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Via IRS Notice 2016-66 (the “Notice”), the Internal Revenue Service (“IRS” or “the Service”) has invited the public to comment regarding how the Service might, via future guidance, articulate a principled distinction between abusive and legitimate captive insurance arrangements taxed under Section 831(b) of the Internal Revenue Code (“Microcaptives”).
I am an attorney and CPA. I have a Master’s Degree in Accounting with a concentration in taxation. I have been a licensed insurance broker actively working in the insurance industry for more than a quarter century. I have been heavily involved with managing captive insurance companies, often of the Microcaptive variety, for more than a decade. I have various securities licenses, and I am an investment advisor fiduciary to over $10 billion in qualified retirement plan assets. Given my background in accounting, law, taxation, insurance and investments, I believe that I’m uniquely qualified to offer insightful comments concerning the questions raised in Notice 2016-66.
Taxpayers Deserve Meaningful Guidance, Not the Administrative Repeal of Section 831(b)
Despite the pleadings of the captive insurance industry and half a decade of sweeping audits and “promoter investigations”, and despite repeated assurances from the IRS over that time that guidance is forthcoming, the Service has declined to provide taxpayers, the captive insurance industry and its own field auditors with any substantive guidance useful in distinguishing truly abusive captive insurance arrangements from perfectly legitimate ones. To the contrary, because the informal guidance offered to date implicates at least as many legitimate Microcaptives as abusive ones, such guidance has served only to blur the lines between legitimate and illegitimate structures. In fact, some IRS agents and Appeals Officers have been quoted on the record as contending that “all Section 831(b) captives are abusive.”
Such irresponsible statements only compound the confusion among those taxpayers and their advisors who seek to honor the law. It’s simply not possible that all, or even most, Section 831(b) captives are abusive, and the industry deserves to know how to distinguish the good from the bad. Failure to provide such guidance by characterizing all or even most 831(b) captives as “abusive” is not just bad tax administration, it is an improper attempt by an administrative agency of the Executive Branch to repeal or nullify an act of Congress.
Where the line between legitimacy and abuse is well-defined, honest taxpayers will reliably approach it without crossing over. However, where the edge of the legal cliff is obscured in a fog of fear, uncertainty and doubt (“FUD”), and where the Service employs after-the-fact “gotcha” tactics to foster an atmosphere of terror, taxpayers lose confidence in the IRS, the democratic process and our system of laws.
Fostering an atmosphere of undue caution via the spread of FUD dissuades the formation and operation of a great many perfectly legitimate captive insurance companies. This is unwise and improper for several reasons.
First, as explicitly detailed in my comments below, Section 831(b) serves important public policy purposes. By incentivizing small businesses to insure risks that they otherwise would overlook (see my comments below for additional details), Section 831(b) helps protect jobs by protecting small businesses against business failures.
The public policy reasons for granting tax benefits to Microcaptives are compelling. They are so compelling that, in 1986, when Congress sought to close tax “loopholes” of all sorts, including even severely reducing retirement plan contribution limits, Congress chose (via Section 831(b)) to expand to small stock companies tax benefits previously available only to small mutual insurance companies. Congress again recognized the public policy benefits of Section 831(b) as recently as the end of 2015 when, via the PATH Act, it expanded the premium limits thereunder from $1.2 million to $2.2 million.
Given this explicit Congressional incentive, the Service oversteps its bounds when it provides no meaningful guidance and then second guesses essentially all taxpayers who engage in the Congressionally-encouraged activity. Even more disturbingly, by identifying “tax avoidance” as the hallmark of an abusive Section 831(b) transaction, Notice 2016-66 seeks to poison the very tax incentive carrot that Congress so carefully dangled.
Second, as court after court has recognized, the McCarran-Ferguson Act grants the states near-exclusive authority to regulate the business of insurance. To date over 40 states, Puerto Rico and the District of Columbia sanction and regulate the formation of captive insurance companies.
