Time to exit your 831(b) captive?

For years the Internal Revenue Service (IRS) has had 831(b) captives in its sights as it has attempted to combat certain abuses. With a place on its Dirty Dozen list since 2014, several high-profile Tax Court losses for certain 831(b) captives, and the establishment of 12 new special examination teams, the IRS is clearly intent on bringing down abusive micro-captives. There is little regard evident for the purpose and effectiveness of one of the most common risk management tools available.

Taxpayers with 831(b) captives currently under audit face not only a loss of premium deductions, but also significant penalties. Unfortunately, this has had a chilling effect on the thousands of 831(b) small captives that attempt to follow the various ‘safe harbour’ rules.

And now, the COVID-19 pandemic has delivered an important message to the business world: unexpected Black Swan events can (and will) devastate a small company in the blink of an eye. It seems like exquisitely bad timing, in the face of this economic hurricane, that the IRS this week launched a mass broadcast of intimidating letters to 831(b) participants.

This leads to the question: what options do taxpayers with 831(b) captives have in a time of increased scrutiny yet very real business risk?

Option 1: wind it down

Owners can elect to close down their 831(b) and liquidate assets. The captive assets will then be distributed to the owner(s) and tax on the distributions will be paid based on the tax position of the owner(s) at the time of distribution (likely at the long-term capital gains rate). Rules and fees for winding down an 831(b) captive will vary among managers and owners will likely have to wait until the end of the claims period so as not to disrupt the risk pool.

This approach certainly makes sense for owners who have lost confidence in their advisors/captive managers or who formed their captive primarily for the tax benefits in the first place. However, for the vast majority of small and middle-market business owners, risk strategy is a vital focus in an unpredictable economy, and captive insurance can be an important piece of a comprehensive enterprise risk management plan.

Option 2: ride it out

It is important to remember that the 831(b) election is not inherently bad. Increased IRS scrutiny does not mean that the majority of micro-captives were formed for the wrong reasons. There is no doubt that properly structured 831(b) captives, formed for true insurance purposes, can be legitimate risk management tools. After all, many Fortune 500 companies have been using them in some form for more than 50 years.

As an 831(b) owner, now is an important time to review the compliance of your captive and the regulatory status and commitment of your captive manager. It is also time to ensure that best practices and safe harbour guidelines are being used by your managers and service providers.

Owners should examine issues that have arisen in recent court cases to ensure appropriate practices are employed. These include: the use of independent actuarial services to determine premiums; the use of professionally accepted actuarial methodologies; the implementation of the key insurance mechanics of risk transfer, risk sharing, and risk distribution; and the use of third-party claims management services.

Commercial insurance markets will continue to harden. A captive strategy provides a way to bring insurance costs under control, while protecting companies against loss. However, even when done right, the IRS clearly sees a big problem with the 831(b)s. It is likely to continue pursuing them aggressively in the foreseeable future.

Option 3: explore a private insurance solution

A private insurance strategy protects against financial losses by funding for unpredictable risks specific to a business owner and their affiliated companies. These risks are typically those that have a relatively low probability of occurring, but could be financially devastating to a business, such as a cyber breach, regulatory change or loss of key supplier.

A private insurance strategy provides a means of clearly identifying these often hidden risks and developing a tax-efficient financing plan in the event that they occur. In addition to funding unpredictable losses, participating in a private insurance structure may enable a business owner to accumulate ‘rainy day’ funds and increase transparency and control over its risk management efforts.

Since 2015, Captive Alternatives has exclusively focused its private insurance programme in Puerto Rico. Puerto Rico has a unique insurance structure written into its insurance code, called a Segregated Asset Plan (SAP). These are insurance policy-linked funds which do not hold their own juridical power. It means the insured does not own the SAP, nor can the SAP make its own business decisions.

Consequently, this demarcates the SAP as no longer functioning as an insurance company in its own right. Instead, it participates as an allocated fund in the reinsurance process of an independently owned reinsurance company, Madison Re. In comparison to an 831(b) captive, this private insurance structure has no artificial premium limit, does not restrict the number or type of participant and can form part of a wealth planning strategy.

An existing 831(b) captive can be reorganised into a non-insurance C corporation under a tax-free exchange process. Tax on accumulated assets is deferred until funds are distributed to the owner. This process allows an 831(b) captive owner to close down the 831(b) and defer taxes until such time as distribution of funds is made.

Captive Alternatives advocates this approach for many 831(b) owners, particularly if they are committed to risk management and want to explore the private insurance solution.

With increasing awareness of the potential for catastrophic risks and their devastating effect on business, the rules of risk management continue to evolve. Nevertheless, the potential to insure one’s own risk remains a powerful and important tool in the risk management space.

Emilie Gastley is director of marketing at Captive Alternatives. She can be contacted at: egastley@captivealternatives.com