It appears the same old song and dance was trotted out at the Vermont Captive Insurance Association conference this Summer. The “Hot Topic” was Internal Revenue Service (IRS) scrutiny of “micro-captives,” a misnomer for small insurance companies typically utilized by small and mid-sized businesses. Small captive insurance companies are largely misunderstood by the captive managers and attorneys who thrived when large corporations were busy setting up and operating their own captive insurance companies. But the large captive insurance company market is largely “tapped-out,” and, not surprisingly, much of the growth in the industry is now driven by small and mid-size businesses. The vast majority of Fortune 500 companies own one or more captive insurance companies. However, the market for small captive insurance companies owned by small and mid-size businesses is barely penetrated (see our prior article discussing the massive under-penetration of the small captive market – CLICK HERE).
So, what is the same old song and dance? Well, consider an August 15 article by Rodd Zolkos in Business Insurance reporting on the VCIA’s annual conference in Burlington titled “IRS scrutiny of 831(b) tax treatment for microcaptives a VCIA ‘hot topic’.” By the way, this is not a criticism of Business Insurance, its reporter or the article written. I am confident they captured and reported on the discussion and sentiment at this “Hot Topic” session at VCIA. The old song and dance is typical hand-wringing by the “old guard” in the captive industry, lamenting the growth of small captive insurance companies and suggesting that their growth threatens the entire captive industry (see our recent article discussing the “old guard” and the true sources of their conduct – CLICK HERE). At their core, the “old guard” in the captive industry demonstrate large company bias and discriminate against smaller businesses and small business owners.
In his coverage of the VCIA event, Rodd Zolkos notes, “Among the “hot topics” discussed at the Vermont Captive Insurance Association’s annual conference in Burlington was the Internal Revenue Service’s scrutiny of so-called “microcaptives” opting for Internal Revenue Code Section 831(b) tax treatment and the potential impact of that scrutiny on the broader captive industry.” This statement accurately reflects the large company bias that still permeates the captive industry today. Large corporations have been benefiting from owning their own captive insurance companies for years. But are we to believe that small and mid-size businesses choosing to follow suit pose a risk to the entire industry?
What clearly was not discussed at the VCIA Conference (or was not reported on because it did not receive prominence) was the purpose of the 831(b) tax election as created by a Democrat Congress in 1986 and signed into law by a Republican President. The Tax Reform Act of 1986 encouraged the formation of small insurance companies by small and mid-size businesses. This was a clear move to “level the playing field,” enabling small businesses to reap benefits that were once accessible only to large corporations (see “Congress Wants You To Own Your Own Insurance Company” – CLICK HERE).
Zolkos notes that “Under Section 831(b), insurance companies earning no more than $1.2 million in annual written premiums can opt not to pay taxes on those premiums, being taxed only on their investment income.” Small insurance companies that make an 831 (b) tax election are often described as microcaptives. Even the term microcaptive is loaded with large company bias as it intonates that a small insurance company is less of an insurance company than a large insurance company. This is simply untrue. Zolkos correctly points out that, “Those microcaptives have been one of the fastest growing areas of captive insurance.”
Reporting on the “Hot Topic” discussion, Zolkos quotes panel members, including Attorney Robert Myers, Attorney Deborah Lambert and David F. Provost, deputy commissioner in the Captive Insurance Division of the Vermont Department of Financial Regulation.
Robert H. Myers Jr., partner at Morris, Manning & Martin L.L.P. in Washington is quoted as saying, “There’s been enormous growth in small captives…It’s very attractive from a tax perspective. The problem is it’s too attractive.” This statement betrays a fundamental misunderstanding of small businesses and small business owners in America. First, there should be far more small captives than exist today, and the present growth rate is still surprisingly low in our estimation – see our article “Why America Needs 100,000 Captives” – CLICK HERE. Competition among domiciles is finally making it attractive for small and mid-size business owners to experience the benefits of captive ownership. The tax advantages referenced by Mr. Myers have been in existence since 1986. If the favorable tax treatment small captives receive is truly “too attractive,” why has it taken almost 30 years for the small captive space to begin to sprout? Furthermore, Congress intended for the small captive market to grow in the first place to help strengthen small businesses across the fruited plain.
