2 September 2022ArticleAnalysis

Stepping up to the captive plate

“Having captives for these types of insurances that are primarily excluded in the commercial market is very significant.”

Teresa Jones, RH CPAs

The Internal Revenue Service (IRS) seems to have a bad taste in its mouth over captives. Put simply, a number of players in the industry formed captives with an improper motive. When people are entering into a transaction solely for some sort of tax benefit as opposed to actual risk management, and that is exposed, the IRS’s radar screen goes up. That’s natural and understandable, and the IRS has successfully pursued several bad players.Setting that aside, you have to understand that it’s not just in captives. You can be a bad player from misusing a 401(k) plan—which has been on IRS’s “Dirty Dozen” list. What we can’t understand is why carry out a blanket attack on the entire industry when Congress has said you can do these things? Congress passed legislation and if you follow these rules, you’re playing by the rules.The fact that the IRS doesn’t like the rules that Congress set out and for it to turn around and attack the entire industry is wrong.Obviously, insurance companies have some advantageous tax laws. The primary one is the ability to deduct the reserves for losses before they are paid—that’s simple. A normal company says: “I’m going to self-insure my workers’ compensation risk, we know we’re going to have losses sometimes so we’re going to put a reserve on our books for those losses. But I can’t deduct that until I actually pay the loss.” However, an insurance company can, so that’s a major reason why insurance companies are a little more advantageous.

“It would be better if those grey areas such as risk distribution were more clearly defined.”

Amanda Cook, RH CPAs

This leads to the question: why is that? Going back to the very beginnings of insurance companies, it was a group of farmers, for example, getting together and saying: “If one of our barns burns down, we want to be sure we can build back that barn.” Everybody shares in each other’s risk, so that inherently means: “We’re going to put up money away, because we know at some point a barn’s going to burn down.” The insurance company is not unduly burdened by receiving all that money up front, paying taxes on it and then not having enough money to replace the barn.That’s the very simplistic mutual insurance scenario and that’s why insurance companies have advantageous tax rules for deductibility of reserves—it makes sense, it’s logical, it’s getting down to the basics and it’s what should happen. The IRS doesn’t like it because “it hasn’t been paid” et cetera, but to say “Insurance companies or captives are all bad, and they are so bad that we’re going to make you fill out a lot more forms, we’re going to make you disclose this and we’re going to cause you pain”, we think is an incorrect and immoral approach.Congress has been biting back at the IRS. We meet with our congressional delegation on a regular basis to discuss it. In 2017 the IRS said it didn’t like 831(b)s and Congress passed legislation to take the premium limit for making the election from $1.2 million to $2.2 million. Now that’s been indexed for inflation of $2.4 million, so Congress said: “Captives are good for business, they help businesses”—so much so that the COVID-19 pandemic is a perfect example of this.Business interruption insurance for pandemics is primarily excluded in the commercial market. We know captives wrote insurance for pandemics, so over the past two years captives have been paying claims in a major way. They’ve been paying claims to keep people employed and that inherently keeps meals on the table.What’s happened over the past couple of years with pandemic insurance in the captive insurance market has been extraordinary. Having captives for these types of insurances that are primarily excluded in the commercial market is very significant and it saved many businesses.

Navigating your way to safe harbours

You have to understand what you can do to be sure you have adequate risk distribution up front. This can be done in a number of ways. There are a couple of safe harbours: IRS Revenue Rulings 2002-89 and 2002-90 provide them.If you’re not in a safe harbour, the Tax Court seems to be moving more towards exposure units for determining risk distribution. So, the thing to do is to analyse how you can comply with the safe harbour. If you can do that—wonderful.If you can’t comply with one of the safe harbours, initially you can choose to share some risk with a bunch of unrelated people through reinsurance, or you can say: “We need to work on our statistically independent risk units and identify them and see if we have enough of those up front.”The Tax Court seems to be moving more towards risk units, but they are hard to define. For workers’ compensation that might mean every employee, for medical malpractice it could be the number of practitioners or the number of beds in a hospital, where you could have one loss and not have a loss in other areas. You have to ensure that you have enough statistically independent risk units, or if you don’t, where are you going to share risk with some others through reinsurance or a pooling mechanism?Pooling mechanisms have been around for a very long time and we think that there probably hasn’t been enough press coverage of the Puglisi Egg Farms case. This was a captive that was managed by Oxford Risk Management which covered an egg farmer who was audited by the IRS, which told the farmer that it was giving him a notice of deficiency. The IRS received a lot of documents and realised it was going to lose, so the IRS conceded the case. However, the egg farmer did not want to let go of the case—he wanted the IRS to let him know that he was okay and that it was not going to come back after him in the future.The case went back and forth in the courts and ultimately the Tax Court said: “We’re not going to let you keep taking this down the legal route because the IRS said ‘hey, you’re right’.” While there wasn’t a Tax Court opinion the IRS conceded the position and said: “Oxford and Mr Puglisi, you’re right—this is captive insurance, there’s risk distribution, we’re giving you a notice of no change”, so it held up. There’s no Tax Court opinion on it but it does let the industry know that captives are real and right, and the IRS was wrong.This is a perfect example of overreach by the IRS. Out of the gate it said: “We’re going to completely disallow this before even performing a proper investigation.” We don’t think that’s right, it’s not fair—you were guilty until proven innocent. We don’t think that’s the best approach, we think the IRS should have looked at the underlying facts and not dragged a proper captive owner through hundreds of thousands of dollars of legal bills because the IRS didn’t do its work properly.

Stick to the rules

Our clients and the people we work with are rule-followers—everybody wants to play by the rules. The problem with insurance is that it’s not inherently defined in the Tax Code, so the definition of insurance is formed by court cases. Those court cases primarily say there has to be three things: (i) risk transfer—you will take risk from here and put it over there; (ii) risk distribution—you have enough parties or enough independent risk units to be insurance. That’s the primary one that we are concerned about; and (iii) insurance in the common notion.The latter refers to the commonly held notions of insurance, which are what the Tax Court said: you have to have policies, you have to have claims, you have to investigate claims, etc. If you have those attributes, the Tax Court says you’re an insurance company.To us it would be better if those grey areas such as risk distribution were more clearly defined. While it is defining safe harbours the IRS is taking the position that all pooling/reinsurance mechanisms are bad. In the Reserve Mechanical Court of Appeals case, the court said in its opinion that pooling works for risk distribution, but when you monkey around with clauses which make a loss to the pool extraordinarily unlikely, that is not insurance.It said you can’t have a pooling mechanism unless you have losses, which is silly. If you go back to our example of a barn burning down, you’re going to buy insurance in case the barn burns down, you don’t need the barn to burn down before you can have insurance—it doesn’t make any sense.Is this because of historical reasons, with states setting insurance rules? We think so, and that state-regulated insurance is the best way to go. That was promulgated by the McCarran–Ferguson Act (15 USC §§1011–1015), in 1945, which said that insurance is state business. The Federal Insurance Office doesn’t regulate insurance companies, states do that and they do a really good job.It’s possible that the IRS is more concerned that many years ago if you had a company offshore it sounded bad, but they are great domiciles—the IRS was concerned about these offshore jurisdictions not regulating insurance companies properly. Now, whether you’re onshore or offshore if you do those three things we mentioned—insurance in the common sense, risk distribution, and risk transfer—you’re an insurance company and you can play by the rules.As hard as the IRS is pushing, throwing some kinds of captives on to the Dirty Dozen list and indiscriminate finger-pointing is a bad thing. People who are doing things right are getting caught up in it—and that’s not fair.