Help Thwart IRS Attacks Against Small Captive Insurance Companies And Small Businesses
By: Sean King, JD, CPA, MAcc
Dear Senator / Congressperson:
I am writing concerning the “tighteners” to IRC Section 831(b) that have been proposed to Senator Grassley’s office by the Self Insurance Institute of America (SIIA).
While we do not oppose attempts by the U.S. Treasury Department, the Self Insurance Institute of America (SIIA) and the National Association of Insurance Commissioners (NAIC), among others, to ensure that small captive insurance companies are operated for legitimate risk management and insurance purposes rather than for estate planning reasons, SIIA’s currently-proposed methods of accomplishing that objective, namely limiting trust ownership and forbidding the purchase of life insurance by 831(b) captives, are actually largely ineffective at accomplishing this purpose and have a number of severe unintended consequences. These proposals reflect an unconscious bias toward larger varieties of captives, and they demonstrate a severe lack of understanding as to why small and medium sized businesses form captives and structure them as they do.
Placing a captive insurance company within an irrevocable trust is often important in protecting the assets of the captive insurance company—the assets that ensure its solvency and ability to pay claims–from creditors of the primary operating business (the captive’s primary insured) or its owners. If such creditors are legally able to seize the stock of the captive insurance company (the insurer) just because the operating business or its owners run into financial difficulties, as creditors could if a majority of the captive’s stock were owned directly by the operating business (the captive’s primary insured) or by its individual human owners (who have often guaranteed the debts of primary insured), then the captive insurance company’s ability to effectively provide ongoing insurance coverage to the primary insured, and even to unrelated third party insureds, is severely compromised. Creditors of the primary insured or its owners, who after seizure of the stock would own a majority of it, could simply liquidate the captive insurance company to obtain its assets, pay dividends that ultimately compromise its financial integrity (even if it meant re-domiciling to a more liberal jurisdiction to accomplish this), or otherwise operate the captive insurance company in the creditor’s interests rather than the interests of the captive’s insureds, thereby undermining the captive’s insurance purpose and risk management objectives. There is simply no reason that bankruptcy or financial difficulties experienced by the captive’s primary insured should result in financial difficulties for the captive insurance company as well, but that will invariably be the case where we cannot protect the captive’s assets from creditors via irrevocable trust ownership.
When it comes to small and medium sized businesses, and their owners who often guarantee the debts of those businesses, the risk of bankruptcy or financial distress is all too real. To give just one example, consider the impact of the recent financial crisis on a great many real estate developers and construction companies during the mid to late 2000’s.
Small businesses, like those who use 831(b) captive insurance companies, are essential to the nation’s economy, and yet they are too often financially at risk, at least in part because they are notoriously underinsured. Small Business Administration (SBA) statistics cited on Ready.gov indicate that small businesses employ nearly half of all private sector workers and have accounted for two-thirds of all new net job growth over the last seventeen years. And yet, per the same website, 40 percent of small businesses fail to reopen their doors after a natural or human caused disaster. And less than a third of them successfully survive their first generation of owners. Owning an 831(b) captive can improve the survivability of small businesses by reducing their risk exposures, but only if the assets of the captive insurance company are not available to the creditors of the primary insured or its owners.
Due to their superior size, geographical dispersion, diversified business model, and access to capital (via issuance of additional stock) and credit (via banks and bond offerings), larger Fortune 1000 companies, and their associated captive insurance companies, don’t suffer the same risk of financial difficulty or bankruptcy as small closely-held businesses do. They likewise have thousands of owners, rather than just a handful. This explains why trust ownership of captive insurance companies is so common among family-owned businesses but not among Fortune 1000 companies.
Preventing 831(b) captive insurance companies from being owned by an irrevocable trust inappropriately limits our ability to protect the insurance company’s assets from creditors of the primary insured or its owners while doing little or nothing to prevent actual estate planning. For instance, the prohibition on irrecoverable trust ownership would do nothing to prevent members of a junior generation from simply owning the 831(b) insurance company outright, thus ensuring that estate planning (the estate-tax free passing of assets from senior generation’s operating business to junior generation’s captive insurance company in an income tax deductible manner) via 831(b) captives can continue even after implementation of the proposed 831(b) “tighteners”.
