Microcaptives: the IRS’s next battlefield in its war against captives?
The Internal Revenue Service (IRS) is moving to deem the captive 831(b) election a presumed tax shelter by codifying it as a Listed Transaction.
Captive insurance scholar Jay Adkisson noted in a recent article that: “… the next thing we come to is a definition of a ‘captive’. The use of this term is unfortunate, since the regulations only deal with a very small subset of captives. Why the drafters did not use ‘microcaptive’ instead is not explained.”
The answer is simple: the IRS lost a major battle in the war on captives with the Tax Court’s dual rulings in Rent-A-Center and Securitas and then won a string of victories by attacking smaller captives securing risk distribution through risk pools, as is popular with captives making the 831(b) election.
However, the IRS showed its hand: the service is not waging a limited war against perceived abuses of the captive insurance form. Rather, it is attacking the industry from the smallest captives and is generating case law to leverage against middle market and large captive insurance companies.
Make no mistake about it: the IRS adheres to the view that captive insurance is not a real thing. The IRS focuses its analysis on the fact that captive insurance companies are reported as a part of the economic family on a consolidated tax return. Thus, the IRS continues to believe that captive insurance is not really insurance since there is no risk shifting to a third party. This doctrine created some absurdities along the way, such as questioning whether the Sears subsidiary, Allstate Insurance, qualified as “insurance” for federal income tax purposes.
Although the IRS lost the argument that captive insurance is not a thing pursuant to the economic family doctrine, the IRS continues to challenge whether captive insurance is really “insurance” pursuant to an ever-complex tapestry of holdings arising out of the Helvering v LeGierse case of 1941.
Here is what the industry needs to do in response.
First, in July 2023 there is an opportunity for notice and comments. All interested parties, including the majority of readers of this article, should opine on how the IRS misunderstands what constitutes insurance. By way of example, the IRS believes that an 831(b) captive should not be required to disclose the transaction on a Form 8886 if it has a loss ratio of above 65 percent or (potentially) a combined ratio of greater than 99.5 percent.
There are several issues here. The idea that a transaction does not constitute insurance if the loss ratio is below 65 percent is laughable. Also, the IRS explicitly notes that it hopes (or demands) that small captives underwrite to zero profit.
Second, industry professionals with the ability to weigh in on litigation need to realise that the IRS is on shaky constitutional ground. The IRS’s war on captives is going on against the express wishes of Congress. Congress revisited Section 831(b) in 2015 and increased the limit from $1.2 million to $2.2 million and adjusted it for inflation, all while the IRS lobbied to get rid of the election all together. So, Congress is aware of this law and wants it to be there. Yet, the executive branch of the government wishes this law were gone.
We have a good old-fashioned separation of powers argument.
Look at the law
There are several ways to resolve a conflict between the executive and the legislative branches of the government. The easiest is to look at the body of law and determine what the general rule of thumb is. For insurance, the McCarran-Ferguson Act of 1945 clearly established that the business of insurance is state law. The licensing of insurance companies constitutes the business of insurance pursuant to the case law arising out of McCarran-Ferguson. The IRS’s position that certain captive insurance transactions stand in opposition to states’ departments of insurance issuing insurance licenses authorising these transactions as insurance. Thus, the IRS is in direct violation of McCarran-Ferguson.
Moreover, the Supreme Court has the power to invalidate agency actions that go too far. The major questions doctrine is a relatively new addition to the canon of the Supreme Court providing that where executive agencies exceed the intent of Congress, the Supreme Court possesses the power to invalidate their actions.
Finally, LeGierse itself stands on flimsy constitutional grounds. There are multiple circuit splits and departures from the LeGierse decision, creating inherently contradictory holdings that are impossible to reconcile.
Elevating the 831(b) election is not just a stake in the heart of small captive insurance companies. Rather, this is a new phase in a much broader war against the essence of captive insurance. Captive insurance is the zenith of risk financing and without it the insurance markets are governed entirely by the whims of the admitted and E&S markets. Captive insurance provides a meaningful opportunity for middle market businesses to expand their operations into the industry of risk financing. This is greater than just tax breaks or cheap insurance. This is about the American dream.
The rule of law guarantees that the law is enforced equitably and fairly against all citizens. The IRS does not regard captive insurance as a real thing. It simply views captive insurance as a means by which to dodge taxes. This is true whether it be Allstate Insurance or an 831(b) captive reinsured by a risk pool. The IRS does not like the corporate form.
Thus, the only rational response is to fight. This constitutes a major change in the policy of the IRS. Some may argue that this is an issue for only the small ball captive insurance managers, but the long arc of history is clear: the IRS dislikes the entire notion of captive insurance because it never relinquished the economic family doctrine.
So, how do we fight?
All litigation needs to focus on a key flaw for the IRS: all of its authority stems from Helvering v LeGierse. Disarming the IRS requires demonstrating to the Supreme Court that the case rests on shaky constitutional grounds. Take away LeGierse and the IRS is forced to play fair.
Matthew Queen is owner of The Queen Firm and CEO of Sherbrooke Corporate. He can be contacted at: email@example.com