22 February 2018Accounting & tax analysis

Recent court cases have not weakened interest in 831(b)s

Recent negative press coverage surrounding 831(b) captives—also known as microcaptives—in part triggered by the outcome of the recent court case Avrahami et al v Commissioner, which ruled in favour of US tax body the IRS, has not deterred mid-market companies from exploring the potential of captive structures.

That is according to Ellen Charnley, president of Marsh Captive Solutions, who says that, if anything, the number of enquiries from mid-market companies interested in this form of risk transfer has increased since the case—although more education is now necessary on the correct use of 831(b) captives.

“We’ve had a number of conversations and perhaps more with potential captive owners than we would have had prior to the case,” she says.

“There is a lot of media coverage out there. If you were to type 831(b)s into the internet, it’s quite likely you will see a bit of negative press somewhere down the lines. So there’s an extra level of conversation taking place on the education side, around the fundamentals of what 831(b)s are trying to achieve.”

In the Avrahami case the court ruled that taxpayers Benyamin and Orna Avrahami, who have set up a microcaptive arrangement to protect their three jewellery stores from terrorist attacks, can’t claim deductions for amounts paid to their captive insurance company. While some believe the circumstances of this case were unique, others claim it will embolden the IRS to question other microcaptive arrangements.

Charnley does not expect a dropoff in the number of prospective owners looking at these structures—in fact she believes captive solutions for mid-size companies is a growing sector—but she thinks it will take companies a bit longer to understand and get comfortable with the 831(b) structure.

“It's still a very valid structure if set up properly. It can be extremely meaningful and beneficial to companies,” she says.

Doing it the right way

Although the 831(b) election for captives has existed since 1986, microcaptives have come under increased scrutiny from the IRS after it was labelled as a ‘transaction of interest’ in Notice 2016-66 in November 2016.

One advantage of an 831(b) captive is that earnings from premiums are not subject to federal income taxes; only investment income is taxed. The maximum annual premium was $1.2 million, but this increased to $2.2 million on January 1, 2017.

In the last few years, the IRS has audited more of these captive structures in the belief that small businesses are using them to insure against improbable risks that they never pay claims on, and the premiums then return to the business owners with little or no tax.

Charnley acknowledges that she would not be surprised if the IRS goes after similarly structured entities to the Avrahamis’ captive, Feedback Insurance Company.

“It’s low-hanging fruit for them because they are pretty poorly set up,” she says. “The facts around the Avrahami case were quite blatant; I don’t think it would be very hard for the IRS to go after similarly structured captives. I personally welcome it as they shouldn’t have been set up in the first place.”

At Marsh Captive Solutions, Charnley emphasises, the company has never advised a client—and never will—to establish a captive purely for tax purposes.

“The main intent of a captive should never be to set up for tax purposes. There should always be a business reason. Avrahami essentially crystallised that; that is to say a number of structures are not doing exactly that, and are potentially capitalising on the tax efficiencies without necessarily having the substance to the formation and the transaction,” she says.

She goes further to say that the case confirms what the industry has already known—or should know—in that the premiums have to be set properly, the exposures have to be relevant, and the capitalisation has to be appropriate.

“Any well-educated and experienced advisor should be able to help a client know how to structure a captive properly,” she says.

She also believes the that there is adequate guidance of what is, and what isn’t, an insurance transaction.

“There’s always an interpretation, and we certainly work with many captive tax attorneys if there’s ever any level of doubt to provide a legal opinion on a structure for our clients,” she adds.

Giving power to the mid-market

The biggest market opportunity for 831(b)s, in Charnley’s opinion, is for midsize firms—whether publicly or privately held—which are looking to evolve their risk management capabilities and take more control over their risk.

“Companies are now evolving. The world is starting to experience exposure that it didn’t 10, 15 or 20 years ago, such as cyber. Companies are trying to understand and quantify the risk themselves and are getting more comfortable with retaining that risk as opposed to simply swapping dollars and paying a carrier for 100 percent coverage.”

Charnley explains that captive structures can provide the parent company with a more structured approach to retaining and financing its own risk, and over time—if they have a good risk management structure and strategy and are controlling their losses—the surplus will grow.

“As their surplus grows, they can see it tangibly in the captive balance sheet and it gives them the confidence to take on more risk, perhaps buy less insurance, and essentially become less controlled by carriers, and take ownership of risk financing for themselves.”

She says a good example of this are the many hospital systems in the US that have captives. “Few , if any, would be taking the 831(b) election or any type of tax benefit because many of of them are non-profits and thereforeit’s irrelevant to them.

“But they form captives for all those reasons—to have really good corporate discipline and best practices in retaining their own risk.”

In terms of the future, Charnley views 831(b)s as a significant growth opportunity.

“Not only would we expect growth within the  number of companies simply filing 831(b)s, but more importantly, we expect the midsize sector as a whole being the primary growth area, regardless of whether they file an 831(b) election.

“That is worldwide, not just in the US. We’re seeing midsize growth in Europe, perhaps with companies using a cell facility. We’re also getting a lot of interest from midsize companies in Asia and Latin America.

“This is not just a growth wave of the sector in the US; this is a midsize growth sector across the globe that we believe will continue.,” she concludes.