Implicit in Congress’s grant of authority to the states is each state’s ability to reasonably define “insurance” and “insurance company”. Regarding the latter, courts have explicitly recognized the near-exclusive authority of the states to define what is an insurance company and what is not. In the RVI Guaranty (RVI) case, the court noted:
We have repeatedly emphasized the significance of State insurance regulation in determining whether an entity should be recognized as an ‘insurance company’.
The courts have likewise repeatedly recognized the essential role of the states in defining “insurance” in the ordinary sense. For instance, when determining whether the policies in the RVI case qualified as valid “insurance”, the RVI court stated:
Most importantly, every State in which petitioner does business recognizes these policies as involving insurance risk and regulates them as “insurance.”
The reasonable determinations of state regulators were the court’s most important factor in concluding that the RVI contracts were indeed “insurance” policies.
With all due respect, the IRS has neither the legal authority nor the practical competence to regulate or define insurance arrangements or to sit in judgement upon those who do so. The courts have consistently rejected the Service’s multi-decade effort to redefine insurance: The IRS has lost nearly every single court case of consequence over the last 40 years where the definition of insurance was at issue, including three in the last two years (Rent-A-Center, Securitas and RVI).
In the recent RVI case, the court criticized the IRS for its narrow and self-serving interpretation of “insurance” by calling its arguments “metaphysical”:
Against this consensus of insurance regulators, insurance auditors, and the insurance marketplace, [the IRS] offers Dr. Baranoff’s opinion that the RVI policies are not “insurance” because they do no cover a “pure risk.”
We find [the Service’s] attempt to distinguish between a “pure risk” and a “speculative risk” in this setting as essentially metaphysical in nature.
Despite these judicial reprimands, the IRS still strives to bend the definition of “insurance” to its will. Industry experts have confirmed that the Service has admitted to acting against Microcaptives in large part because “the states are not doing their jobs” at defining and regulating the business of insurance. Respectfully, by what authority does the IRS make such a determination? What qualifications does it have to do so? None. By second guessing the reasoned judgment of state insurance regulators and by using the its tax enforcement powers to contradict them, the Service substitutes its rather questionable judgement for their’s, anointing itself as a de facto regulator of insurance contrary to Federal law.
Third, by failing to provide clear guidance to well-meaning taxpayers, the Rule of Law is threatened. The Rule of Law protects citizens from the arbitrary and subjective exercise of state power by requiring that such power be exercised only in accordance with well-defined and established laws. However, by shrouding the edge of the legal cliff separating legitimate and “abusive” captive insurance arrangements in a fog of FUD, the Service subjects taxpayers to severe ex post facto punishments meted out at the arbitrary and subjective whim of unelected IRS officials.
The IRS Suffers No Information Deficit
In the absence of truly needing additional information to formulate the promised guidance, Notice 2016-66 lacks proper legal foundation and is simply an abuse of discretion. According to the Notice, such information is required because “the Treasury Department and the IRS lack sufficient information to identify which Section 831(b) arrangements should be identified as a tax avoidance transaction…” However, everyone who has been involved with Microcaptives knows that this justification is simply untrue. The Service has admitted that it’s untrue.
The IRS is nearly five years into a nationwide audit sweep of Microcaptives coordinated by a group of IRS Captive analysts (such as Brandon _____ in Kentucky and Julie Ward in Dallas) and supervised by the IRS Chief Counsel’s office. Hundreds, if not thousands, of Microcaptives, representing a statistically meaningful percentage of all Microcaptives in existence, have been audited as a consequence of this nationally coordinated program.
The Information Document Requests (IDRs) issued in these nationally-coordinated audits are extraordinarily broad, essentially demanding every single record related to the Microcaptive from the time the Microcaptive transaction was first discussed or considered until the present. CPAs representing clients in these audits, many with decades of experience practicing before the IRS, regularly indicate that they have never before seen such comprehensive, demanding and overly broad document requests. What has become the standardized Microcaptive IDR consists of 42 to 46 categorical questions that, with subparts, exceed 117 demands. The purpose of such overly broad IDRs is obvious to everyone in the Microcaptive industry: To impose such a burden upon taxpayers that they will abandon the very insurance arrangements that Congress encourages.
