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831(b)s: Under the Microscope

Captive International Magazine

July 24, 2017

831(b) captive insurance companies have been under the microscope for six months as the Internal Revenue Service subjects them to the greatest possible scrutiny. What’s behind this sudden concern? US Captive investigates.

The past year or so has not been a happy one for managers of 831(b)s captive insurance companies who had a previously happy relationship with the Internal Revenue Service (IRS). In November last year, the IRS announced in Notice 2016-66 that it was placing all 831(b)s under full scrutiny, meaning that it was going to put all of them under a financial microscope to make sure they were legitimate. It was a decision that stunned the industry.

In a December 2016 report about the Notice from the International Risk Management Institute (IRMI), Donald J. Riggin, CEO of The ART of Captives, a consultancy specializing in alternative risk financing techniques wrote: “In Notice 2016-66, the IRS made a transaction of interest announcement. A transaction of interest is one that the IRS suspects may be illegal but doesn’t have enough information to make the determination. If its suspicions are confirmed through the collection of certain data, the transaction becomes ‘listed’, meaning that it has been determined to be a prohibited transaction.”

Riggin said there are two requirements compelling promoters and taxpayers to divulge the details of the 831(b) transaction, only one of which must be satisfied. First, if the captive’s loss ratio is 70 percent or lower, compliance is required. Second, regardless of the loss ratio, if the captive has provided any type of loan or another sort of financial transfer to its parent company or any other company or individual, compliance is required. Moreover, the disclosures must include data from up to five years of captive activity.

In addition, he added, the 70 percent loss ratio requirement is somewhat high given the fact that commercial insurers’ acceptable loss ratios run between 60 and 65 percent depending on the line of insurance. By design, the vast majority of 831(b) tax shelter captives have extremely low loss ratios, as losses reduce the amount of premiums subject to the tax advantage.

Formed with good reason

Section 831(b) captives’ claim to fame is that earnings from premiums are not subject to federal income taxes; only interest income is taxed. The maximum annual premium was $1.2 million, but this increased to $2.2 million on January 1, 2017.

The primary users of these captives have been small to middle-market, privately owned companies. The 831(b) captive was created in 1986 as part of that year’s tax overhaul. As IRMI points out, they were originally designed to help small agriculturally-focused insurers weather the liability crisis of the mid-1980s and compete effectively with their larger brethren.

“The tax advantage provided by Section 831(b) did not long escape the notice of estate and tax planners,” says Riggin. “For almost 20 years, firms have used these small captives to shield a portion of their clients’ earnings from income tax on the premiums. For over five years, the IRS has been investigating these transactions and has concluded that many of them may constitute illegal tax shelters. In these cases, the captive promoters appear to follow the rules of captive insurance, but, in reality, these efforts only hide the true nature of their tax shelter strategies.

“However, there is a variety of perfectly acceptable reasons for a captive or small insurer to elect to be taxed under section 831(b). This assumes that taxation is not the primary reason for forming the captive and that the transaction creates economic substance for all parties.”

Todd Mezrah, CEO of Mezrah Consulting, clarifies saying: “Primarily what 831(b)s allow you to do is insure the risks of an operating entity where traditional commercial coverage for those risks might not exist, or where the coverage might exist but might be too costly to obtain. If you’re in one of those two situations an 831(b) might make sense.

These types of exposures may include loss of franchise, loss of a key supplier, or loss of a key customer. Those aren’t normal and customary risks that are prevalent in the commercial marketplace today. Typically you can’t call up a third party property and casualty broker and say ‘can you write me a policy for loss of my key customers’—they’ll look at you as if you’re crazy,” he says.

“But that’s a legitimate risk—and a pretty big one, especially for a small business which might be depending on a customer for 20 or 30 percent or more of its revenue.

“If there are specific risks to an individual company’s industry, type of business, demographics or all of the above, that’s where an 831(b) can really come into play.”

Take a look in the mirror

If 831(b)s are so useful, why the sudden degree of scrutiny from the IRS? For Michael Mathisen, partner at Baker Tilly, the recent close inspections are partly the fault of the captive insurance industry itself, or rather one part of it.

