Strangled by the regulations - is IRS’s 831(b) diktat a step too far?

Matthew Queen (pictured), attorney at law at The Queen Firm, lays out why he views the IRS’s new 831(b) regulations as unconstitutional.

The IRS has launched its latest attack on the 831(b) election, issuing final regulations that label certain micro-captive insurance transactions as "listed transactions" or "transactions of interest". Ironically, these regulations come during a record-breaking wildfire season and in the wake of a severe hurricane season, when insureds desperately need insurance solutions. The IRS now threatens to eliminate one of the most effective options to resolve commercial insurance problems. 

This article aims to provide a summary of the regulations, demonstrate why they are problematic, and outline how the regulations violate multiple areas of federal law. Finally, it  outlines short, medium, and long-term solutions to resolving the IRS’s war on captive insurance. For more detailed data and analysis on the constitutionality of the IRS’s regulations, the following white paper provides a road map for the Executive Branch to instruct the Treasury Department to issue a Revenue Ruling providing relief for small captive insurance companies.

Click here to view document.

Regulations Overview

The new rules require reporting of captive insurance companies making the 831(b) election in specific scenarios:

1. Listed transactions: The IRS deems these tax avoidance schemes, imposing hefty penalties for non-disclosure. A captive becomes a listed transaction when:

• An insured entity's owner holds at least 20% of the captive

• The captive makes the 831(b) election

• The captive finances related parties

• The captive maintains a loss ratio below 30% over 10 years

2. Transactions of interest: The IRS considers these potentially tax-avoidant, mandating detailed disclosures. A captive falls into this category when it meets the above criteria but either:

• Satisfies the financing factor, or

• Maintains a loss ratio of 60% or less over 10 years

Problematic Implications

These regulations create numerous practical and legal issues:

1. They burden captive owners and managers with excessive complexity, mandating IRS disclosure for any 831(b) captive triggering the rules within a decade. This imposes costly auditing and reporting requirements while empowering the IRS to penalise even inadvertent non-disclosure of past transactions.

2. The financing factor amounts to a government cash grab. It forces profitable captives to distribute underwriting profits in ways that trigger taxation or face reporting requirements. Investing profits into business expansion could lead to prosecution for operating a "tax shelter" – a standard applied to no other form of insurance.

3. The loss ratio factors lack rational basis. They reflect the IRS's misguided suspicion of underwriting profits, ignoring the fundamental goal of insurance: to generate more premiums than claim payments. Regarding this arbitrary profitability threshold as "tax abuse" stems from bureaucrats who misunderstand insurance operations. No other industry faces accusations of running a tax shelter for being too profitable.

The IRS justifies these regulations by citing its experience prosecuting allegedly abusive 831(b) captive transactions. While claiming not to eliminate the 831(b) election outright, the IRS imposes onerous reporting requirements and threatens prosecution for "abusive" transactions. This thinly veiled attempt to eliminate the election through non-legislative means undermines the intent of Congress in creating the 831(b) option for small insurance companies.

What is insurance?

The IRS bases these rules on an incorrect foundation. It defines "insurance" for federal income tax purposes using an outdated four-prong test from Helvering v LeGierse: 1) risk shifting; 2) risk distribution; 3) an insurable risk; and 4) insurance in the commonly accepted sense. This holding is superseded by the progression of commercial property and casualty insurance. 

In 1941 the Supreme Court issued an opinion in Helvering v LeGierse. At issue was an extinct transaction involving the interplay of a purported life insurance policy with an annuity. The transaction was common during Depression-era America as a means by which to escape the estate tax. The Supreme Court has not revisited the definition of insurance for federal income tax purposes since LeGierse and Circuit Courts disagree on the holding’s continued relevance. 

The world has changed since early 1941. America entered and eventually, with its allies, won the Second World War. In 1945 Congress passed the McCarran-Ferguson Act, declaring that the business of insurance is state law. America went through a cultural revolution in the 1960s. And again in the 1980s. And again, today. Yet, the limited definition of insurance from a life insurance case decided prior to the invention of captive insurance remains the IRS’s standard for what constitutes insurance. 