Regarding life insurance, just as some banks place a significant portion of their Tier 1 capital in BOLI (bank-owned life insurance), and just as nearly 70 percent of Fortune 1000 companies place their nonqualified deferred compensation plan money in COLI (corporate-owned life insurance), and just as many mainline commercial insurance carriers often invest a portion of their reserves in iCOLI (insurance company owned life insurance), and all of them for reasons that have nothing at all to do with estate planning, many closely-held captive insurance companies of the 831(b) variety do the same. BOLI, COLI and iCOLI are popular in these contexts because, in today’s unique interest rate environment, specially designed life insurance contracts are one of the few remaining places where one can obtain yield while still getting principal guarantees, minimizing volatility, ensuring high liquidity, and obtaining some tax efficiencies. As compared to other options, life insurance cash surrender values are backed by the full faith and credit of highly rated life insurance companies and, in some cases, by state guarantee pools. Additionally, in many states life insurance cash values enjoy additional asset protection advantages against creditors versus other assets.
In short, investing in life insurance often represents a reasonable trade-off between ensuring safety of the captive’s principal while achieving some yield, guaranteeing liquidity, minimizing volatility, and achieving tax efficiencies. That life insurance is so often used by publicly-traded banks and Fortune 1000 companies, neither of whom are burdened by estate planning considerations at all, is proof positive that a great many of the decisions to place 831(b) captive assets into life insurance are driven by sound economics that benefit the captive itself rather than the secret or nefarious estate planning concerns of the captive’s owners.
Preventing 831(b) captives from owning life insurance on the lives of its direct or indirect owners or the owners of its primary insured, as has been proposed by SIIA, is basically the same as preventing them from owning life insurance altogether since the captive insurance company is unlikely to have a sufficient insurable interests in the lives of anyone else.
To conclude, depriving 831(b) captive insurance companies of the ability to be majority-owned by an irrevocable trust or of the opportunity to place assets in life insurance forces them to invest less wisely, reduces their claims-paying ability, exposes their assets unnecessarily to creditors of third parties, requires them to assume more investment risk than advisable, places them at a competitive disadvantages versus other types of insurance companies (captive or otherwise) who don’t face similar restrictions, makes them less effective at fulfilling their mission, and unnecessarily harms both the captive insurance industry and the life insurance industry, both of which are important to many states (including Iowa), while doing little to solve actual estate planning concerns. The net effect will be the formation and survival of fewer legitimate captives than otherwise, and a reduction in the financial security of small and medium sized businesses as a result.
If the goal is to limit the use of captive insurance companies in an estate planning context, then SIIA’s proposed tighteners fail miserably, and at a steep cost. Rather than attacking estate planning indirectly through these so-called tighteners, Congress could do so directly in ways that don’t have unintended consequences. For instance, a simple estate tax rule requiring that premiums paid to an 831(b) electing insurance company within “x” years of death be included in the taxable estate of a decedent when valuing the decadent’s business interests would resolve the issue permanently and without undue side effects. There are other potential solutions as well.
Finally, to the extent that Congress may have additional concerns about life insurance in particular, simply limiting the use of life insurance to some reasonable percentage of the captive’s assets, as is already done within qualified retirement plans today, would prevent abuses without depriving captive insurance companies of the important benefits of having some life insurance assets on their balance sheets. The battle over “tax deductible life insurance” was fought in the qualified retirement plan world decades ago, and the solution (limiting life insurance to less than half of the assets of such retirement plans) was a fair and effective one. Something similar could be done with captives.
Thank you for your consideration of this matter.
Sean Gregory King, JD, CPA, MAcc
Principal & In-House Counsel
CIC Services, LLC
To download an editable Word version of Sean’s letter, CLICK HERE.
Please mail to all Senators and Congresspersons listed below.
Senator Chuck Grassley
135 Senate Office Building
Washington, DC 20510
Senator Roy Blunt
260 Russell Senate Office Building
Washington, DC 20510
Senator Pat Roberts
109 Hart Senate Office Building
Washington, DC 20510-1605
Senator Amy Klobuchar
302 109 Hart Senate Office Building
Washington, DC 20510
Senator Tammy Baldwin
717 Hart Senate Office Building
Washington, D.C. 20510
Congressman Paul Ryan
1233 Longworth House Office Bldg
Washington, DC 20515