In addition to these extensive taxpayer audits, the IRS has launched multiple “promoter investigations” of captive insurance managers and/or captive attorneys in which it has demanded comprehensive records related to every client served by the so-called “promoter”. I am personally aware of at least four such promoter investigations, though I suspect that there are many more.
Given five years of sweeping, laborious audits of hundreds or thousands of Microcaptives combined with multiple promoter investigations, the suggestion in Notice 2016-66 that the IRS suffers from an information deficit is transparently false. To the contrary, the Service has gathered so much information via these audits and promoter investigations that it can’t even process it all: In nearly every instance with which I and others in the industry are personally familiar, the IRS is habitually asking Microcaptives under audit to voluntarily extend the statute of limitations. The rationalization for requesting the extension is that the auditor has had insufficient time to review the voluminous documentation provided despite the fact that, in most instances, the IRS has had the requested documents and records in its possession for more than a year.
Should the taxpayer deny any such request for extension, the IRS immediately issues a Notice of Deficiency alleging that the captive is either deficient or abusive. The Notice of Deficiency is issued despite the fact that the IRS just conceded via its extension request that it hadn’t completed review of the relevant documentation.
The Enormous Burden of Notice 2016-66 on Small Business
Virtually all Microcaptives are owned and operated for the benefit of the nation’s small businesses. Small businesses of the type that frequently form and operate Microcaptives constitute the backbone of the nation’s economy. According to Small Business Administration statistics cited on the Department of Homeland Security’s disaster preparedness website, Ready.gov, the nation’s small businesses employ nearly half of all private sector workers, constitute 99.7% of all employers in the country, and have accounted for nearly two-thirds of the nation’s job growth over the last 17 years.
These small businesses do not have the financial and legal resources of Fortune 1,000 companies. Consequently, complying with the requirements of Notice 2016-66 is an extraordinary burden to such companies and their owners. Given Congress’ clear desire to incentivize the very conduct that the IRS now squelches, such burdens are unjustified.
Notice 2016-66 is so burdensome in part because it requires the filing of redundant information by multiple parties and fails to make any provision for information about certain taxpayers already in the Service’s possession. Much of the information requested by the Notice is already available to the Service via the annual tax return filings. In addition, hundreds of Microcaptives that have been audited over the last five years have already provided the Service (at great expense) with essentially all of the information it now demands again in Notice 2016-66.
Additionally, complying with Notice 20160-66 requires multiple other parties to provide the Service with identical and redundant information, also at great expense. For instance, the Notice and related regulations require that the Microcaptive, each insured of the Microcaptive, any fronting company, any “material advisor” to the transaction and potentially multiple individual owners of one or more of the preceding to all file the same, redundant information with the IRS. Such wasteful redundancy is completely unnecessary and should be eliminated.
Each party obligated by Notice 2016-66 to file the redundant information is often represented by different CPAs or lawyers. Given potential penalties of $50,000 for even inadvertent incomplete disclosures, the CPAs and lawyers must go to extraordinary lengths to coordinate their filing efforts to ensure that the filings made by the various independent parties are both totally consistent and absolutely complete. Such coordination multiplies the cost of compliance and the resulting burden on these small businesses exponentially.
Making virtually every Microcaptive transaction a “reportable transaction” has other wide-ranging, devastating and potentially unintended effects upon small businesses. For instance, some of our small business clients are currently in the process of going through a merger and/or acquisition. It is a standard covenant in most every sophisticated merger document or stock purchase agreement that the seller has “not participated in any ‘reportable transaction’ within the meaning of Treasury Regulations Section 1.6011-4(b)”. SEC Form 8-K also requires filers to make representations about whether their companies have engaged in “reportable transactions”. By unnecessarily retroactively classifying almost every single Microcaptive transaction as a “reportable transaction,” the Service placed in jeopardy an uncountable number of business transactions across the country.
Additionally, as a consequence of Notice 2016-66, some of the Nation’s largest financial services institutions will no longer permit any Microcaptive to open bank or brokerage accounts, presumably for fear that the institution could somehow be deemed to be a “material advisor” as a consequence. Without access to the nation’s banking and financial system, even perfectly legitimate Microcaptives will be completely unable to fulfill their important role in insuring the nation’s small businesses.
