attack on Section 831(b).
On February 3rd, 2015 the IRS issued a release (IR-2015-19). Among other things, this release makes clear what the industry has known for some time now– the IRS’s attack on Section 831(b) is coordinated, intentional and seeks to undermine the express will of Congress. By launching a coordinated attack on the variety of captives favored by small businesses, the Service is trying to achieve through the spread of fear, uncertainty and doubt, not to mention intimidation, that which it has been completely unable to achieve in the courts. The IRS has lost nearly every single court case of consequence involving captive insurance companies in the last thirty years, including two important ones in the last twelve months alone (Rent-A-Center and Securitas).
As the IRS notice suggests, the IRS’s justification for attacking 831(b) is that small business owners are being “sold” sham captive insurance companies by “promoters” as a gimmick for that “promoter” to gain new business. The tax benefits are simply the bait to get the small business owner to “bite”. The IRS suggests that the low claims activity and high profit margins common in such captives are “proof” that they insure “implausible” risks and that the captive is simply a tax dodge. That the primary insured often pays a significant percentage of its gross revenue to insure low-frequency but high-impact risks, and varies the premiums from year-to-year based upon the business’ profitability, is likewise offered by the IRS as evidence of a sham.
This rationale for attacking small business captive insurance companies is anchored in the Service’s fundamental misunderstanding of small businesses, the backgrounds of the advisors who traditionally serve them, and the purposes of 831(b).
The Service makes much of the fact that many of these transactions are “tax motivated”. However, per the relevant House and Senate Committee Reports, 831(b) was adopted by Congress specifically to “extend the [tax] benefit of the small company provision [of the Internal Revenue Code] to all eligible small companies, whether stock or mutual.” Since mutual companies enjoyed this benefit under previous versions of the IRC, Section 831(b)’s explicit Congressional purpose was therefore to provide a tax “benefit”, or incentive, to small captives (small stock companies). As with any tax benefit provision (ponder Section 401(k), for example), Congress intended by adopting IRC Section 831(b) to induce taxpayers to act in ways that they otherwise would not, and to do so for the public good. By attacking taxpayers for biting at the very carrot that Congress had dangled, the Service seeks to deprive taxpayers of this important benefit and undermine the express will of Congress.
What public good does 831(b) serve? The survival of small businesses, for one. The U.S. government’s own disaster preparedness website for small businesses, ready.gov, notes that “40% of businesses affected by a natural or human-caused disaster never reopen”. Helping small businesses survive such disasters is important to the government and to our economy because, per the Small Business Administration’s statistics cited on the ready.gov website, such businesses “represent 99.7% of all employers, employ about half of all private sector employees, have generated 65% of all net new jobs over the last 17 years, and made up 97.5% of all identified exporters.” Congress was justified in inducing businesses to manage risk via the tax incentives of 831(b), and the IRS is abusing its power by seeking to deprive the public of them through a highly publicized and coordinated attack.
Importantly, ready.gov recognizes that it’s not the high-frequency but low impact risks that endanger small businesses but rather the low-frequency and high-impact ones often insured via 831(b) captive insurance companies due to cost considerations—that the Service derides as “implausible”. On its ready.gov website pages for small business disaster preparedness, the government notes that:
- “Businesses can do much to prepare for the impact of the many hazards they face…including natural hazards like floods, hurricanes, tornadoes, earthquakes, and widespread serious illness such as the H1N1 flu virus pandemic.
- Human-caused hazards include accidents, acts of violence by people and acts of terrorism.
- Examples of technology-related hazards are the failure or malfunction of systems, equipment or software.”
Via the sweeping and abusively broad audits of 831(b) captives currently taking place, the IRS seeks to define the “plausibility” of a given risk by whether or not the business in question sustained losses from that particular risk within the last ten years. If not, the service sees that as evidence of an “improper” tax-avoidance motivation. However, by that definition, insuring against something as common and needed as fire is “implausible” for most every small business owner because the typical small business does not sustain fire-related losses every ten years.
