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Jeremy Colombik, president, Management Services International
4 September 2019Law & regulation

Tax benefits for captives are not a crime


Following Syzygy Insurance v Commissioner and other cases the Internal Revenue Service (IRS) has brought—and won—against 831(b)s, some people have concluded that these structures are nothing more than a tax dodge. What are the legitimate legal and tax benefits to setting up as an 831(b) captive?

There are five main benefits from setting up an 831(b), or any other form of captive for that matter, and I have tax as number five on that list. Tax can be a benefit from forming a captive, but it cannot be the only one.

The first of the five main benefits is being a profit centre. Owning an insurance company allows the owner(s) to retain the premiums and profits that a commercial carrier retains when insurance is purchased through it.

The second main benefit is that it allows owners to get coverage that may not be available in the commercial market. The third main benefit is that it increases risk awareness. This means educating the owner(s) on risk that they were, and were not, aware of. This is important because even if owners are aware of the risk, they may not be aware of its severity.

The fourth main benefit is better risk management. This means that captives can plug exclusions and gaps that exist in their commercial insurance policies.

There is nothing wrong with setting up a captive because you want to make money, and there is nothing wrong with receiving tax benefits in a captive. There are other areas that business owners use for tax benefits, such as 401(k) tax-qualified pension plans and buying buildings.

Setting up a captive should not be only about saving money on taxes. Captives offer a range of other ways for owners to make money, by reducing risk or getting better coverage(s), which are legitimate reasons for setting up a captive that elects an 831(b) status.

Were Syzygy and the other prosecuted captives shams?
In the most high-profile cases it certainly looks like the courts made the right decision. In Avrahami for example, it looks clear that the captive was not doing business the right way and there is very little argument from the industry that Syzygy was a legitimate captive.

But there have been many cases where the IRS lost, which are less widely reported, so if the IRS investigates your captive, it does not mean you will lose, nor does it mean that you have improperly structured your captive.

How concerned do captives need to be about the Tax Court’s interest in 831(b)s?
There are approximately 600 docketed cases in which the IRS is going after captives, but there are between 4,000 and 6,000 831(b) captives in the US, meaning around 10 to 15 percent of captives get caught up in these cases.

It may actually be less than that—in a case such as Avrahami you have 100 or so people in the pool who the IRS will likely go after individually because it knows it has a good chance of winning.

In other words, the chances of getting embroiled in an IRS investigation are small, and even smaller if you are doing business the right way.

What do captives need to do to prove to tax authorities they are legitimate businesses?
It comes down to being able to account for the decisions the insurance company has made. For example, a captive does not technically need an actuary, and there is no legal requirement for it to use one. However, it does need to be able to show how it priced a particular risk, so if there is no actuary it had better be able to show which models and data it used when calculating the premium pricing.

In most cases having an actuary is recommended, especially for anyone worried about attracting the attention of the IRS, because not having one might look suspicious. The IRS is very interested in pricing, and it is one of the things it is very focused on, so you need to be able to show that your numbers did not appear out of thin air.

Next, you need claims. If the captive is only a year or two old, not having any claims is justifiable in many cases: some captives are there precisely to ensure low frequency, high severity risks such as earthquakes in the commercial area, so there may not be claims for a while. However, in most cases, with mature captives, there will be claims every year, and there should be a claims manual and a process.

The captive must look like an insurance company, with all the things you would expect an insurance company to have, such as renewal letters, notifications of changes to policy terms and claims procedures, to name a few.

It helps to be able to show that occasionally a claim is denied, because denying claims is something that insurance companies do. Also, it helps to issue the policies in a timely manner and not issue them at the end of the policy term, because that is not how insurance companies operate.

In one case the IRS was looking at a captive that had more than 50 percent of its reserves tied up in an investment that it had no access to, which made no sense at all given that reserves are supposed to be there to cover claims. Areas like that will arouse suspicion.

Do captive owners have other, safer options than 831(b)s available to them?
There has been some impact on interest in these structures. An 831(b) election is most commonly taken by small to medium sized companies’ captives, as it offers certain tax benefits. Some companies looking to form a captive are looking at it and deciding not to make that election, simply because they do not want the worry or hassle of the IRS looking into them.

What a captive dreads is an information document request (IDR). Even if the captive has done nothing wrong, getting an IDR is an issue because of the time and the cost associated with providing the required documentation.

To avoid that risk altogether a prospective captive may decide not to make the (b) election, in which case it becomes an 831(a), which offers many of the same benefits without the tax benefits of an 831(b) election.

It is a very personal choice. My advice to people is that if they do everything right and have their processes in place and all the right documentation, they will be able to demonstrate that they are a legitimate insurance company if the IRS comes calling.

For some people it is enough to know that but for others, the risk of having the IRS even ask the questions is enough to put them off going down this route.

If captives want to look like proper insurance companies and fear deviating from what they do, does that undermine their ability to innovate?
I do not see that as a problem. Insurance companies are in the business of making money and they are all looking at different markets and pricing things their own way. It is just a fact that captives are more flexible than traditional insurance companies.

We saw that in the cyber market when it first started around seven years ago, when captives were doing things the commercial market could not do. Now the commercial insurers have got much bigger in cyber but there are still many exclusions in their policies, and captives are being used as a way to plug those exclusions and ensure companies have comprehensive cover. I do not see any evidence that captives cannot innovate.

Captives have to act like traditional insurance companies in terms of having claims, policies, manuals, processes, and in being able to demonstrate how they arrived at a number when it comes to pricing. However, they don’t have to look like any particular traditional insurance company when it comes to being innovative.

Do you agree that these tax cases will be good for the industry in the long run, by weeding out bad actors?
Yes and no. These cases are doing a good job of finding the bad apples in the captive insurance industry and deterring any new bad apples from coming into the industry. However, my problem is that this controversy is deterring good apples as well as bad.

Some companies could be setting up 831(b)s for perfectly legitimate reasons but decide not to do it because they do not want the aggravation. That is a shame because the 831(b) might be the most efficient vehicle for them to use.

Some people set up 831(b)s for the right reasons, but the IRS opens a case against them which is completely unwarranted. Many of these people could beat the case if they had the stomach to fight it, but they decide to settle because of the cost and stress involved in fighting. There is a cost-benefit calculation to be made here—in a lot of cases people just want to be done with the whole thing as quickly as possible.

I hope and expect that things will calm down once the IRS loses a high-profile case, which eventually it will. This may reduce the IRS’s focus on the captives industry and convince people who are on the fence about making the (b) election to go for it, by showing them that even if the IRS does come after you, it can be beaten if you have done things the right way.

My hope is that once the IRS has gone after the most winnable cases, and particularly the people in the pools of the captives that it has already beaten in court, it will turn its attention elsewhere. Most captives that elect to form as an 831(b) do so for perfectly legitimate reasons.

Jeremy Colombik is president of Management Services International. He can be contacted at:  jeremy.colombik@themsicorp.com