In short, by requiring that multiple parties (Microcaptives, their owners, fronting carriers, all “material advisors” and potentially their owners individually) file enormous amounts of redundant information, much of which is already in the IRS’s possession or otherwise available to it, Notice 2016-66 places an extraordinary and improper burden on small businesses while providing the IRS with little to no additional information that is useful in helping the Service articulate a distinction between so-called “tax avoidance transactions” and “other Section 831(b) related-party transactions.” It’s no exaggeration to say that Notice 2016-66 jeopardizes the entire Microcaptive industry.
If the information required by Notice 2016-66 was truly necessary for the IRS to properly enforce the tax laws, perhaps the placing of these extraordinary burdens upon small businesses could be justified…perhaps. But as noted above and emphasized below, this simply is not the case.
The True Motive Behind Notice 2016-66
If the Service does not in fact need more information to adequately differentiate legitimate from abusive transactions, then what is its real motivation in issuing Notice 2016-66?
No doubt exists on the part of anyone knowledgeable about Microcaptives: The Service seeks to administratively repeal or nullify Section 831(b), contrary to our democratic system, Federalism and the Separation of Powers doctrine. The Notice itself confirms the Service’s hostility to the Congressionally approved tax incentive by designating any “tax avoidance” motive as a tell-tale sign of “abuse.”
But answering the tax incentive call of Congress simply cannot be per se abusive.
The Service well knows that designating most every Microcaptive arrangement as a reportable transaction, and tainting any tax avoidance motive as an improper “tax avoidance” scheme, dissuades even legitimate (especially legitimate) Microcaptive arrangements. Notice 2016-66’s onerous filing requirements (placed on Microcaptives, their owners, their fronting companies and all “material advisors”), combined with chilling penalties for even inadvertent failures, makes forming and operating a Microcaptive far more costly and risky for small businesses than it otherwise should and would be. Its effect is to chill, if not kill, the very activities that Congress intended to incentivize. Consequently, it’s effectively an administrative repeal of Section 831(b).
In pursuit of this administrative repeal, the Service is using enforcement powers that were originally granted to it by Congress to assist the IRS in ending abusive and unlawful tax practices that exist contrary to law and Congressional intent. By instead employing these powers to subvert the intent of Congress, the Service thumbs its nose at the very source of its enforcement authority. The Service should not therefore be surprised if and when Congress decides to deprive it of such enforcement powers, or to severely limit them.
Helping Compliance by Clearing the FUD
The most valuable service that the IRS provides is helping citizens comply with statutes enacted by Congress. Taxpayers cannot do so when the line between compliance and noncompliance is shrouded in a fog of FUD. It’s particularly challenging when the IRS is the source of that FUD.
Any future guidance should therefore illuminate (rather than shroud) the line between abuse and legitimacy. To effectively do that, such guidance must take into account the unique risk profiles of the nation’s small businesses.
The Unique Risks of Small Businesses
The Department of Homeland Security’s website, Ready.gov, emphasizes that small businesses are uniquely exposed to risk in ways that larger companies are not. Unlike large companies, small businesses often have concentrated revenue streams. Sometimes their entire business model hinges upon one or two key contracts or business relationships. Additionally, the revenue streams of small businesses are often very geographically concentrated. And finally, unlike a Fortune 1,000 company, small businesses can’t easily and quickly access capital and credit markets when cash flow is disrupted by one or more unexpected events.
As a consequence of these unique risks, small businesses and their owners (unlike Fortune 1,000 companies) can be easily bankrupted by even temporary interruptions of cash flow. The government’s own statistics confirm this: According to Small Business Administration data cited on Ready.gov, 40% of small businesses never reopen their doors after a natural or human caused disaster. And, according to the US National Cyber Security Alliance, 60% of small companies are unable to sustain their business for more than six months after suffering a successful cyber-attack. Per IBM, small and mid-sized businesses are the targets of 62% of all cyber-attacks.
