Should Fear Of An Audit Chill Prospective Captive Owners?

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CAPTIVE REVIEW recently reported that the number of world-wide captive insurance licenses declined for the first time in decades.  The number of active captives decreased by 136 from 6,618 to 6,482.  This is a slight decrease, and it is probably more than off-set by the addition of new cell captive insurance companies.  However, it does demonstrate that growth stalled in 2017.

This is unfortunate because thousands (if not hundreds of thousands) of businesses would benefit from Alternative Risk Transfer (ART) via a captive insurance program.  The tremendous benefits provided by captives remain unchanged.   What has changed has been government scrutiny of captives in Europe (particularly offshore captives) and IRS scrutiny of captive owners in the U.S. (again, with particular scrutiny of offshore captives).

And this raises an important question.  Should fear of an audit stop a business owner from acting in the best interest of the business and its employees?

It’s important to note that the IRS’ actions appear to be out of step with Congress.  In 2015 Congress just gave small captives a “longer leash” by raising the premium limit to make an 831(b) election from $1.2 million to $2.2 million.  So, if captive owners face an audit for choosing to own their own insurance company, they are being audited for doing the very thing that Congress has been encouraging them to do – start and operate captive insurance companies to protect their businesses.

Audit sweeps are not unusual.  And, clients operating properly formed captives for legitimate risk management reasons should not be overly concerned.  The IRS frequently targets certain industries or types of tax returns for extra scrutiny in order to obtain a statistically valid sample for measuring overall compliance.  For example, several years ago the IRS launched an audit sweep of 401(k) and 403(b) retirement plans, discovering that 401(k)s were mostly compliant while 403(b)s were not.  This led to new 403(b) plan regulations being issued.

Given the dramatic risk management and tax planning benefits of captive insurance companies, the IRS’ interest is no surprise.  The good news is that captive owners seem to be fairing pretty well so far, at least in our experience.  The IRS lost three high-profile tax court cases in the last three years (Rent-a-Center, Securitas and RVI Guaranty).  The IRS won in the high-profile Avrahami case, but the Avrahami captive structure was extremely vulnerable, as it failed to achieve risk distribution, lacked regulatory oversight, made massive loan-backs to the business owners, and was plagued by a host of other issues.  It’s safe to say most captives – particularly those regulated by a responsible captive domicile – won’t be exposed like the Avrahami captive structure.  And, IMPORTANTLY, captives formed today have the benefit of being able to structure in hindsight and avoid all shortfalls of the Avrahami arrangement.

Nevertheless, we want to remind owners of captive insurance companies how important it is that ANY inquiries from the IRS (whether via a formal audit or informal telephone call/survey) be handled professionally and accurately.  For this reason, we advise that captive owners not attempt to answer questions from the IRS about their CIC on their own.  Instead, direct all IRS questions to your CPA.  Your CPA should then contact the attorney who oversees your captive in order to gain the necessary background information to accurately respond to any IRS requests.

Does it make sense to wait to form a captive to avoid a potential audit?  If a business would benefit by owning a captive insurance company, it is potentially short-sighted to wait for multiple reasons.

First, such a view assumes captive audits will be ongoing well into the future.   Historically, when the IRS has done audit sweeps, it has issued guidance based on its findings.  Captives formed today could likely benefit from additional guidance provided by the IRS, making them either 1) less likely to be audited in the future, or 2) able to quickly produce information that specifically addresses the guidance provided by the IRS.

Second, and perhaps most importantly, it ignores the significant opportunity cost of doing nothing.  The benefits of owning and operating a captive insurance company can be dramatic.  Forfeiting those benefits for even a year or two can be extremely costly over time, especially when one considers the lost compound interest on the forgone benefit.  Nobody advocated taking a “wait and see” approach to adopting 401(k) plans when they were being audited at higher rates than usual.  The same logic should probably be applied to captives.

Third, even if one’s captive is audited (which is still statistically unlikely), it is exceedingly unlikely that the cost of defending the transaction in an audit would exceed even one year’s tax savings from engaging in it, unless it goes to court.  And the cost likely would not exceed two year’s tax savings even if it did go to court.

Lastly, the captive itself should have tremendous liquid reserves that can be tapped to cover the cost of defending itself if audited, so cash-flowing a defense should rarely be an issue for owners of a captive.

In short, the decision to establish a captive insurance company is ultimately one of weighing costs and benefits.  The potential of an audit does increase the potential cost, but in almost all cases not enough to exceed the benefits.