Additionally, these high impact but low frequency risks are only “remote” when considered individually. When viewed as a group, and given sufficient time, the odds of one of the risks noted on ready.gov occurring is too large for all but the most brave, immune or ignorant of small business owners to ignore, as the ready.gov website itself makes clear. Given that even a single occurrence of just one of these risks constitutes an existential threat to the business, and that the financial security of the small business owner is tied to his business, it’s no wonder that they take these “implausible” risks so seriously. As a group, they are not “implausible” at all.
A traditional risk often insured via 831(b) captive insurance companies, repeatedly attacked by the IRS as “bogus” and “implausible”, is terrorism insurance. At captive conferences across the country, members of the IRS have been know to ask the audience rhetorical questions like, “who needs terrorism insurance in Iowa?” And yet the ready.gov website makes it perfectly clear the risk of terrorism is very real, would likely have a devastating impact on an unprepared small business, and “should” be protected against. How many small businesses could survive a quarantine of even short duration, or a sustained interruption of the supply chain, or loss of power or water for a meaningful period of time? Remember the Small Business Administration statistic that 40 percent of small businesses never recover from an occurrence.
The IRS also frequently asserts that terrorism policies are mispriced, with premiums being “inflated” to achieve underserved tax deductions. This contention is belied by two key facts. First, business interruption insurance in the commercial mainline market that would reimburse small businesses for lost revenue (not just property damage) resulting from terrorist attacks of certain varieties–including chemical, biological, radiological and nuclear attack–is often unavailable. Said another way, no mainline commercial insurer will cover some of these risks at any price, and not because these risks are “not real” (they’d love to charge for insurance that’s not needed, after all) but rather because they are too real and potentially too devastating.
Second, the terrorism risk is so significant that Congress passed the Terrorism Risk Insurance Act (TRIA) in order to induce the insurance industry to issue certain types of terrorism coverage at all. Even then, these policies usually only cover property damage (not loss of revenue), and they exclude the most extensive risks completely.
Given that, even with the government-provided backstop afforded by TRIA, the insurance industry still won’t issue many important terrorism coverages at any price, the IRS’s contention that captive premiums for these policies are being systematically inflated to justify larger tax deductions is demonstrably wrong.
Ready.gov specifically advises small businesses to purchase insurance as a means of mitigating the financial impact of these “implausible” risks. However, purchasing commercial, mainline insurance to protect against all or most such existential risks, if it is available at all, is cost-prohibitive to the typical small business, amounting to ten percent or more of the businesses gross revenue in some instances. What small business can afford to devote more than ten percent of its gross revenue to the “sunk cost” of purchasing third-party commercial insurance, especially when that insurance is notoriously riddled with exclusions and limitations?
This is why small businesses are increasingly using 831(b) captive insurance companies instead, and incentivizing them to do so is explicitly why Congress provides the 831(b) tax “benefit”. An 831(b) CIC permits the business owner to retain underwriting profits in the more likely event that none of the existential threats discussed on ready.gov materialize. These profits may eventually be plowed back into the business. Profits from insuring unrelated third parties (via participation in risk distribution pools) further reduce overall insurance costs to the business, and the pools themselves serve to diversify the business’ risks. Insurance policies obtained via the associated captive insurance company and risk pool typically have far fewer exclusions, making the business more bullet-proof. And, yes, the tax benefits provided by 831(b) greatly reduce the cost of purchasing so many different types of important insurance.
Without the tax subsidy of 831(b), the cost of protecting against these risks in bulk would be prohibitive, and even more small businesses would fail to prepare. The Service would have us believe that paying 10% or more of gross revenue to a captive for such premiums is, again, de facto evidence of a tax sham (since no business would presumably ever pay this amount to third parties for the same coverage). But then, that’s the very point of Section 831(b): To incentivize businesses to protect against risks that they otherwise would not, and to subsidize them, through tax benefits, in doing so.
The service would likewise have us believe that varying premiums from year to year is evidence that the taxpayer is just trying to dial in a certain level of tax savings. But, honestly, what business would ever devote 10 percent or more of its gross revenue to a single expense item if it didn’t have the flexibility of cutting that expense as business conditions fluctuate and warrant?
