Once Again the IRS Gets a Little Right and Much Wrong in Placing Captives on its Dirty Dozen

It’s been said that a dog returns to its vomit, and this is certainly true of the IRS and its 2016 “dirty dozen” publication, which once again includes “abusive” varieties of captive insurance companies on its list of scams.  We don’t joyfully look for opportunities to cross swords with the IRS.  However, when the Service’s pronouncements smell more like propaganda designed to intimidate than useful information designed to educate, we are duty bound to polish our sabers (in this case our pens, which are often mightier than swords).

The CIC Services Rule of Thumb

Since our inception, we have been champions of small and mid-size business owners.  In our evaluation of articles by industry pundits and pronouncements by the IRS, regulators and various associations, we follow a simple rule of thumb:

Does this body of work seek to educate, provide clarity and demonstrate the multitude of advantages that captives can afford to small and mid-size business owners while reasonably addressing negative trade-offs of captive ownership and exposing scams?

If the answer is “yes,” then we support it.

On the other hand, if a body of work seeks primarily to intimidate, obfuscate or create fear, uncertainty and doubt (“FUD”) in an attempt to discourage small and mid-size business owners from acting in the best interest of their businesses, their families and their employees – then we criticize it vigorously.

The IRS’ 2016 dirty dozen listing, at least as it addresses captive insurance arrangements, falls into the latter category.  Like last year, this year’s “dirty dozen” pronouncement intentionally obfuscates the relevant issues related to captive insurance companies,  and it  is contradictory to both both statutory law and case law.  The Service provides little in the way of meaningful guidelines or tests to assist taxpayers in distinguishing good captive insurance companies from shams.  Rather, in a show of borderline lawlessness, the Service uses the 2016 dirty dozen publication to rehash supposed evidences of “abuse” that were explicitly shot down in 2015 by the U.S. Tax Court in the RVI Guaranty Case.

In light of its utter defeat in the case, not to mention Congressional action in December to stem abuses ( H.R. 34), one would think the IRS would have at least modified its language against captive insurance companies to be consistent with the actual law – not so.

Credit Where Credit Is Due

Let’s first acknowledge where the IRS has acted reasonably.  In its “dirty dozen” release, the Service correctly begins by acknowledging that captive insurance companies are “a legitimate tax structure.”  Furthermore, “Tax law allows businesses to create ‘captive’ insurance companies to enable those businesses to protect against certain risks.”  Correct.  The Service goes on the state, “The insured claims deductions under the tax code for premiums paid for the insurance policies while the premiums end up with a captive insurance company owned by the owners of the insured or family members.”  Once again, correct.  Finally, the Service contends, “The captive insurance company, in turn, can elect under a separate section of the tax code to exclude up to $1.2 million of its net premium income per year, so that the captive is taxed only on its investment income.”  Correct again.  The Service is referring to the 831(b) tax election.  In 2017, the premium limit will increase from $1.2 million to $2.2 million.

So, if captives are perfectly legitimate as the IRS begins by saying, then…what’s the issue.  Well, the Service considers some of these captives to be abusive.  Which ones?  Ahh, therein lies the rub.  In the “dirty dozen” publication, the Service provides only one helpful standard or guideline useful in distinguishing legitimate captive insurance arrangements from abusive shams.

Specifically, with shams, “[u]nderwriting and actuarial substantiation for the insurance premiums paid are either absent or illusory.”   We wholeheartedly agree with this statement.  Insurance policies that are not properly underwritten and priced by an actuary are not real insurance.  If, by the term “illusory,” the Service is suggesting that actuaries deliberately lie (also known as fraud) in their pricing of policies, we agree this would also disqualify policies as being real insurance.

Crossing Swords

With the exception of the one helpful standard noted above, the Service predictably gets most everything else wrong.  In its opening attack, the IRS betrays its utter ignorance and disdain for small business and small business owners.  The Service states, “unscrupulous promoters, accountants, or wealth planners persuade the owners of closely held entities to participate in these schemes.”   The IRS’ goal in making this statement is to drive a wedge of doubt between small business owners and the professionals who traditionally advise them about risk and taxes—CPA’s, tax and estate planning attorneys, property and casualty brokers, wealth managers, etc.   The IRS often labels these absolutely critical advisors to small and mid-market businesses as “promoters” in an effort to discredit them.

This promoter label is intentionally inflammatory.  Its use demonstrates either an ignorance or disregard for how small and mid-sized business actually get financial, risk management and tax advice.  The small business owner is not born with knowledge of small captive insurance company and their risk management benefits, nor do many such businesses have true Chief Financial Officers or Risk Management Officers (like large corporations do) to guide them in these matters.  Instead, they must rely upon the proactive advice and counsel of these outside professionals , the IRS’ “promoter,” to gain sufficient understanding of the rules and opportunities.  Trying to drive a wedge of doubt between these businesses and the professionals who serve and advise them does small and mid-market businesses, not to mention the country, a huge disservice.