Most practitioners overlook the reality that the holding is misinterpreted by the IRS as a four-part test. The actual holding included only two parts: risk shifting and risk distribution. The Tax Court in the Carnation case added the other two prongs from LeGierse’s dicta in the late 1970s, effectively legislating from the bench. The Tax Court missed the mark and handed the IRS an incredible weapon – in effect the power to unwind virtually any captive insurance transaction it disfavours on shaky reasoning. 

Risk shifting is not a proper element of property and casualty insurance. It is fine for life insurance, which lacks deductibles, self-insured retentions, or corridors. However, property and casualty policies often involve large deductibles in commercial transactions. Many 831(b) captive insurance programmes primarily finance large deductibles (e.g., $250,000 retention or more) for traditional insurance coverage. Mandating insurance transactions to require absolute "risk shifting" misunderstands how insurance works. 

This is not merely opinion. The IRS was pilloried on this exact issue in the 1980s in the case of Sears v CIR. It took the position that premiums paid to Allstate were not insurance for federal income tax purposes since Sears owned Allstate. 

The Seventh Circuit lambasted the IRS for questioning Allstate's status as insurance and criticised its reliance on LeGierse to invalidate the insurance transaction. The court emphasised that risk shifting does not apply to modern property and casualty policies, as self-insured retentions, corridors, and deductibles constitute risk retention. Therefore, failing to shift risk per LeGierse cannot justify unwinding an insurance transaction. 

Further, the pair of Ninth Circuit cases, AMERCO and Harper Group, generally state that risk shifting manifests out of sufficient risk distribution. Ironically, the IRS correctly critiqued these holdings on the grounds that these holdings fold the element of risk shifting into risk distribution. The net effect of that is to abrogate risk shifting as an element of insurance. The IRS was right. Risk shifting is not a real element of insurance. 

The IRS's regulations rely on the supposed "four prongs of the test" from this case and its progeny. The obsolescence of this case renders the IRS's regulations arbitrary and capricious, as they lack valid legal precedent. A narrow insurance definition addressing an extinct life insurance transaction cannot serve as the basis for defining all insurance. 

Most captive insurance case law emerged from the Tax Court’s incorrect view of insurance, as misunderstood by the IRS, through the lens of a ruling eroded by the march of time. Circuit Courts are primed to reconsider the holding in LeGierse. Since there is a significant difference of opinion as to the applicability of LeGierse in property and casualty transactions between the Seventh, Ninth and other circuits, this is an issue very likely to generate interest from the Supreme Court of the United States. The IRS needs LeGierse to wield power in any way it sees fit. That is unjust and unconstitutional.

The Business of Insurance is State Law

In 1945 Congress declared that the business of insurance is state law. The IRS is not permitted to “invalidate, impair, or supersede” state law governing insurance companies. The IRS argues that these regulations do not “invalid, impair, or supersede” state law because tax code provisions merely impose taxes, separate from state insurance laws. It also argues McCarran-Ferguson allows some federal insurance regulation.

These arguments lack merit, as the "listed transaction" designation effectively labels captive insurance arrangements abusive tax shelters. The IRS shamelessly suggests taxpayers can obtain state insurance licences and operate 831(b) captives but must face consequences if the IRS deems the transaction abusive. This is akin to the mafia advising a business owner that there is no obligation to pay protection money but there are consequences for failing to do so.

In practice the IRS’s rules supersede the state’s position that a transaction qualifies as insurance. The net effect of declaring a transaction illegal for federal income tax purposes is that the state’s insurance licence is nothing more than a piece of paper. For the IRS to hide behind legalistic layers of transactions allegedly relating solely to the income tax implications of a captive insurance company is insulting. The effect of declaring a transaction a “tax shelter” is that the transaction is illegal. Where states authorise a captive insurance company to do business, but then later on the IRS deems that transaction arbitrarily a “tax shelter”, the clear intent is for the IRS to operate as a federal regulator of insurance.

The IRS’s audacity to hide its intent behind the thin veil of purported tax code enforcement is rich given that one of the IRS’s primary weapons to prosecute its cases is the step transaction doctrine. The IRS promotes the view that tax transactions should be viewed with an eye on substance over form. In practice, this means that if a taxpayer layers a transaction together with a series of superficial business decisions that ultimately yield no economic benefit aside from lowering taxes, then the IRS pierces through the whole litany of paperwork pursuant to the step transaction doctrine.