The IRS offers up the involvement of nontraditional captive insurance advisors, people who the service seeks to taint as “salespeople” and “promoters,” as additional evidence of some nefarious tax motive. Consequently, the explicit objective of the IRS in launching its attacks, as admitted in the text of the notice referenced above, is to scare and silence these advisors so that the public, and small business owners in particular, are unable to learn about and benefit from the Congressionally authorized tax incentives of captive insurance companies. However, the presence of these nontraditional captive advisors is easily explained by their well-known risk management expertise, their knowledge of small businesses, and the broader captive insurance industry’s neglect of 831(b) captives as “too small” to be worth their while. Given that the mainstream captive industry has largely ignored these small business owners, preferring instead to focus on the larger variety of captives formed by Fortune 1000 companies and the like, it’s no surprise that these small business owners are looking instead to their traditional advisors–CPAs, wealth managers, financial planners, life insurance producers, local property and casualty agents, etc., people the IRS now publicly disparages as “salespeople” and “promoters” of “abusive tax shelters”—for assistance in forming and managing their much-needed captive insurance companies.
Small business owners well understand the existential threat of these risks, and they have an inherent interest in protecting against them. 831(b) makes it economically feasible for them to do so whereas previously it simply was not. However, the small business owner is not born with knowledge of how to enjoy the benefits of 831(b). Since most don’t have true Chief Financial Officers to guide them, they must rely upon the advice and counsel of outside advisors, the IRS’s “promoter” to gain sufficient understanding of the rules and how to abide by them. Specifically, any responsible business owner will seek to be “convinced” that the tax benefits of Section 831(b) are available and legitimate. He or she will also seek to understand:
–What happens to the money while it is in the captive insurance company.
–How the assets of the captive may be invested.
–The circumstances under which the business owner can take money out of the captive and the tax implications of doing so.
–The impact of forming this new captive on his or her existing estate planning (no responsible highly successful business owner who is well advised makes any long term business decisions without considering the estate planning implications since estate taxes are likewise an existential threat).
Consequently, it is not unusual, nor should it be considered improper, for captive manager’s or advisor’s “marketing materials” (as the IRS likes to call them) to focus on addressing these points in particular—points that, from experience, the captive advisor knows will require more elaboration and explanation to the business owner than the insured risks themselves. In its sweeping and abusive audits, the Service contends that these education pieces—what it calls “marketing materials”–are simply further “proof” of an “improper” tax motivation, justifying its conclusion that the captive is a “sham”.
In this respect, the IRS shamelessly wants to have its cake and eat it too. Where a taxpayer is less-than-diligent in vetting the tax implications of the captive insurance transaction, the IRS will allege that he or she had “no reasonable basis” for taking the deduction, and therefore will assess accuracy and/or negligence penalties, and even preparer penalties if it can. And yet, when the business owner and his advisors do in fact vet these issues extensively, the Service offers up the business owner’s “focus on taxes” as “proof” that the whole transaction was a tax-motivated sham, likewise then assessing accuracy/negligence penalties and preparer penalties. The IRS abusively seeks to create a “head’s we win, tails you lose” scenario.
The IRS has launched hundreds of captive audits over the last couple of years. They have likewise targeted dozens of honest captive advisors, some pillars of the 831(b) captive industry, for abusive and unnecessary “promoter investigations”. Fortunately, the IRS is not having great success in attacking these captives or their promoters, especially once the case makes it to Appeals (which can take years). But, success in court or at Appeals isn’t their objective. Their objective is to terrorize 831(b) captive insurance advisors into submission by bankrupting as many of them as they can (via incredibly costly and never-ending “promoter investigations,” which unlike a taxpayer audit have no statute of limitations and offer no procedural protections), and also to dissuade small business owners from even considering perfectly legitimate 831(b)s, via the spread of fear, uncertainty and doubt (which is the entire purpose of IRS Release IR-2015-19) as to which transactions are legitimate and which are not. In this manner, the Service hopes to achieve through intimidation what it has been wholly unable to achieve in the courts, and to subvert Congressional will in doing so.
Your prompt intervention is required in order to prevent the IRS from using improper tactics to circumvent the express will of Congress as codified in IRC Section 831(b). As the Joint Committee on Taxation considers expanding 831(b), please take the opportunity to insist that they address specifically the Service’s efforts to thwart their will.
Sean Gregory King, JD, CPA