IRS Acknowledges 831(b) Captive Insurance Companies Are “A Legitimate Tax Structure”

It is no secret that the IRS is no fan of captive insurance companies, whether they are owned by large corporations or small businesses.  Over the last few years, two things have become increasingly clear.

One, the IRS continues to lose in U.S. Tax Court in its attacks on captive insurance companies.  In 2014, the Service was dealt stinging defeats in both the Rent-A-Center and Securitas cases.

Two, the IRS has embarked on a public relations and harassment campaign to achieve by fear and intimidation what it has been unable to achieve legally in court.

An April 10 article in the New York Times covered the Service’s recent attack on small captive insurance companies but really came up short on telling the whole story.  In failing to cover the story fully, the New York Times – either unknowingly or knowingly – aided the IRS in its abusive PR campaign.  The article was written by Paul Sullivan and titled, “I.R.S. Is Looking Into Captive Insurance Shelters.”  Clearly, this is not the most objective headline.  Sullivan points out that the IRS has placed captive insurance companies on its “Dirty Dozen list of tax scams.”

To read the article in the NY Times, CLICK HERE.

In its “Dirty Dozen” release (IR-2015-19), the IRS states:

Another abuse involving a legitimate tax structure involves certain small or “micro” captive insurance companies. Tax law allows businesses to create “captive” insurance companies to enable those businesses to protect against certain risks. The insured claims deductions under the tax code for premiums paid for the insurance policies while the premiums end up with the captive insurance company owned by same owners of the insured or family members.

The captive insurance company, in turn, can elect under a separate section of the tax code to be taxed only on the investment income from the pool of premiums, excluding taxable income of up to $1.2 million per year in net written premiums.

To read IR-2015-19, CLICK HERE.

Notice in the Service’s opening sentence the admission that small captives are a legitimate tax structure.  This is really an admission of what plainly written U.S. law already states.  Nevertheless, the IRS is broadly attacking small captives because the Service fundamentally misunderstands small businesses and the unique challenges that they face.

In its reporting, the New York Times failed to properly position the IRS’ attack on small captives as coordinated, intentional and seeking to undermine the express will of Congress.  Congress passed legislation in 1986 that created small captive insurance companies.  The Service makes much of the fact that many captive 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.

Not surprisingly, the New York Times also failed to report on the “public good” that is fostered by small captive insurance companies.  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.”

Concerning the IRS, Sullivan wrote, “The agency took particular exception to promoters who drafted policies “to cover ordinary business risks or esoteric, implausible risks for exorbitant ‘premiums,’ while maintaining their economical commercial coverage with traditional insurers.”

Some of the “experts” interviewed by Sullivan, addressed this assertion but came up wanting.  I suppose it would be expecting too much to ask the New York Times to ask the obvious question, “Since when does the IRS have expertise in risk management?”  Should the IRS be the authority on defining the “plausibility” of a given risk?  The Service has sought to define plausibility 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.

Not surprisingly, the New York Times calls out one of the IRS’ favorite attacks on the legitimacy of small captives – 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 undeserved 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’ contention that captive premiums for these policies are being systematically inflated to justify larger tax deductions is demonstrably wrong.

The New York Times could have done its readers a service by pointing out that small businesses are increasingly using 831(b) captive insurance companies as part of a long term survival strategy.  Congress provides the 831(b) tax “benefit” to incentivize them to do so.  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.  

Unfortunately, the New York Times also adopts the IRS’ jargon for attacking the professionals that advise small and mid-size business owners.  The IRS often labels financial advisors and captive managers as “promoters.”  This label is ridiculous.  The small business owner is not born with knowledge of self-insurance via a small captive insurance company.  Since most don’t have true Chief Financial Officers (like large corporations) to guide them, they must rely upon the advice and counsel of outside advisors, the IRS’ “promoter,” to gain sufficient understanding of the rules and how to abide by them.

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 advisors, especially once the case makes it to Appeals.  But, success in court or at Appeals isn’t their objective.  Their objective is 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.

Rather than serving as just another mouthpiece for IRS abuse, the New York Times should stand against it.