Likewise, the IRS’s feeble attempt to hide its intent to elevate itself to a de facto federal insurance regulator vis-a-vis the finalised regulations is transparent. The IRS views 831(b) captive insurance transactions with suspicion and passed arbitrary and capricious rules pursuant to the Treasury Department’s rulemaking power in order to eliminate small captive insurance companies. This is unconstitutional. Congress passed the 831(b) election. Whether the IRS likes it or not, the election is part of the US Code and the IRS lacks the authority to remove it sans legislative intervention.

What is the purpose of 831(b)?

Starting a small insurance company is tough. Insurance companies need money to pay claims and all states mandate minimum solvency standards in order for such a company to secure its licence. Also, insurance companies pay claims. Finally, all income is taxable. Taken together, this creates a very difficult situation for small companies to enter the market since all insurance companies need to balance underwriting with claims, solvency and taxes. This challenge was insurmountable for most small mutual companies in the first half of the 20th century thus Congress passed the precursor to the modern 831(b) election permitting an exclusion of underwriting profit from small insurance companies. 

The IRS correctly notes that the 831(b) election is not merely for captive insurance companies. It was passed by Congress to create an environment for new insurance carriers to form and flourish. The graveyard of insolvent mutuals from the early 20th century stands as a testament to the necessity of the election. 

This issue was revisited in 2015 during deliberations on the PATH Act. In those hearings Senator Chuck Grassley noted that farmers in rural communities continue to rely on these small mutuals and that the 831(b) election is necessary to accommodate the needs for small insurance companies to pay claims. See Transcript of Open Executive Session Relating to Inter Alia, an Original Bill Relating to Modifications to Alternative Tax for Certain Small Insurance Companies, Hearing Before the S. Comm. On Finance, 115th Cong. (Court Reporting Transcript of Lisa Dennis), at 56 (2015) (Statement of Senator Grassley – concerning Small Mutual Inflation Bill).

To justify its final rules, the IRS misrepresents the nature of the 831(b) election. It posits that “Congress enacted section 831(b) in the interest of simplifying the Code, not to encourage the use of small captive insurance companies.” This is intentionally misleading. Congress passed the precursor to the 831(b) election to assist with the development of small insurance companies. Captive insurance companies are, almost by definition, small insurance companies. The IRS attempts to distract taxpayers by accurately noting that nothing in the 831(b) legislative history explicitly states that the election is for captive insurance companies. 

That is a distinction without relevance. The reason that captive insurance companies need the election is to help them generate sufficient capital to pay claims. This is explicitly stated by Congress; the IRS knows this because it lobbied against the 831(b) election during the PATH Act’s passage, and this recharacterisation of the 831(b) legislative history is an intentional rewriting of history in order to promote the IRS’s anti-captive insurance position. 

Troublingly, the net effect of the IRS’s position is that some taxpayers are more equal than others. If a taxpayer wishes to use captive insurance as a means by which to start a new venture in the insurance industry, that taxpayer is forced to fight endless battles with the IRS as a suspected criminal. In contrast, if a taxpayer raises significant amounts of capital to start an insurance company, then the IRS is fine. The rich win and the middle market is out in the cold.

Next Steps

There is a short-term solution. The Executive branch of the US government can instruct the Treasury Department to issue a Revenue Ruling outlining the problems with leveraging LeGierse as the definition of insurance and outline various elements creating a rebuttable presumption that a captive insurance transaction qualifies as insurance. 

In the medium term, captive managers and owners can challenge these rules in federal court. Ryan has already done so on a handful of grounds relating to the Administrative Procedures Act. There are more opportunities to challenge these regulations than the counts in that complaint.

Finally, the long-term solution is for Congress formally to address captive insurance transactions and enact a law protecting them. Several lobbying organisations are promoting this, but captive owners and managers need to promote the importance of this through their representatives and senators. 

Matthew Queen can be contacted at: matthew@thequeenfirm.com

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