Recent IRS And Congressional Focus On Micro-Captives

Introduction

Captive insurance companies have been used for risk management purposes since the 1960s, when industrial corporations found insurance for their risks either challenging to find in the marketplace, or expensive. One solution was to form wholly-owned and controlled insurance companies (hence the term "captive") for risk management purposes. The primary benefits to captive owners are the ability to customize their risk management programs and to eliminate some of the overhead built into premiums charged by commercial insurers. Tax issues have also been a key consideration in the formation of captives, and they led to a long and tortured history of litigation between owners of captives and the Internal Revenue Service (the "IRS"). At this point, most of the contentious issues, primarily the deductibility of premiums paid to captives, and the tax treatment of the captives themselves, are largely settled. (Issues relating to captives have also been a matter of controversy in the insurance regulatory community. See, e.g., Highlights from the NAIC Spring Meeting on PBR and Captive Insurance Companies, April 16, 2015, and other Duane Morris Alerts cited therein.)

More recently, however, a number of advisors, accountants and estate planners have come up with a new use for captives. These advisors advocate the use of small captives (sometimes referred to as "micro-captives" or "section 831(b) companies1") for tax and estate planning purposes. Although the risk management purposes of micro-captives is part of the presentation of the benefits of micro-captives, some have been structured so that the tax and estate planning aspects completely overwhelm their insurance aspects. Both the IRS and Congress have taken notice of the use of micro-captives for tax and estate planning purposes.

Recent IRS and Congressional Activity

On February 3, 2015, the IRS issued a release addressing "Abusive Tax Shelters on the IRS 'Dirty Dozen' List of Tax Scams for the 2015 Filing Season." The release noted the following:

Another abuse involving a legitimate tax structure involves certain small or "micro" captive insurance companies. Tax law allows businesses to create "captive" insurance companies to enable those businesses to protect against certain risks. The insured claims deductions under the tax code for premiums paid for the insurance policies while the premiums end up with the captive insurance company owned by same owners of the insured or family members.

The captive insurance company, in turn, can elect under a separate section of the tax code [section 831(b)] to be taxed only on the investment income from the pool of premiums, excluding taxable income of up to $1.2 million per year in net written premiums.

In the abusive structure, unscrupulous promoters persuade closely held entities to participate in this scheme by assisting entities to create captive insurance companies onshore or offshore, drafting organizational documents and preparing initial filings to state insurance authorities and the IRS. The promoters assist with creating and "selling" to the entities often times poorly drafted "insurance" binders and policies to cover ordinary business risks or esoteric, implausible risks for exorbitant "premiums," while maintaining their economical commercial coverage with traditional insurers.

Total amounts of annual premiums often equal the amount of deductions business entities need to reduce income for the year; or, for a wealthy entity, total premiums amount to $1.2 million annually to take full advantage of the Code provision. Underwriting and actuarial substantiation for the insurance premiums paid are either missing or insufficient. The promoters manage the entities' captive insurance companies year after year for hefty fees, assisting taxpayers unsophisticated in insurance to continue the charade.

The IRS has been aware of the aggressive use of section 831(b) companies for some time: Reports in the trade press indicate that numerous audits of section 831(b) companies are ongoing.

Also in February, the Senate Finance Committee considered a legislative proposal that would increase the limitation on premiums from $1,200,000 to $2,200,000, but that would have significantly restricted the uses of section 831(b) companies by limiting to 20 percent the percentage of premiums that could be received from any one policyholder (or group of related policyholders), as well as prohibiting section 831(b) companies from assuming reinsurance.2 However, the restrictive provisions were met with opposition and did not survive a voice vote of the Committee.

On April 14, 2015, Senator Orrin Hatch introduced S. 905, a bill that would, as did the earlier proposal, increase the premium...