831(b) – The future of a flawed model
When I started out Bermuda in the early 1980s, the captive was a risk management solution for very large corporations. In 1986 under the Reagan tax reform regulations, a valuable tax benefit commonly known as the “micro-captive insurance company exclusion.” or 831(b) came into law. The intent of the law was to promote the use of captives by mid-sized companies to pursue the public policy benefit of building reserves and helping companies avoid catastrophic hits to their income and stability.
Little used until the late nineties, the election has become a core risk management solution for smaller companies. The IRS, over the years, has established some safe harbor guidelines that most captive management companies try to follow. Primary amongst these are that a captive should be operated like an insurance company with competent underwriting, claims handling and management of surplus. However, the election has also led to the growth of a number of 831(b) captive that skirt the safe harbor rules to promote the tax deductions available for captive premiums. The IRS, understandably, has become concerned about this, but has had difficulty defining what makes a good vs a bad captive.
Anyone Googling 831(b) captive is treated to a raft of negative headlines. The 831(b) captive has been featured on the IRS “Dirty Dozen” list for a number of years. This annual list warns taxpayers against “abusive micro-captives” that “lack many of the attributes of genuine insurance.” This is generally taken to mean that 831(b) captives that don’t follow the Safe Harbor rules will be subject to audit.
The PATH Act 2015 severely limits ownership options in an attempt to kill “generation-skipping” estate plan transactions. The Path Act also increased the maximum premium limit to $2.2 million, so it wasn’t all bad. In late 2016 the IRS declared 831(b) captives a “Transaction of Interest” and required copious filing of annual returns that described the transaction and went back more than five years. Finally, in June of 2017, the US Tax Court issued a ruling on the Avrahami captive, denying premium deductibility and setting out some reasons why. Although the case was very specific to the facts, and many captive managers would argue that their model is very different, it did provide some new guidelines to the IRS’s concerns. Again, operating the captive as a proper insurance company, managing adequate reserves, having claims, and properly organizing risk sharing were all important factors. More cases are expected soon which may further curtail the use of the 831(b).
Thus the 831(b) has become somewhat tarnished, and trusted advisors and business owners are understandably wary of venturing into new 831(b) vehicles, or considering whether existing structures are too much trouble. This is a shame because a captive can help jump start the process of Enterprise Risk Management in a smaller concern. During the initial process of captive feasibility analysis it is common for an owner to ask about other “hidden” risks and start to understand how insurance costs can be further controlled with deductibles and excess coverages.
It is likely that the 831(b) will continue, with ever more onerous oversight and limitations. Some owners will decide not to continue with their captive, and explore ways to close it down – such as under a tax free exchange into an investment company, or simply closing it down. Other new solutions are emerging in Puerto Rico, an unincorporated U.S. territory regulated under US Federal law – but with its own tax system, which has created an International Insurance sector to attract captive business. It is now possible to create smaller captives, without the necessity of the 831(b) election.
The hope of most participants in the small captive space is that the “rules of engagement” are further clarified by the IRS and Congress, and that good actors can continue to grow this sector. Every Congressman and Senator likes to say that “small business is the engine of growth”, so helping companies to identify and control catastrophic risk remains a worthy objective, and deserves the support of government.