The inherent fragility of small businesses is further evidence by studying the effects of hurricanes Katrina and Sandy: These storms (and their after-effects) bankrupted thousands of small and often family-owned business, costing the country tens of thousands of good jobs and slowing economic growth in entire regions for many years. By contrast, Fortune 1,000 companies experienced only a temporary and manageable hit to earnings as a consequence of these storms.
It’s the Remote Risks that Are the Problem
It’s not usually the ordinary, day-to-day, high-frequency-but-low-impact risks—the types of risks that small businesses already insure through mainline commercial carriers– that are the existential threats to small businesses across the country. Rather, it’s primarily the low-frequency-but-high-impact risks—risks that might only happen once a century (like Hurricanes Katrina or Sandy, or the recent wildfires in Gatlinburg, Tennessee) that threaten our nation’s small businesses.
To assist small businesses in assessing and managing these real but remote threats, the Department of Homeland Security (“DHS”) operates a disaster preparedness website for businesses (https://www.ready.gov/business). On that page and subsequent linked pages, the DHS implores small businesses to consider all the various risks impacting their business models, especially seemingly remote ones:
The [business risk] planning process should take an “all hazards” approach. There are many different threats or hazards. The probability that a specific hazard will impact your business is hard to determine. That’s why it’s important to consider many different threats and hazards and the likelihood they will occur. (https://www.ready.gov/planning).
Ready.gov provides this chart as an example of such hazards and their associated impacts:
(Chart taken from: https://www.ready.gov/risk-assessment)
Note that the emphasized “hazards” in the DHS’s chart above—explosions, natural hazards, hazardous materials spills, terrorism, workplace violence, pandemic disease outbreaks, long-term power outages, supply chain failures, and cyber-attacks—are (1) usually not covered by traditional insurance policies carried by most small businesses and (2) are not very likely to happen to any given small business in a given year or five years. Nonetheless, the hazards are a very real and constant threat, as the DHS recognizes.
The Important Role of Small Business Advisors
Most small businesses simply can’t afford sophisticated and highly qualified Chief Financial Officers or Chief Risk Officers. Rather, they usually obtain such services on an “outsourced” basis. Consequently, to the extent that these businesses get financial, tax, insurance or risk management advice at all, it is most often from outside advisors–CPAs, lawyers, financial planners, investment advisors, insurance brokers, etc.—people that the Service unfairly maligns as “promoters”. With no meaningful guidance from the Service, these professionals alone must carry out Section 831(b)’s Congressional purpose.
These “material advisors” face a tremendous practical challenge in advising their clients: How to get these busy business owners to focus on important-but-not-urgent matters like enterprise risk management or sponsoring a retirement plan for the business. Congress provides tax incentives, in part, to aid these advisors in enticing their clients.
The tax incentives provided by, for instance, sections 401(k) and 831(b) of the Internal Revenue Code are intended by Congress to motivate taxpayers and their advisors to act in ways they otherwise would not. After all, without the tax incentive, who would really save money in 401(k)s–a vehicle where the investment options are limited, taxpayers are penalized for taking out their money too early, are penalized taking out their money too late, and where they can only access the money if they die, become disabled, quit, are fired, or retire?
Most businesses who offer 401(k)s learned of their advantages from outsourced advisors—CPAs, attorneys, financial planners, etc. Consequently, “material advisors” play an essential and much needed role in educating the public about behaviors that Congress has deemed important enough to incentivize with tax subsidies.
In its zeal to collect more taxes by administratively repealing Section 831(b), the IRS must resist driving a wedge of distrust between small business owners and the advisors who serve them. Maligning these advisors as “promoters” and requiring “material advisors” to register and disclose their clients breeds distrust. Without the critical services provided by these trusted advisors, small businesses are starved of good legal, tax, accounting, insurance and financial advice, making them even more fragile than they already are and undermining public policy.
Given this, any future guidance on the subject of Microcaptives should avoid the judgmental pejorative “promoter.” Such pejoratives undermine the credibility of the IRS and the confidence of the public that their government remains objective and committed to honoring Congressional mandates.
