831(b) Captive Tax law Update – Tax Law Changes Effective 2017, and Pending Tax Court Case

The IRS put a stake in the ground in 2015 adding 831(b) captives to its Dirty Dozen list. This does not mean 831(b) captives are abusive or tax shelters; it merely means the IRS has seen enough aggressive tax minimization planning using 831(b) captives to formally (indirectly) announce it wants to chill the growing use of such risk management structures, despite IRS senior tax counsel stating on several previous occassions they had no such intentions. The Protecting Americans From Tax Hikes Act of 2015 enacted early this year contains tax law changes to IRC code scetion 831(b). Beginning with tax years starting after December 31, 2016, these changes restrict continued use of 831(b) captives integrating estate tax avoidance ownership structures shifting the captive insurance company asset outside of the estate of the insured business owners. We will publish more soon on the exact impact of these new tax code changes which overall are positive for the vast majority of businesses and taxpayers benefiting by use of small captive insurance companies to improve risk management and risk finance programs.

IRS Challenging Perceived Abusive Captive Programs and Promoters

It has been widely reported there are some captive promoters who do a sloppy job in the design, formation and management of client captives, focusing primarily and nearly exclusively on the potential tax savings legislatively afforded such captive structures, rather than on improving a closely held enterprise group’s risk management programs as must be the primary focus of properly designed and formed captive insurance solutions. These allegedly abusively designed captives may not be deemed truly legitimate risk management programs on close inspection; if such is the conclusion on IRS review, assuming the taxpayers capitulate or lose in litigation, the captive owners and affiliated insured businesses are at risk of losing premium deductions while possibly having premium payments taxed as income to the recipient insurance company, and also being assessed substantially onerous penalities and interest. Criminal implications are even possible in extremely abusive situations. This can even happen when a captive is licensed by a US state as an insurance company, concluding definitively it absolutely is an insurance company under state law, yet the IRS concludes that for federal income tax purposes it is not an insurance company qualifying for use of federal statutory tax incentives afforded insurance companies.

The IRS challenge to¬†Benjamin and Orna Avrahami’s captive insuring their Arizona jewelry businesses, in litigation at this time, is currently one such case the IRS perceived as falling short of captive design, formation and management standards expected today to qualify as an insurance company for US federal taxation purposes. The dispute is pending in court as of the time this article was written. The IRS is attempting to prove the captive was not a legitimate risk management program meeting US tax law requirements. They are asserting deficiencies including but not limited to inadequate underwriting behind the captive design, no real risk of material claims arising from the exposures covered, and a primary business objective when setting up the captive of tax minimization and avoidance, not of risk management improvements.

Even if the underwriting and other design and operational elements meet practice standard muster, the IRS will likely argue the captive runs afoul of the Affordable Care Acts’ new Economic Substance Test rules, as well as other and predecessor tools/theories the IRS has in its war chest to challenge taxpayer reporting positions deemed to lack substance and go beyond legal tax avoidance into the area of being abusive and prohibited tax shelters.

The final court decision in the Avrahami case is expected to add additional needed guidance on several controversial issues taxpayers and the IRS often disagree on. In recent years, in cases where the taxpayers have stood up for themselves in court, the courts have overwhelmingly sided with taxpayers in most captive disputes. It would be a very good thing for both taxpayers and the government if more clarity in regulatory guidance were provided on issues of concern to the IRS as they did in 2002 with the now widely referenced safe harbor trilogy – Revenue Rulings 2002-89, 2002-90 and 2002-91 – which underlie the growth in use of smaller captive structure solutions since publication of the safe harbors.

Landscape Possibly Changing, Against Taxpayers to Some Respect, Due to Recent Tax Code Amendments

The new I.R.C. section 831(b) tax law changes taking effect for 2017 may increase the complexity for designing qualifying 831(b) captives, and will likely make it impossible to integrate materially valuable asset protection and wealth transfer planning benefits with a family business group’s enterprise risk management practice by having the captive ownership held by children or other lineal descendants of the insured business’ owners. ¬†Bottom Line: the tax law changes leave room for continued legitimate use of advanced captive insurance programs and structures; the changes will however likely eliminate or greatly restrict use of advanced estate tax, asset protection and wealth transfer planning integration where captive insurance companies are owned by children and grandchildren of a business owner, usually through irrevocable trusts as owners of the captive. Captives set up to achieve such ancillary benefits will need to be reviewed carefully by legal and tax advisers as it appears such benefits can probably be protected with proper planning.

Besides targeting ownership structuring that attempts to shift captive assets out of a business owner’s taxable estate and also out of reach of his or her creditors, the new tax law changing 831(b) rules also impact the qualifications for a captive desiring to qualify for the valuable 831(b) tax election. These new rules are flexible enough so that most if not all existing 831(b) captives will be able to continue for years to come, in most cases probably with little to no changes, assuming of course they have been properly designed, managed and operated. This is all tentative as the 831(b) tax statute changes are very recent and do not take effect except for captive years beginning in January 2017. So everyone has time to discuss and analyze and understand the impact and plan accordingly.

References and More Information:

  • Read the New York Times article published January 15, 2016 by Paul Sullivan, by clicking here.
  • Read more captive tax articles by clicking here.
  • For a good primer on the evolution of captive best practice standards, click here.

Disclaimer: Nothing herein is tax, legal or financial advice.