One of the major problems with 831(b)s was that there was some over-zealousness on the part of the captives industry, with some captive companies selling these vehicles to clients. A lot of these clients either didn’t understand, or they were not a proper fit for, a captive insurance company,” says Mathisen.

“They were sold these 831(b)s as a way to arbitrage tax rates and save money ad infinitum if they keep it going forever. If that’s the only reason to set up a captive insurance company then the IRS looks at it and says‘no, that’s tax avoidance, not insurance’.

“We’ve always talked about and accepted captive insurance companies as a true risk-bearing vehicle. If they’re set up like an insurance company, and they are treated by the owner as an insurance company—you pay premiums and you pay claims—then it’s treated as an insurance company.”

However, according to Mathieson, captive managers went to companies that had no idea how insurance companies were run.

“Under the old law those companies were basically told if they put in $1.2 million of premium this year and they can invest it and get, say, 8 percent return, or a little under $100,000 of investment income on that, that’s all they’re going to be taxed on if they’re set up as an 831(b).

“In addition, they’re not going to have any claims, so they get a deduction for that $1.2 million on their corporate side, which on a 34 percent rate is a $400,000 benefit to them. If there are no claims ever then that’s a permanent benefit, and even if they close it further down the road when it comes back out, that could be a dividend that has a preferential rate of 20 percent.

“They’ve taken a deduction of the 34 percent, aSet featured imagend they’ve had a 20 percent income, so they’ve arbitraged 14 percent of their taxes.” Mathisen points out that if that was the sole purpose of setting up the captive insurance company then the IRS—rightly—says they’re not going to treat that as an insurance company, they’re going to treat it as a general corporate entity and deny deductions for the ‘premiums’.

They’re going to treat it as something set up to have money put in it, so they’re not going to allow it to be classified as an 831(b) and they’re going to tax it appropriately, deny your deductions and when the owners take the money out the IRS will look at the interest accrued,” he says.

“The thing about an 831(b) is that if you set it up for risk management purposes—which is what you should be doing—then you should get over the first hurdle. The whole analysis of the 831(b) and the captive should be: ‘do I need a captive?’.

“That should be the first question you ask. That and ‘do I need it for risk management purposes? Do I have things on my books that I am at risk for, but either I’m not buying insurance because it’s too expensive or there’s really not the insurance out there for the type of risk I have, but it is an insurable type of risk, so I can put that in there, I can take premiums on it and yes, I’m going to have losses’.”

Mathisen adds that the second part of this, one that captives overlook, is that insurance companies have premiums in, but they also pay losses. The captives that are bound to fail have no claims for years. As a result, when the IRS looks at 831(b)s they’d see five, six, seven years of premiums being put in but not a single dollar of claims. The IRS might, therefore, say there’s no insurance company in the world that had zero claims, with the exception of big cat riders, and 831(b)s are not cat riders.

Overzealous or fair business?

The IRS also looks at the type of risk. Mathisen claims that’s the other place where captive insurance management companies got overzealous because everyone understands that there are alternative risks out there, types of risk that aren’t traditional risks that you might be able to put into a captive insurance company.

In addition, he claims, they went so far as to monetize foreign currency risk, when it’s clear that with foreign currency you can buy options on it, or futures, and there are all sorts of financial products that can be bought for currency risk. It’s not an insurable risk, but in their zeal to come up with that million-odd number for their clients to show the biggest benefit for them and to allow them to sell the product to their clients, these captive managers came up with these types of risk that the insurance industry doesn’t believe are insurable—and which the IRS says are not insurable.

“This is why the IRS intervened to get this area tightened up, so only real captives can get the benefit,” says Mathisen.

The last part the IRS sees as abusive was that 831(b) captives were being used as wealth transfer vehicles, going outside the estate and gift tax. People were setting up 831(b)s and making their children the owners of those captives. A combination of no claims and annual premiums meant that such 831(b)s could get very wealthy, very quickly, with no state or gift tax but still allowing tax deductions on the premiums, so the IRS came up with rules looking at ownership.

Why has the IRS been treating 831(b)s as questionable? “In two words: bad actors. A lot of bad actors have attempted to take advantage of 831(b)s, by either manufacturing risks that don’t exist specific to their business, for example, kidnapping insurance for executives when there’s no danger of that or earthquake insurance for the state of Nevada. Those aren’t legitimate exposures to insure,” Mezrah replies.

