6 August 2019Accounting & tax analysis

The uncertain future of 831(b)s

Microcaptives—also known as small captives, or 831(b) captives—have had a rocky last few years. They’ve contended with Internal Revenue Service (IRS) audits, losses in the US Tax Court, and alleged conspiratorial conduct from prominent captive management companies.

Syzygy Insurance v Commissioner marks the third victory for the IRS against microcaptives in the US Tax Court, following Reserve Mechanical in 2018 and Avrahami in 2017. While this may spell further scrutiny for the sector, much of the captives industry is confident this will not deter companies from forming legitimate 831(b) captives, and in fact these cases can arguably provide guidance.

“With each new ruling we get a clearer picture of what the tax courts may view as acceptable practices of an insurance company,” says Nate Reznicek, director of operations at CIC Services.

“Each opinion is also a result of the individual facts and circumstances of the individual cases. Although the rulings were not favourable to the taxpayer, it’s also a general consensus in the industry that the recent rulings involved captives with less-than-stellar fact patterns.”

While 831(b) captives have existed since 1986, they have come under increased scrutiny from the IRS after being labelled as a ‘transaction of interest’ in Notice 2016-66 in November 2016.

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

Microcaptives have now been listed on the IRS’s ‘dirty dozen’ list for the fifth consecutive year—a list that highlights what the IRS considers to be common scams that taxpayers may encounter at any time. In certain abusive microcaptive insurance tax shelters, promoters, accountants or wealth planners are said to persuade owners of closely-held entities to participate in schemes that lack many of the attributes of insurance.

Avrahami v Commissioner was the first high profile microcaptive case, in which the US Tax Court disallowed the “wholly unreasonable” premium deductions the taxpayer had claimed under a section 831(b) arrangement, concluding that the arrangement “was not insurance” under long established law.

Judge Mark Holmes—the judge in the Avrahami case—will be the judge in the remaining two microcaptives awaiting opinion, Caylor Land & Development v Commissioner, and Wilson et al v Commissioner.

What went wrong with Syzygy
“The Syzygy opinion is no surprise,” says Brandon Keim, tax law specialist and partner at Frazer Ryan Goldberg & Arnold.

“I previously commented that I thought Syzygy would suffer the same fate as the captive in Reserve Mechanical if the court accepted the government’s contention that the layered pooling arrangement lacks actuarial support, and indeed it has,” he says.

Highland Tank & Manufacturing, a family-owned business in Pennsylvania that provides custom-built steel storage tank solutions, formed Syzygy Insurance Company in Delaware in December 2008 with California-based captive manager Alta Holdings.

The captive distributed risk by participating in the US Risk and Newport Re captive insurance pools and reinsuring unrelated risks. US Risk was the fronting carrier for Syzygy from 2008 to 2010, and Newport Re from 2010 until 2011.

Judge Robert Ruwe’s opinion, filed on April 10, ruled that although Syzygy was organised and regulated as an insurance company, met Delaware’s minimum capitalisation requirements, and paid a claim, its insurance-like traits did not overcome the arrangement’s other failings.

Ruwe’s opinion read: “Syzygy was not operated like an insurance company. The fronting carriers charged unreasonable premiums and late-issued policies with conflicting and ambiguous terms.”

The US Tax Court examined a number of key issues in the case, relating to how premiums were calculated, Syzygy’s policies, how risk was distributed, the lack of claims submitted, and the captive’s questionable investment choices.

The court held that premiums were not actuarially determined, suggesting there had been no evidence to support the calculation of premiums. The captive manager Alta set the premiums without providing any underwriting models outlining its pricing methodology.

Keim continues: “Captive owners and managers that rely on a layered pooling arrangement need to ensure that there is actuarial support for the premium splits, or abandon the structure for a first dollar quota share arrangement.

“Actuarial support for premium determinations continues to be a requirement to be accepted as an insurance company by the Tax Court.”

While not submitting any claims does not necessarily show that a captive is not operating as an insurance company, the insured in the Syzygy case had admitted they were aware of losses that would have been eligible for coverage but did not report them, Reznicek explains.

“As these losses were related to one of Syzygy’s most expensive insurance policies (and one of the key risks the insured stated as a reason for forming the captive) the Tax Court ruled that ‘failure to submit claims after paying deductibles is indicative of the arrangement’s not constituting insurance in the commonly accepted sense’,” he says.

First of its kind
David Kirkup, chief operations officer at Captive Alternatives, points out that Syzygy is the first of the recent Tax Court cases in which a fronting company was used to issue policies.