In its second line of attack, the Service contends, insurance “policies may cover ordinary business risks or esoteric, implausible risks for exorbitant premiums”.  We addressed the exorbitant premiums issue above and have no qualms with it.  If insurance policies are not correctly priced by a competent actuary, then we agree that real insurance does not exist.

However, the IRS continues to suggest that “ordinary business risk or esoteric, implausible” risks are not real and not insurable.  In some audits, they have sought to measure the “implausibility” of a given risk by whether or not the business had any losses from that risk over the prior ten year period.

This measure of implausibility is absurd, and the U.S. Tax Court agrees.  The department of homeland security’s website, Ready.gov, disagrees as well.

U.S. Tax Court on Business, Esoteric and Implausible Risk

In 2015, the U.S. Tax Court dismantled IRS arguments attacking certain types of risks as “uninsurable.”  On the specific issue of whether there is a difference between insurance risk and speculative or esoteric risks, the court said:

In any event, we find [the IRS’] attempt to distinguish between a “pure risk” and a “speculative risk” in this setting as essentially metaphysical in nature. 

When a court uses a word like “metaphysical” in this context, think of it as a gentrified way of saying “stupid.”  And, the IRS’ position on these matters is indeed stupid, as most any insurance professional or state insurance regulator would attest.

The court also noted:

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 [IRS] 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. 

On the supposed implausibility of risks being insured, the court stated:

The thrust of [the IRS’] position is that the RVI policies did not transfer enough risk of loss because losses were relatively unlikely to occur. This argument is unpersuasive on both theoretical and evidentiary grounds. Both parties’ experts analogized the RVI policies to “catastrophic” insurance coverage, which insures against earthquakes, major hurricanes, and other low-frequency, high- severity risks. An insurer may go many years without paying an earthquake claim; this does not mean that the insurer is failing to provide “insurance.”

And finally:

“[The IRS’] effort to split hairs by disentangling the causes of loss are philosophically interesting.  But we do not think they carry much weight in determining whether the RVI policies constitute “insurance” for Federal income tax purposes.”

Ready.gov on “Implausible” Risks

Let’s look beyond the courts and consider what other Federal agencies, those with actual knowledge of small business and the risks they face, have to say on the matter.  The U.S. government’s own disaster preparedness website , Ready.gov, notes 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—those that the IRS often 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.”

Clearly the IRS is incapable or unwilling to recognize the reality of the existential threats faced by small and mid-market businesses.  Fortunately for us all, the states, the courts, Congress, and administrative agencies with actual expertise in the matter don’t suffer the same deficit.

Perspective on Small Business, Captives and the “Dirty Dozen”

Perhaps the question should be asked: What is 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.  According to Ready.gov  “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 also 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.”

Protecting small and mid-market businesses from ruin is therefore important public policy.  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 based not in law or on court victories, but on a propaganda campaign designed to spread fear, uncertainty and doubt.  Placing small captives on its “dirty dozen” list is part of the attack.

The IRS’ attack on small captives is coordinated, intentional, intended to undermine the express will of Congress and is contradictory to established case law.  When the service tries to scare the public away from the benefits of an actual Code Section using obfuscation and FUD rather than statutory, regulatory, or case law, or publishing clear guidelines,  it is an act of lawlessness.

The Service rationalizes its behavior based on 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 critcizing taxpayers for biting at the very carrot that Congress has dangled, the Service seeks to deprive small and mid-market businesses of the important benefits of 831(b), and in doing so they seek to deprive the country of the corresponding public policy benefit.

Nonetheless, owners and prospective owners of legitimate captive insurance companies—those that insure real, relevant risks of multiple insureds in exchange for actuarily-determined premiums– should rest comfortably in the fact that the IRS’ hands are mostly tied—tied by the courts and tied by Congress.

Viewed in this light, the Service’s FUD campaign is actually a very positive sign:  When the IRS resorts to propaganda in an attempt to achieve through obfuscation and FUD that which it has been wholly unable to achieve in the courts or Congress, it “doth protest too much.”  These protests should be considered an act of desperation.  “If you can’t beat ‘em, scare ‘em”, is the general sentiment.

But taxpayers who ignore the propaganda and focus on the actual law and expressed will of Congress will continue to enjoy the outstanding risk management and tax benefits of captive insurance companies.  Knowing that both the courts and the Congress are on their side, taxpayers should not be dissuaded from forming or operating real captive insurance companies, even those that insure only or primarily “ordinary business” or “speculative” risks, despite IRS spreading FUD to the contrary.