The Extraordinary Cost of Insuring These Unique Risks
The Department of Homeland Security understands the importance of insurance to small businesses even when the IRS does not:
Inadequate insurance coverage can lead to a major financial loss if your business is damaged, or operations are interrupted for a period of time. (ready.gov)
And yet, most small businesses do not insure against business interruption or similar risks. In my experience, adequately insuring a typical small business against most all identifiable relevant risks, such as those emphasized in the Ready.gov chart above, can cost a business as much as 10% to 20% of its gross revenue each year. How many small businesses can afford the sunk cost of insuring against such risks via third party commercial insurance arrangements? Few to none.
The partial self-insurance features of captive insurance, the ability to customize policy provisions, and the tax subsidy offered by Section 831(b) all combine to make insuring against these otherwise cost-prohibitive risks affordable in many instances. Reducing the after-tax cost of insuring real but remote risks is, in fact, an important public policy purpose behind Section 831(b) that should not be overlooked.
Section 831(b) Was Intended to “Simplify” Administration of the Nation’s Tax Laws
Another purpose of Section 831(b) was to reduce the burden on taxpayers by simplifying the tax code. Per the relevant House and Senate Committee reports, 831(b) was intended to “simplify” the prior tax rules which were deemed “inordinately complex” and to extend “the [tax] benefits of the small company provision to all eligible small companies, whether stock or mutual.”
The tremendous complexity and burden resulting from the issuance of Notice 2016-66 run directly contrary to an important Congressional purpose behind Section 831(b)—simplification. Notice 2016-66 should be revoked and any future guidance should avoid unnecessary complexity.
Fluctuating Premiums and “Targeting” of Tax Deductions
The profits and cash flows of small businesses are much more volatile and less predictable than Fortune 1,000 companies. Consequently, small business must be prepared to revise their budgets on short notice to preserve liquidity. Such fluctuations in expenses are not evidence of some improper tax avoidance motive or of improperly targeting a specific level of tax deduction from year to year but rather are usually simply a function of volatile cash flow.
Any future guidance should avoid suggesting that it is improper or suspect for small businesses to vary their risk management and captive premium budgets from year to year based upon business profitability and cash flow.
Contract Coverage and Loss Histories
Coverage that is merely illusory or truly implausible is clearly abusive. However, the Service must be careful not to substitute its subjective business judgement for the reasoned judgement of the business owner, his or her advisors, insurance agents, state regulators, and/or experienced actuaries when deciding which risks are relevant to a given business and whether or not coverage is indeed “illusory”. While the IRS is good at collecting taxes, others have far more experience and better judgement, when it comes to protecting small businesses against risk.
In fact, the Service’s judgment is such matters is rather suspect. Consider how the court in the RVI case responded to IRS concerns that certain novel risks or policy provisions were not the proper subject of “insurance” contracts in the commonly accepted sense:
In sum, we find that the RVI policies give rise to insurance “in its commonly accepted sense.” Le Gierse, 312 U.S. at 540. We agree with respondent that these policies have unique features, but these features correspond to, and are driven by, the characteristics and business needs of the underlying leasing transactions. We do not see why an insurer’s tailoring its policy terms to the risks it undertakes to insure should prevent its policies from qualifying as “insurance.” The arrangements between RVIA and its insureds “are characterized as insurance for essentially all nontax purposes * * * [and a] special rule for tax purposes is not justified by either statute or case law.” Sears, Roebuck, 96 T.C. at 101.
Simply insuring novel risks, even remote (but relevant) ones, does not therefore make an arrangement “implausible”. No policy driven by a good faith assessment of “the characteristics and business needs” of the insured should ever be considered “implausible” simply because the risk is novel or remote.
An insured’s loss history is therefore almost completely irrelevant in determining whether or not a given policy is plausible. Prior to hurricanes Katrina and Sandy, how many affected small businesses had previously suffered losses from hurricanes over the prior ten, twenty or even thirty years? And, prior to the recent fires in Gatlinburg, Tennessee, how many area businesses had suffered a business interruption over the last 50 years due to uncontained forest fires? How many small businesses in Southern California have suffered an earthquake related loss over the last decade? The answer to all these questions is…effectively none. And yet all of these risks are “plausible”.