“These entities are manufacturing risks that are not real risks specific to their business and in addition, even though they might be legitimate risks they’re not going out to a third party actuarial firm to promulgate the premiums, which should be market-based premiums associated with those risks.

“For instance, while cyber insurance is a big deal at the moment and could be covered via an 831(b), bad actors could be manufacturing a million-dollar premium for that exposure without going to an actuarial firm to evaluate what the true premiums would be given the client’s risk profile,” he continues.

“Risk profiles would take into account items such as the revenues, the size of the business, type of business, prior loss history and more. By not getting the proper evaluation done, they’re just putting a number down as to what the premium would be. They’re not doing what they should to justify the existence of their own insurance companies—they might not even have a bona fide insurance company.”

Separating wheat from chaff

There are, however, a lot of good players out there and some very good captive managers. The great majority of captive managers do things for a risk management purpose, says Mathisen. But there are, as in every industry, players who go too far.

“When Baker Tilly takes on a client that has a captive, or wants to know if they should be going into a captive, the company does due diligence on the client’s behalf, as it goes through the captive management plan, and asks what is or is not real insurance, and what is the proper type of risk that should be in the plan, looking at what the IRS would think if they audited the client,” he says.

“As long as they are done correctly, for the correct reasons and on the correct basis, 831(b)s are perfectly legitimate vehicles. Moreover, in addition to being set up for the correct reasons, if they are needed over a long-term period they need to be correctly maintained and treated over that time period, with the operators sticking to the rules so that the IRS or any other regulators cannot make any complaint about misuse or changes.

“831(b) captives can be incredibly valuable vehicles for a company. Set it up properly and treat it properly, in the way that a real insurance company would be treated—if you honor those steps the IRS, even if they are taking a hard look at these vehicles, can’t complain.”

Mezrah agrees. “How do we deal with this? How about just follow the rules,” he says.

“There are clear rules in 831(b)s that give guidelines on what would be considered a bona fide insurance company. You have to have risk distribution and risk transfer. You need an actuarial evaluation and your own business plan, and that needs to be submitted to the state of jurisdiction—there’s a formal process. “Follow the rules and do what the IRS is saying you can, within the guidelines. You can’t make stuff up. Even if the risk is a legitimate one you need to go out and confirm market-based pricing for that particular risk. There are certain things that the IRS is going to require you to do in order to fulfill the opportunity to utilize 831(b)s to code.

“Unfortunately, because we’ve had a lot of bad actors in the US, the IRS has been scrutinizing all captives to try to figure out for themselves who’s following the rules and who are some of the bad actors. As of now, everyone’s guilty until proven innocent. In the IRS’s defense there’s been so much abuse out there in the marketplace that it has something of a right to assume guilt before innocence,” he says.

“The reality is that even for the professional firms who did follow the letter of the law, have the appropriate documentation, claims history, appropriate risk sharing and distribution—they’ve done everything right—the attitude of the IRS is ‘right, looks ok, but who actually knows, let’s dig deeper and deeper’. It’s a monumental effort to try and defend yourself when in fact you have done everything right.”

As a result, Mezrah says, some of the firms that have done everything right are being punished, so to speak, with excessive scrutiny on the part of the IRS.

“A few hundred audits are being done right now by the IRS. It’s a lot of legal costs, time and resources, and for a small company that can be a big burden. Some might have had an actuarially justified premium of $250,000 paid into their captive and then spent $50,000 in legal fees defending what they did, which has been fully documented and above board. They wonder when is this going to stop, and how much more in legal fees will they have to pay?

“The IRS needs to trust someone, to trust a structure, a model, a list of practitioners—maybe have an approved list—but they’re on a witch-hunt. You can appreciate it from their perspective—if someone put in $1.2 million which has now increased to $2.2 million and it’s not legitimate, then the government has lost a million dollars in revenue, so they’d be a bit upset,” he concludes.

 

Note: This material is intended for informational purposes only and should not be construed as legal or tax advice and is not intended to replace the advice of a qualified attorney or tax advisor.

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