Shivkov v Artex and more 831(b) blues
“Captives that are insuring dubious risks with flimsy actuarials supporting the insurance rates are not likely to withstand scrutiny.”
A common misconception is that people think they sound smarter if they use big words. At least one peer reviewed study from Applied Cognitive Psychology discredits this theory. Use simple words and get your point across.
Some captive insurance managers suffered from a similar problem. They thought that if they put together a complex captive insurance structure that carefully mirrored every court holding pertaining to risk shifting and risk distribution that they would survive an 831(b) challenge.
The IRS proved those managers wrong. After Notice 2016-66 hundreds of 831(b) captives were challenged by the IRS as sham operations. For the past two years the IRS has secured an enviable record of success in captive insurance settlements and Tax Court victories.
Some of those captive managers and promoters are now in jeopardy. A recent case seeking class action status, Dimitri Shivkov v Artex Risk Solutions, alleges that Artex violated the Racketeer Influenced and Corrupt Organizations (RICO) Act in putting together deficient captive insurance structures. The evidence in this case has not been made public so it is difficult to say whether the court will approve the class or whether the plaintiffs have a good case.
Many 831(b) captives were transparent tax shelters created by promoters to take advantage of an unintended consequence in the Internal Revenue Code. The promoters may point at their clients and argue that the captive owners understood what they were getting into, but that is not likely to fly in front of a jury. This case is likely to settle for a lot of money.
This class action is probably not the last word on 831(b) captive insurance tax shelters. Thousands of 831(b) captives were incorporated from 2010 to 2016. Many of those captives insured dubious risks, never paid a single claim, and participated in a risk pool similar to those found in the Avrahami and Reserve Mechanical cases. Expect more litigation from aggrieved captives owners who had to pay a couple million in fines and penalties to the IRS.
Start making sense
There is nothing wrong with a small captive insurance company but the 831(b) election should be an afterthought. If it makes sense, then make the election. Every taxpayer with a captive writing less than the statutory gross written premium should consider the 831(b) election. But captives that are insuring dubious risks with flimsy actuarials supporting the insurance rates are not likely to withstand scrutiny.
Fortunately, 831(b) tax shelters have fallen out of use. However, other issues can create problems for captive managers.
In December, about 4,000 home health employees filed a class action alleging that the Healthcap Assurance captive insurance company was used to avoid paying Medicaid-funded workers their full additional wages and benefits in violation of the Wage Parity Act. The complaint alleges that the captive was used to create a single employer welfare benefit plan to appear in compliance with the Wage Parity Act but really misappropriated Employee Retirement Income Security Act (ERISA)-covered Plan assets.
There are few areas of captive insurance more complex than benefits. Using a captive to fund or partially fund an employee benefits programme can create tremendous problems if it is improperly managed.
There are scores of unintentional mistakes that can trigger significant penalties from the Department of Labor. Many captive managers decline to manage benefits captives aside from funding a portion of a stop-loss plan above the employer’s self-insured retention. This is a safe strategy.
Any captive manager or promoter working in the ERISA space needs a lexicographic understanding of how the captive complies with prohibited transactions and other regulatory issues. It is best to work with ERISA specialists when setting up these captives.
Hopefully the Healthcap Assurance lawsuit is a misunderstanding. Unfortunately, the lawsuit will be a tremendous cost of resources even if there is no merit to the plaintiffs’ claims. This reinforces the broader point for captive insurance benefits funding: work with ERISA compliance experts before applying for the insurance licence.