8 August 2018Accounting & tax analysis

US Tax Court cases should not hurt legitimate captive market

Upcoming US Tax Court cases - Caylor, Wilson, and Syzygy Insurance - have likely been selected by the IRS to target deficient captive models; but the outcomes of these cases should not hurt growth in the legitimate captive market.

This is according to David Kirkup, CFO and COO at Captive Alternatives, speaking to Captive International ahead of the VCIA annual conference in Burlington, Vermont.

“Presumably the IRS has carefully curated the upcoming cases to highlight what they view as deficient captive models,” said Kirkup. “We think some of these new cases may have firmer foundations on risk distribution and pricing and will have the benefit of the court rulings on Avrahami in their defense submission, so it will be interesting to see the court’s opinion and whether they believe that any captive models can have substance.

“In particular, Caylor bases its risk distribution on having multiple sibling entities, so is likely of peripheral interest to mainstream small captives, but will likely also address reasonableness of pricing and coverage.”

Kirkup suggested that Reserve Mechanical and the Avrahami case were both likely selected because the IRS viewed them as poor examples of the captive model, and that the cases highlight the IRS strategy of focusing on the underlying pooling mechanism and risk distribution.

“If the pool is found to be faulty, then all the participants in that pool may lose their 831(b) election. Anecdotal reports tell us there are already 800 or more captive cases headed to tax court, and increased focus through audits and annual returns have been in place for a while,” he said.

One of the positive side of these cases, in Kirkup’s view, is that the IRS - in defining a “bad captive” - is being forced to provide more guidelines as to what constitutes a good captive.

“But there is increasing frustration in the insurance industry that a lack of straight-forward guidance on small captives is failing to provide a way forward to America’s small and mid-size businesses in their desire to use all the legitimate tools of modern risk management,” he added.

Kirkup said he does not see the legitimate captive market shrinking as a result of these cases.

“There will be increased efforts to leverage the captive to reduce traditional insurance premiums – in both casualty and benefits spaces, not just to formally fund uninsured enterprise risk,” he explained.

“Smaller companies have existential risks that are usually ignored and uninsured – putting people, profits and, yes, taxes in jeopardy. Large Enterprise Risk claims, such as product recall can be reimbursed 50 percent or more from a legitimate risk pool, demonstrating a significant advantage beyond the tax benefit of the 831b election. Captives clearly have a place.”

Kirkup remains optimistic for the future of properly designed captive programmes that address risk shifting and distribution, can demonstrate arms-length pricing and management, and have documented histories of claims reserving and loss payments.

“It is also worth pointing out that regardless of the outcome for the IRS in these cases, the 2015 Path Act confirms that Congress fully supports the 831(b) captive option. Thus, at some point the fundamental IRS dichotomy on captives of “Yes you can, but no you can’t” needs to be addressed – with a comprehensive guide to doing things the right way. We are actively involved with the Self Insured Institute of America (SIIA) who will help lead the way in demonstrating the legitimacy of captives and self-insurance,” said Kirkup.