Any future guidance should drop references to claims histories or loss runs as being useful in distinguishing legitimate from illegitimate arrangements since any such reference would likely implicate far more legitimate captives than abusive ones, thereby compounding uncertainty and contributing to FUD.
Just as a given insured’s loss history is largely useless in differentiating abusive arrangements from legitimate ones, the claims ratio of the insurance company is likewise largely irrelevant to determining whether or not it is a real insurance company providing real insurance. A low claims ratio is no indication that the insurance company is illegitimate or abusive or that its coverage is merely illusory. To understand why, consider an obvious and nearly universal risk—fire.
On average only about 0.3% of the structures in the US suffer a fire loss each year. This means that a given insurance company insuring 1,000 structures against fire loss, and charging competitive market rate premiums for doing so, would reasonably expect (on average) only about three claims per year. However, note that the same company insuring only 100 structures would reasonably expect only about one fire loss claim every three years. And finally, the same company insuring only 12 structures (as some Microcaptives do per Revenue Ruling 2002-90, for example) would reasonably expect one fire loss every 30 years on average.
In short, any insurance company that insures exclusively or primarily low-frequency-but-high-impact risks like fire (or terrorism or supply chain interruption or cyber-attack or any number of other risks such as those emphasized on Ready.gov) and that distributes those risks among a relatively small number of insureds (in a manner permitted by Revenue Ruling 2002-90) will invariably have a very low loss ratio in most years. This does not make such companies illegitimate or even suspect.
The RVI case is once again instructive on this point:
An insurer may go many years without paying an earthquake claim; this does not mean that the insurer is failing to provide “insurance.” [The IRS’s expert] acknowledged that, under many catastrophic coverages, the odds of a loss occurring may be quite low. He was aware of no instance in which an insurance regulator had determined that the risk of loss on a policy of direct insurance was too “remote” for the product to be treated as “insurance.” And respondent offers no plausible metric by which a court could make this assessment.
Given that legitimate Microcaptives often insure low-frequency risks and distribute those risks among a relatively small number of insureds, loss ratios are useless in differentiating abusive captives from legitimate captives. Consequently, any future guidance should omit references to claims ratios.
Operating Like a Commercial Carrier
Courts have recognized time and again that captive insurance companies are governed by different economics than commercial carriers and therefore cannot be expected to operate like a commercial carrier would. For instance, in the Rent-A-Center case, the Service argued that the captive insurance company’s premium-to-surplus ratio differed substantially from that seen among commercial carriers, and that this differential was therefore evidence of a sham. However, the court disagreed:
“…comparison of Legacy’s premium-to-surplus ratios with the ratios of commercial insurance companies, was not instructive. Commercial insurance companies have lower premium-to-surplus ratios because they face competition and, as a result, typically price their premiums to have significant underwriting losses by retaining sufficient assets (i.e., more assets per dollar of premium resulting in lower premium-to-surplus ratios) to earn ample amounts of investment income. Captives in Bermuda, however, have fewer assets per dollar of premium (i.e., higher premium-to-surplus ratios) but generate significant underwriting profits because their premiums reflect the full dollar value, rather than the present value, of expected losses. Simply put, the premium-to-surplus ratios do not indicate that Legacy was a sham.”
Comparing the performance of captive insurance companies to that of commercial carriers based on arbitrary metrics like claims ratios, premiums-to-surplus ratios, etc. is unhelpful in differentiating abusive arrangements from legitimate ones. Any future guidance should avoid references to the practices of commercial carriers and should not rely upon arbitrary metrics drawn from such comparisons.
Parental Guarantees, Insider Loans, “Circular Flow of Funds”
Many legitimate captive insurance companies make use of parental guarantees, “loan backs” or loans to related parties. The Service frequently tries to taint such arrangements as de facto improper or suspect, and it does so again via Notice 2016-66. However, the courts have often disagreed with the Service on this point. See, for instance, the Rent-A-Center and Securitas cases.