The real point is that the combination of captive benefits including significantly improved risk management, accumulation of loss reserves, asset protection, and favorable tax treatment have become a prudent choice as the cost to set-up and operate a captive have come down. Such a cost – benefit analysis should not be labeled as “too attractive.” Imagine arguing that 401 (k) plans which are increasingly affordable for small businesses to implement are “too attractive.” Oh no, more people are saving for the future.
Not surprisingly, Myers is also quoted saying, “In many cases, they have been oversold by wealth managers, estate planners, financial planners and so on.” It is certainly possible for captives to be oversold based solely on their tax ramifications, and we would oppose any presentation of captives that focuses solely on tax treatment. However, this statement about financial advisors once again demonstrates prejudicial large company bias. Many small business owners really don’t have a CFO or Finance Department. They often have bookkeepers or accountants. Where a CFO provides financial strategy to a large corporation, a wealth manager often provides financial strategy to a small business or small business owner. And, all risk and risk management is financial. Risk and finance are intertwined. If wealth managers shouldn’t introduce business owners to the risk management benefits of a CIC, then any large corporation where the CFO or Finance Department played a role in establishing a CIC should be equally suspect.
The Business Insurance article continues by shifting focus to reinsurance pools that enable small insurance companies to distribute risk, meeting a key requirement to qualify as insurance for tax purposes. Myers notes that the IRS’ plan is to attack risk pools. Again, not surprising, the I.R.S. is also demonstrating large company bias. Reinsurance pools, also known as risk pools, are clear evidence that small captive insurance companies owned by small and mid-size businesses are making diligent efforts to meet all requirements to be appropriately recognized as insurance companies. Myers notes, “If the IRS determines the pools aren’t valid, it will then treat the pool participants as tax shelters rather than insurance vehicles.” Clearly, captive managers and small insurance companies must go the extra mile to ensure their reinsurance pools are compliant. Compared to large insurance companies, many small insurance companies must go to great lengths and extra efforts to be able to enjoy the risk management benefits that large corporations have enjoyed for decades.
Regarding reinsurance pools, it is also worth noting that the I.R.S. should pick its battle carefully. Reinsurance pools typically represent a host of captives that have built up reserves. Most are financially capable of defending themselves and appealing any challenge all the way to the U.S. Tax Court. The Service’s track record attacking captives before the U.S. Tax Court has not been sterling. In fact, many cases have served to open the door (or to validate) more aggressive practices by captive insurance companies. In the recent Rent-A-Center case, the Tax Court upheld a parental guarantee arrangement that has been considered a “no-no” by most captive managers. Read our three recent reviews of the Rent-A-Center case (CLICK HERE, CLICK HERE, CLICK HERE).
On a positive note, David F. Provost, deputy commissioner in the Captive Insurance Division of the Vermont Department of Financial Regulation, said “While some microcaptives may be being formed for noninsurance purposes, there are many small captives doing legitimate insurance business…Our position is the same: We license insurance companies, and your taxes are your business…There are plenty of good, well-planned small captives that take advantage of this election.”
In conclusion, the “Hot Topics” discussion at VCIA furthers an ongoing “old guard” misunderstanding of the challenges and risks facing small and mid-size businesses. Small business owners have different risks than large businesses and their approach to risk management will often be different. Small captives go to great lengths to be compliant by participating in reinsurance pools and should be expected to vigorously defend against any attack by the I.R.S. Too often the “old guard” thinks small businesses should run their CICs like large corporations do. The U.S. Tax Court stated that Rent-A-Center did NOT have to manage its CIC in the same way commercial insurers operate. By extension, small CICs must not by necessity mirror large CICs in their risk management strategy and management approach.