4 September 2022ArticleActuarial & underwriting

Still under the IRS’s microscope

Looking at the world of microcaptives, it would be fair to say that in the past year they have appeared in a lot of headlines.The main reason has been that a specific kind of microcaptive, labelled as 831(b), has been the target of prolonged attention by the Internal Revenue Service (IRS).In June 2022 the IRS finalised its annual “Dirty Dozen” scams list, which covers areas that it regards as illegal tax schemes, for the 2022 filing season. In this year’s list, the IRS specifically targeted “abusive microcaptive insurance arrangements”, wherein promoters, accountants, or wealth planners persuade owners of closely held entities to participate in schemes that lack many of the attributes of insurance.For example, coverages may “insure” implausible risks, fail to match genuine business needs or duplicate the taxpayer’s commercial coverages. The “premiums” paid under these arrangements are often excessive and are used to skirt the tax law.According to David Slenn, partner, tax trusts and estates at US law firm Akerman, using the word “controversial” about the US captives market is appropriate, with a lot of the controversy being driven by the IRS, with all kinds of procedural issues on top of substantive issues.Slenn pointed out that recent procedural developments included the General Accountability Office and its review of the of the IRS and its actions, and the Supreme Court rendering its opinion on potential procedural missteps that were taken in classifying certain captive transactions as reportable transactions.“Then you’ve got all the substantive woes that the microcaptive industry is experiencing,” Slenn explained. “There were four Tax Court opinions and for the first time a US Circuit Court of Appeals opinion, which basically blessed the way the Tax Court was approaching microcaptives.”Slenn said that some in the microcaptives sector have always complained that there’s not enough guidance on this area and asked why isn’t the IRS providing guidance. However, there are now four Tax Court decisions and a Circuit Court opinion that agrees with the Tax Court’s approach. Consequently, Slenn said, the excuse that there’s no guidance out there no longer applies.

Legal clarity

“The guidance includes Reserve Mechanical in a foreign withholding context, domestic captive cases that have been decided, cases that involve taxing the captive’s income if the insured was denied a deduction, risk pool cases that have been decided, a non-risk pool case with the Caylor decision—there are all kinds of fact patterns and that’s certainly some guidance,” Slenn explained.“Then the Supreme Court decided that the Anti-Injunction Act did not prevent advisors from challenging whether the IRS complied with the Administrative Procedure Act (APA)—there was a recent decision in which, on remand, the district court found the IRS did not comply with the APA when issuing Notice 2016-66.“However, the court did not require the IRS to return all the reportable transaction forms back to taxpayers nationwide.”Slenn pointed to other issues, which include microcaptive promoter Celia Clark suing the IRS for dragging its feet for years before imposing massive promoter penalties, along with a lawsuit involving the issue of whether the state of Delaware can withhold documents under Delaware insurance law, where the IRS seeks those documents in its investigation of microcaptives.There is also the CIC Services lawsuit, where the IRS was found not in compliance with issuing Notice 2016-66, but recently again the judge narrowed that release to require the IRS turn over those forms to the promoter, not taxpayers nationwide.“Where does that leave us? There are these procedural battles but on substantive grounds the IRS has a perfect record in cases that have gone to trial,” Slenn said.“A lot of attention was given to the Puglisi case, the stipulated decision involving a microcaptive programme, but that decision didn’t go to trial on the merits. There are stipulated decisions all over the Tax Court involving microcaptives, you just never hear about them.”A stipulated decision is one where the parties agree to it. It may or may not involve a payment, it depends on what was agreed upon.Not all stipulated decisions are pro-taxpayer, but the public seldom hears about those, as the IRS doesn’t broadcasting its stipulated decisions, he added.In addition, there is civil litigation, which includes captive-related class actions. Although these have subsided in the public eye, Slenn doesn’t think that civil litigation is going to completely disappear.

Cautious captive interest

Despite these actions, Slenn said, there’s still interest in captives. Advisers are being extra-cautious about what clients enter into and he thinks that the enterprise risk programmes that rely on pooling are still the number one IRS target. As a result, captives that involve commercial coverages or dealer-type captives, employee benefits, and so on, will not be seen as a big issue.Slenn believes that business owners are being advised to avoid 831(b) elections altogether. People are still concerned about whether they need to report annually to the IRS and are therefore avoiding borderline issues that might attract the attention of the service. Slenn therefore sees continued interest in captives, but the interest in 831(b) enterprise risk captives is decreasing.He defines enterprise risk as being the coverage that a company typically has not had historically but which they now need.“That’s supposed to be their marketing pitch: coverages that you never considered but you should,” Slenn explained. “The reason you had never considered them is probably that you didn’t need them.“That’s the marketing pitch but it’s also an argument the IRS is using. If you paid $50,000 for your commercial and all of a sudden you’re paying a million or two million for coverages that you’ve never needed, then you can see why the IRS will be curious.”Slenn does not think that the IRS has anything against captives. Instead, he thinks that they are aware of captives being abused and are not going to ignore it; it’s not captive insurance in general, it’s a certain type of captive programme that is being targeted. He also wondered how many more legal decisions on captive misuse are needed before the abuses cease.“The IRS is looking at a particular type of captive where expensive coverage is being bought for exposures that have never resulted in claims in the past, and the question is: why?” Slenn pointed out.“Why would you pay that much money for something you’ve never had any losses for, that’s one of the big questions the IRS will focus on. This is not to say such a coverage is abusive per se, but it’s something the IRS will closely scrutinise.”According to Slenn it’s becoming much clearer where the legal line and the position of the IRS lie. As a result, those behind the abusive captives are winding them down and those that are planning to create a captive are doing so for business reasons. Although this might result in losses, Slenn points out that that’s the nature of insurance: it’s fortuitousness.

A silver lining?

The microcaptive sector is going to continue to see the fallout of this, Slenn feels. There will be a period of transition where the number of captive owners that were using questionable coverages will eventually phase out and captive insurance in general will come stronger out of this mess.This will lead to a lot more focus on why this being done—the feasibility study behind the creation of a captive is going to be looked at critically—and it should be.Slenn pointed to Vermont as having set a good example.“Vermont never signed on for any of this, it was never a haven for 831(b)s. It did not sign the amicus brief in the Tenth Circuit appeal, so Vermont comes out of this unscathed and viewed as a leader for how a domicile should be run,” Slenn said.“Vermont was in it for insurance the whole time. They did not look at 831(b)s as an opportunity to prop up their insurance department—they didn’t need to. The big players out there, the big captive managers who didn’t make this a priority for them weren’t going to live or die with the 831(b) election, they’re not going to be impacted by this.”As well as coming out of the 831(b) controversy unscathed, some might even be stronger. This is because people might look at other providers and other domiciles as being victims of bad practice and void them.Instead, they’ll gravitate to the people who were doing it right the whole time. So, for all the storm clouds that have surrounded microcaptives, there just might be a silver lining.