“The majority of Syzygy’s policies were written for excess coverage, and the largest policy was a kind of generic deductible reimbursement coverage. Additionally, policies were not issued in a timely manner: in two of the three years in question, the policies were not issued until after the policy period had already ended,” says Kirkup.

“Ideally, most coverage will be first dollar and not duplicative of existing coverage. Incidental excess and guaranteed asset protection coverages are acceptable, provided that a deep understanding of commercial coverages is present. Of course, policies should be issued as quickly as possible and always timely for the coverage period.”

In terms of investments, Syzygy largest two were life insurance policies that totalled more than 50 percent of the captive’s assets, with substantial restrictions on access.

The Tax Court stated: “We do not think that an insurance company in the commonly accepted sense would invest more than 50 percent of its assets in an investment that it could not access to pay claims.”

“It is interesting that this case is now citing Avrahami for reference, notwithstanding that Avrahami is a poster child for a ‘bad’ captive,” says Kirkup.

Uncertain future
These US Tax Court cases paint a negative picture of the industry, and the IRS has committed to curbing abusive arrangements through audits, investigations and litigation.

In fact, the IRS says, it has devoted substantial resources with more than 500 docketed cases in tax courts, and is conducting a number of income tax examinations of participants in these arrangements, along with investigations into captive insurance promoters.

In 2014, David McManus, then president of Artex Risk Solutions, confirmed the company was involved in an IRS investigation into the captive insurance industry, which he suggested involves a number of other captives managers who specialise in 831(b) captives.

Artex, among other captives service providers, would go on to be the defendants in an Arizona-based lawsuit at the end of 2018 that alleged they had conspired to design, promote, sell, implement and manage illegal tax-advantaged captive insurance strategies using attempted 831(b) elections.

In Dimitri Shivkov v Artex Risk Solutions, it is alleged the promoters of these 831(b) structures had sold the captive strategies for the purpose of receiving and splitting substantial fees. The lawsuit also stated that the transactions under the captive insurance strategies were not insurance, the plaintiffs and class members’ captives were not insurance companies, and their attempted 831(b) elections 
were unlawful.

One of the attorneys representing the plaintiffs in Shivkov v Artex, David Deary of Loewinsohn Flegle Deary Simon, says he believes the conspiracy extends further than the named participants to other major microcaptive managers.

Another case, Pilot Series of Fortress Insurance v Commissioner, in which the taxpayer is accused of using a captive as a tax shelter, was scheduled for trial on June 3, 2019, although the case has now settled, with the taxpayers conceding beforehand.

The case involves Jim Cameron, the sole shareholder of glass manufacturing business Cameron Glass, based in Oklahoma, who formed Pilot Series of Fortress Insurance (Pilot) as a Delaware-based captive with the assistance of Artex Risk Solutions.

Pilot subsequently made an election to be taxed as an insurance company under 
IRC 831(b).

It is alleged that the ownership of the captive was structured to allow some or all of the wealth accumulated in it to be passed to Cameron’s children and grandchildren, in order to avoid the application of gift taxes or the use of Cameron’s lifetime exclusion.

An unnamed source told Captive International that it is safe to assume there will be further class actions filed against captives managers in the next year or two, and that the IRS is likely to continue to win the Tax Court cases.

“Quite frankly, if you work for a manager that continues to promote 831(b) tax-efficient solutions then you should run,” the source said.

“There is an argument that the purveyors of these captives (prior to Avrahami) were simply aggressively working within the law. Now that the case law has started to emerge, the potential of criminal liability for promoting these transactions is very real.”

At the start of the year, the Captive Insurance Companies Association (CICA) published new guidance on the use of risk pools following Reserve Mechanical and Avrahami. Commercial Insurance and Captive Insurance Industry: Commonly Accepted Practices provides a review of the structure and use of risk pools, addresses some of the common misperceptions, and provides guidance on commonly accepted insurance practices.

Captive insurance associations and many industry professionals have always advocated best practices for microcaptives, which continue to be a cost-effective method for smaller and medium-sized companies to get involved in alternative risk financing.

“Market factors aside (adverse selection, hardening market, etc) we continue to expect significant growth in the captives space,” says Reznicek.

“Further rulings will continue to provide additional guidance to the industry and set an appropriate foundation for the formal transfer of risk and funding for future losses via captive insurance company ownership.”

Kirkup adds: “While we think that some of the issues will be clarified on appeal, ground rules to ensure small captive viability are beginning to emerge.”