Where the related-party loan or guarantee occurs on commercial terms and does not jeopardize the capitalization or claims-paying ability of the Microcaptive, the courts have consistently found them to be proper even despite a potential “circular flow of funds.” And, in determining whether a given insider transaction compromised the captive’s claims-paying ability or capitalization, the courts have consistently deferred to the determinations of the domicile regulators. See, again, the Rent-A-Center and Securitas cases for examples.
Consequently, any future guidance suggesting that insider transactions are de facto suspect is as likely to implicate as many legitimate arrangements as abusive ones. Rather than tainting all insider transactions, future guidance should simply emphasize the need for commercial terms (for instance, insider loans should bear a commercial rate of interest) and the need to comply with the requirements of domicile regulators.
True Evidence of Abuse
If the items noted above are not helpful in differentiating abusive captive structures from legitimate ones, then…what would be? The following is a listing of true indicia of abuse that would implicate primarily abusive tax schemes while leaving most all legitimate captive insurance arrangements unharmed:
- Pre-arranged written or verbal understandings that no or very few legitimate claims will be filed.
- Pre-arranged understandings that insulate one or more insureds from bearing a meaningful portion of the losses associated with claims filed by other insureds.
- Premium pricing that is not actuarially determined based upon each insured’s unique risk profile or that is determined in actuarially-deficient or unsupported ways or that is not updated with each policy renewal or issuance.
- Premium pricing that is not adjusted from year-to-year to reflect experience of the insured and insurer or the existence of “hard” and “soft” property and casualty premium markets.
- Arrangements that lack sufficient risk distribution and/or true risk-shifting.
- Arrangements where the captive’s assets are used in ways (invested, loaned, distributed, etc.) that have not been approved by domicile regulators or that, in the estimate of regulators or auditing CPAs, jeopardize the claims paying ability or capitalization of the captive.
- Material and repeated noncompliance with the rules and regulations of the licensing jurisdiction.
- Policy terms that are so novel, vague or ambiguous as to defy actuarially sound pricing or render the occurrence of valid losses largely subjective.
- The insuring of risks that state regulators do not define or regulate as valid “insurance” risks.
- Repeated failures on the part of the insured to file claims for valid, insured losses.
Notice 2016-66 undermines important public policies as codified by Congress, unfairly targets small businesses, attempts to administratively repeal Internal Revenue Code Section 831(b), impinges upon the exclusive authority of the states to regulate and define insurance, runs in contravention to court precedent, has many unintended but devastating consequences, and subverts the Rule of Law. It imposes a burden on small businesses that is improper and completely unnecessary for the Service to fulfill its obligation of enforcing the nation’s tax laws.
Notice 2016-66 should be revoked and replaced with meaningful guidance. After five years of coordinated audits and multiple promoter investigations, the IRS has all the information it needs to articulate a principled distinction between abusive captive insurance arrangements and legitimate ones.
To be truly useful and to avoid improperly chilling or killing legitimate captive insurance arrangements, any future guidance must be narrowly crafted to implicate truly abusive arrangements while exonerating the vast majority of legitimate ones. Consequently, such guidance should avoid designating as indicators of abuse structures or arrangements that are frequently employed even by legitimate captives.
When articulating what is legitimate and what is not, the Service must defer to the public policy objectives behind Section 831(b) and court precedent rather than insisting upon its own contradictory and long-discredited opinions and preferences. In particular, this means abandoning its attempts to malign or taint all tax-motivated Microcaptive transactions as improper or abusive. Forming an 831(b) captive insurance company for tax reasons is no more improper than forming a 401(k) plan for tax reasons. Honest taxpayers should never be punished by the IRS for biting at the tax carrot that Congress has so carefully dangled in front of them, and it’s improper for the IRS to attempt to poison the carrot.
Courts have repeatedly rejected the IRS’ attempts to carve out a special, limited definition of insurance for federal tax law purposes, and the IRS should abandon its multi-decade effort to challenge or subvert those court rulings. Instead, the Service should offer the public meaningful guidance by focusing attention on true indicators of abuse such as those indicated in my comments above.
Sean G. King, JD, CPA, MAcc
Principal, CIC Services, LLC