Jan 19
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831(b) Captive Tax law Update – Tax Law Changes Effective 2017, and Pending Tax Court Case

By | 831(b) tax issues, Captive Best Practice Standards, Captive Taxation | No Comments

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.

Dec 09
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831(b) Captive Insurance Company – 2016 Legislative Development Hot Topics

By | Captive Legislatibve Developments, Captive Taxation, IRS Audits of Captive Insurance | No Comments

Jay Adkisson, former Chairman of the Captive Insurance Committee of the American Bar Association, is again out front alerting the insurance industry about important developments. In his December 9th article titled “2015 Extender Bill May Throw Out 831(b) Captives Baby With The Bathwater,” Mr. Adkisson cautions that passing such legislation without proper debate, industry input, and fine tuning will have negative economic consequences while minimally impacting government income tax collections through the bills hidden tax increases. He asserts the 2015 Extender Bill as written fails to protect legitimate use of 831(b) electing insurance companies by successful closely held businesses across the country. “Today, section 831(b) is used by numerous small insurance companies to fill gaps in traditional coverage where large insurance companies have either completely left the marketplace, or charge so much in premiums that the purchase of such insurance is uneconomical. Many smaller businesses today would be completely exposed to such things as products liability claims, employee practices claims, environmental claims, and numerous other claims but for their coverage from 831(b) insurance companies. This is the baby,” Mr. Adkisson states in his Forbes article.

Ironically, Mr. Adkisson is probably the single most responsible captive industry professional pointing a negative spotlight on the 831(b) captive industry; articles he has published in recent years have heightened concerns within the IRS and within state regulatory circles about the growing use of 831(b) qualifying captive solutions utilizing 3rd party risk pools. The use of risk pools as part of an 831(b) captive design is to protect the captive from shock losses in its early years, and often to more clearly meet complex risk distribution requirements under US federal tax rules for a captive to be deemed an insurance company for tax purposes, thus qualify for use of the 831(b) election and other tax incentives afforded insurance companies.

Notably his prior Forbes article published in March 2014 titled “IRS Noose Starting To Tighten In Sham Risk Pools” caused widespread industry concern and controversy. Other industry lawyers responded noting Mr. Adkisson in his earlier years as a captive professional spoke at conferences promoting the tax benefits of captive arrangements (read Sean Kings piece titled “Feeding Trolls” by clicking here), not the risk management benefits, suggesting Mr. Adkisson has in more recent years been trying to distance himself from “tax shelter promoter circles,” whoever they might be. If there are tax shelter promoters assisting clients or encouraging sale of life insurance in abusive situations driven only by tax impacts, some of them may have been schooled by Mr. Adkisson’s earlier analysis that perhaps helped birth the use of 831(b) captives by successful small family businesses. The tone and content of many of Mr. Adkisson’s writings in recent years directly or indirectly attacking the small family owned captive industry (captive insurance solution use by companies smaller than the fortune 1000) he helped create is hard to understand from any perspective other than scoring points with IRS enforcement officials, and to be well positioned for hire as special litigation counsel or an expert witness.

On the legislative front, and response to enacted changes to existing insurance statutes, suffice it to say that there likely will surface structural solutions should the 2015 Extender Bill or something similar to it pass. These structural solutions will emerge to help protect legitimate use of 831(b) captives by small closely held businesses. Sophisticated transactional lawyers nearly always find a way to legally restructure solutions where there is legitimate need as there is for expanded effective alternative risk finance and transfer programs.

Regarding abuse of tax incentives, it is important to remember tax incentives exist to be utilized, and there already is recently expanded tools in the IRS arsenal to combat tax abuse. One example is the new Economic Substance Test part of the Affordable Care Act. It should in and of itself prove sufficient over time to address clear 831(b) use abuses. The US already has the most pervasive and complex tax code in the world, and the largest enforcement agency behind it. Truly simplifying the tax code, and reducing the need for expansive audit and enforcement staff, is the best path should Congress and the IRS want to help make the US economy more competitive, create better job opportunities for our children, and stop the growth and deficit spending of the federal government.

For more insight on this issue, read the following comments to Mr. Adkisson’s re-publication of his article on LinkedIn:

  1. Martin Eveleigh

    Middle market businesses face a great number of risks for which insurance is not readily or affordably available in the commercial insurance market. For example, my friend in Charlotte who operates a number of fast casual restaurants, seven of which were closed for 3 days and two for 3 weeks as a result of flooding in Columbia, SC. He discovered that his flood insurance did not cover business interruption. And another Charlotte business owner, whose business relies heavily on online sales, who suffered a loss this year of hundreds of thousands of dollars when her website crashed; an event for which insurance is effectively unavailable. The threat to her business is existential.

  2. Martin Eveleigh

    1d

    Martin Eveleigh

    While large companies have balance sheets that enable them to weather these storms and have formed captive insurance companies to help finance these and other risks, middle market businesses often do not have the strength to survive such events. By offering an incentive to finance risks in a captive insurance company, the election available under S.831(b) helps middle market businesses deal with adversity and so encourages entrepreneurship and job creation.

