More clarity needed on micro-captive tax rulings

Recent tax court rulings on micro-captives do not take account of the diversity of legitimate insurance business models, says a leading advisor.

Recent tax court rulings on micro-captives do not account for the diversity of legitimate insurance business models and the principle of safe harbour could also be threatened, says Van Carlson. 

The history of defining a captive insurance company becomes complicated, especially because neither “insurance” nor “insurance company” is defined in the US Internal Revenue Code. Captives are insurance companies owned by their insured. (For example, Apple owns Apple Care.)

Congress essentially gave back to states the regulation of insurance in 1945 via the McCarran-Ferguson Act. The Act states that “Acts of Congress” that do not expressly purport to regulate the “business of insurance” will not pre-empt state laws or regulations (with a targeted limited exemption for federal antitrust laws).

The McCarran-Ferguson Act gives insurance regulation to the state level, and states determine if a company is a legitimate insurance company based on rules, regulations, and memorandums. The Act doesn’t specifically address the US federal tax treatment of captive insurance companies, though captives are required to select to be taxed under the US federal tax election section 831(a) or 831(b).

While we look to state law to determine if a company is a legitimate insurance company, we must primarily look to the tax courts, who interpret and apply US tax laws, to determine each of the requirements for taxation. 

At issue is whether an 831(b) captive (also referred to as a micro-captive because it writes smaller premiums than the insurance companies electing to be taxed under 831(a)) will be considered an insurance company for US federal tax purposes.

The tax courts examine a state's captive insurance regulations to determine whether the captive meets those regulations and is thus legally considered an insurance company in that state. But that is only one part of what they consider.  

 For a company to be considered an insurance company for US federal tax purposes, the courts ask the following questions: 

1. Does the company operate as a business? 

2. Is it insurance in the commonly accepted sense? 

3. Does it meet the definition of risk distribution? 

4. Does it meet the definition of risk shifting?

Unfortunately, the courts do not address all aspects noted above when they hear an 831(b) captive case. Through previous cases, we have been given a set of nine factors to consider whether a captive is an insurance company operating with the common notions of insurance. Thus, we sit tight with each case, eager to learn any more insight or instructions into how the Tax Court interprets the requirements. Ideally, the requirements need to be clearly defined to create a legitimate captive for federal tax purposes.

 One of the most recent cases we can look at is Keating v. CIR, T.C. Memo. 2024-2 (Jan. 4, 2024). As a very brief overview of the facts, because there are many pertinent intricate details, the case ultimately involves three individual owners (Terance Keating, Arthur Candland, and Cheryl Doss) of Risk Management Strategies, Inc. (RMS). 

RMS ultimately owned a captive named Risk Retention, Ltd. (RR) which domiciled in Anguilla. While RR is vital to understanding how the tax court determines what constitutes a legitimate 831(b) captive for income tax purposes, thus the entire point of the suit, it’s important to note that RR was not a party to the suit. The court is going after the captive's owner company (RMS) regarding what federal tax deductions it took because it owned RR. 

RMS essentially acted as a sole employer for its clients, service providers for special needs trusts, and other entities. It also contracted its services with national banks in the banks’ capacities as Trustees. In addition to the services it offered, initially, RMS assumed risks they required and those the banks required, such as professional liability, automobile liability, general liability, employee liability, workers’ compensation, unemployment liability, and others via RR. 

When the Affordable Care Act was enacted, RMS began offering health insurance coverage to its employees. To this end, it formed a voluntary employees’ beneficiary association and entered into a contract with a stop-loss insurance carrier and claims administrator. In the three years the court addressed, an estimated $700,000 in premiums were written yearly. 

To determine if the contract between RMS and RR was insurance for federal tax purposes, the court focused on whether it was “insurance for the commonly accepted sense”. RR was found to be properly licensed in Anguilla as an insurance company and complied with its regulations. However, the court determined it did not operate as a valid insurance company.  

There were problems with the captive which made it suspicious. For example, in the judge’s opinion, the owners and service providers had too much input in the premium pricing, how and when premium payments were made, retroactive issuance of policies, claims adjudication, and there were undocumented loans. The judge pointed out these poor facts, as similar ones have been pointed out in related cases.  

However, the judge also determined that the transaction was suspicious because risk pools were structured to meet safe harbour. Safe harbour is a crucial tax compliance tool for insurance companies because it explains how protection can be granted from liability or penalties if certain conditions are met.

The immediate danger with this ruling is by challenging the intention behind structuring a pool to meet a safe harbour, the court potentially turns a compliance tool into a contentious issue. This is contrary to the purpose of having safe harbours in tax law. 

In the RMS case, the Tax Court ventured into assessing insurance companies “typical operations”. This goes beyond its role of interpreting tax law and ventures into setting de facto operational standards for insurance companies. The court’s assessment of RMS’s practices as atypical or not in line with standard insurance practices does not take account of the diversity of legitimate insurance business models, especially in the context of 831(b) captives. Captives are inherently distinct from traditional insurance companies.

If the Court continues to determine these types of cases on a fact-by-fact analysis, we may benefit in future understanding of what they are looking for and what benefits specific 831(b) insurance companies in very specific situations. 

But we will continue to flounder on understanding how to meet “insurance in the commonly accepted sense” to be taxed as an insurance company without some official instruction, either provided by Congress or proscribed by the IRS. While we wait, we can all agree that those captives and related service providers with the best intentions of meeting requirements to be taxed as an insurance company will continue to waste time and money.

Van Carlson is the founder and CEO of SRA 831(b) Admin. He has over 25 years of experience in the risk management industry and is passionate about helping businesses protect themselves from unforeseen risks.

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