The IRS is stepping up its attack on some captive insurance companies

Captive insurance companies are used to insure the risks of many businesses, especially businesses that have certain types of large and complex risks. These policies are owned by the insured or a related party and are governed by various sections of the Internal Revenue Code of 1986, as amended, including IRC §831.

When discussing servitudes, it is important to understand the difference between servitudes authorized under §831(a) and servitudes created under §831(b), which the IRS increasingly considers tax avoidance and tax evasion methods. Let’s take a look at these differences and see how slaves are used.

Know the difference

There are two main types of captive insurers: those that make a §831(b) election to be treated as a small insurance company (ie microcaptive) and those that do not and are regulated under IRC §831(a).

Those who choose to create §831(a) bonds do not face a limit on the amount of compensation that can be paid and there is no limit on the number of owners (participants) of the bond. On the other hand, the decision to make a §831 (b) captive can be made only if the salary paid is at least $2.3 million (the limit is 2022 – the limit is adjusted annually). In either case, the amount paid is usually tax deductible.

For §831(a) captives, capital gains (the amount of cash paid, disallowed reserves and expenses) are taxable while for §831(b) captives, capital gains, but not capital gains, are taxable. Therefore, a company can, in effect, pay a premium to its captive insurance company without the captive paying taxes. This appears to be very different in the eyes of the IRS, and that the documents and complaints are lengthy actions of the type of third parties that are governed by §831(a) and are not conducted by related parties.

These low prices, along with the lack of tax on the underwriting costs, have led to abuse of taxpayers who produce captive insurance policies and audits by the IRS. Often times, microcaptive owners and investors focus on tax benefits with little or no attention paid to insurance benefits. These include poor underwriting, low rates, little if any coverage, and little or no shared risk (eg, reinsurance).

This clearly explains why the IRS views §831(b) entities less favorably and assesses them as tax avoidance vehicles while §831(a) slaves are not viewed as such. In 2014, the IRS added §831(b) slavery to its “Dirty Dozen” list, calling slavery “abusive arrangements.” Then in 2016, the IRS issued Notice 2016-66 in which the agency wrote that §831(b) slaves have the ability to avoid or evade taxes.

As if the message about these slaves wasn’t clear enough, three recent rulings by the US Tax Court have given the IRS the upper hand in disputes involving §831(b) slaves. These cases are based on several questions:

  • Does a §831(b) captive insurer act as an insurance company?
  • Is the §831(b) captive organized, controlled and operated as an insurance company?
  • Has there been a feasibility study showing the value of captive insurance over existing insurance?
  • Are the captive insurance company’s design, operations and coverages aligned with the needs of the insured companies?
  • Is §831(b) subject to sufficient letters?
  • Are the plans provided by construction?
  • Were the charges reasonable and were the charges confirmed by the arm’s length transaction?
  • – Is there a history of paying claims?
  • – Is there “risk shifting” and “risk sharing?”

Last year, there was a landmark §831(b) slave ruling in the Caylor Land & Dev. V. Commissionerwhere the court ruled that the §831(b) arrest did not qualify as insurance for federal income tax purposes.

Recently, on May 13, 10Th The Circuit Court of Appeals ruled on the taxpayer’s appeal in Reserve Mechanical Corp. v. Commissioner. The appeals court agreed with the tax court’s decision affirming the IRS’s decision that the company was not exempt from tax as an insurance company under §501(c)(15) and that the income it received should be taxed at the 30% rate under §881 ( a). As a result, Reserve Mechanical not only lost the money it paid to the prisoner, but the prisoner had to pay taxes on the money he received from Reserve Mechanical – double taxation plus interest and penalties on the loan!

The works of captives

The tax benefits of forming a captive insurance company can be attractive. However, these benefits should be secondary to the need for different types of insurance that the hostage taker can provide. Captive insurance arrangements can provide consistent coverage while reducing transaction-related costs.

We live in an age of increasing cyber-attacks, threats to control and disruption of online resources (to name a few) and we have only seen what a virus can do to a crippled company. The insurance companies in prison can provide is very important to keep the business going. By focusing on providing services through the long-term market and paying taxes, when possible, §831(a) captive insurers have risen above the negative interest they brought §831(b) captives.

Some examples of coverage provided by auto insurance policies include:

Property related – due to damage to equipment, natural disasters, maintenance and marine and marine incidents.

Business disruption – due to transportation disruptions, loss of contract, loss of a key employee, cyber attacks, infectious diseases and strikes or riots.

Rules and regulations – due to legal protection, loss of license, changes in laws and government investigations.

Additional information – due to increased debt, reinvestment, gap closures and resource gaps.

Jay C. Judas, JD, M.Sc. is the CEO of Life Insurance Strategies Group, an independent life insurance consulting firm. Jay can be contacted at [email protected].

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