  3. Nigel Bailey

    1d

    Nigel Bailey

    Is this the result of lobbying by traditional insurance companies, or just the IRS?

  4. Jay Adkisson

    1d

    Jay Adkisson

    @Nigel — It is the result of (1) Sen. Grassley wanting to increase the 831(b) limit for farm mutuals — but needing a revenue offset to increase the limits, and (2) the IRS wanting to clamp down on “tax shelter captives” and by doing so providing Grassley with the revenue offset that he needs. Even if this doesn’t get past (and maybe more likely if it doesn’t), the IRS will likely come down in 2016 with some pretty onerous rules for 831(b) captives.

  5. Click here for a direct link to Mr. Adkisson’s blog.

Oct 26
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Importance of Actuaries in IRS Audit of 831(b) Captives

By | Captive Best Practice Standards, Captive strategic reviews, Captive Taxation | No Comments

The article below being republished explains the weight placed on actuarial testimony by the tax court in the recent RVI case. It confirms the importance of the associated best practice standards we as a firm have been promoting for years now. Our strategic review service will help you address any deficiencies your program may have had in prior years.

Here is the republished artucle by and experienced actuarial firm’s view of the RVI case:

The recent decision of the U.S. Tax Court in RVI Guaranty Co. Ltd. & Subsidiaries v. Commissioner of Internal Revenue (RVI v. IRS) is not only the latest in a string of victories for the insurance industry, it is also yet another case where the expert testimony of actuaries holding credentials from the Casualty Actuarial Society (CAS) were pivotal in the decision of the court.

Briefly stated, the RVI v. IRS case was focused on a determination of whether residual value insurance constituted insurance for federal income tax purposes. In supporting RVI’s contention that residual value insurance was in fact insurance for tax purposes, the court had several key findings that appear to have applicability in other insurance and particularly captive insurance coverages. The Court:

  • had no difficulty finding that from the insured’s perspective they were paying premium to transfer meaningful risk of loss.
  • rejected the contention that coverages with low frequency and high severity do not provide risk transfer solely due to the absence of claims. The Court recognized that residual value insurance was analogous to hurricane and earthquake insurance in that an insurer may go many years without paying a claim. In the words of the Court, “this does not mean that the insurer is failing to provide ‘insurance.’”
  • went on to note that “(m)any insureds who pay premiums will not incur losses.”
  • reinforced that “perfect independence of risks is not required” for risk distribution.
  • gave credence to both the state insurance regulatory treatment and the Statutory Accounting Principles as they were applied to residual value insurance at RVI by their regulators and auditors, respectively. In regard to the regulatory aspects of this issue, they specifically cited that “Congress has delegated to the states the exclusive authority (subject to exception) to regulate the business of insurance” in deferring to the opinion of state insurance regulators.
  • gave weight to how “commonly accepted notions of insurance” applied to residual value insurance. In particular, the facts that state insurance departments treat this coverage as insurance and that many well-established insurance companies provide similar coverage and treat it as insurance were considered in the opinion. This is a bit of a departure from prior decisions.
  • found that “speculative risk” in some cases can still be insured.
  • found that “(f)or more than 80 years, the States have regulated as ’insurance’ contracts that provide coverage against decline in market values of particular assets.”

As interesting as the key elements of the decision are, the importance of the expert testimony of actuaries from the CAS cannot be overlooked. This continues a trend of the Court placing significant importance on the testimony and credibility of actuaries in other cases such as ACUITY, A Mutual Ins. Co. v. Commissioner of Internal Revenue. In the RVI case, two leading members of the CAS played instrumental roles. Current CAS President, Bob Miccolis, of Deloitte Consulting, and former American Academy of Actuaries Casualty Practice Council Vice President, Mike Angelina, who currently serves as executive director of the Academy of Risk Management and Insurance at Saint Joseph’s University, were essential to the success of RVI’s case. On the essential issues of risk transfer/shifting, risk distribution, commonly accepted notions of insurance, and the definition of insurance risk, their testimony was critical and was often specifically cited in the opinion. The Court went out of its way in discussing the issue of insurance risk to state, “The Court regarded Professor Angelina as a credible witness and found his testimony helpful.”

The IRS’ experts did not fare as well. During the same insurance risk discussion the Court in evaluating one of the IRS’ experts (an academic and non-actuary) stated “we found her testimony argumentative and unpersuasive.” Another expert upon cross examination “ultimately conceded … errors, acknowledging that his method of computing loss ratios systematically understated the true extent of petitioner’s losses.” The error in question demonstrated a lack of understanding of the coverage provided by residual value insurance and undermined the credibility of the expert.

In RVI v. IRS, the U.S. Tax Court continues to provide the insurance industry with meaningful and favorable clarification of fundamental concepts such as risk distribution, risk transfer, and the definition of insurance. They also continue to place a great deal of importance on the credible testimony of actuarial expert witnesses.

Read full article by clicking here.

Oct 25
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US Licensed Captives May Have Advantage if IRS Challenges Tax Incentives

By | Captive Best Practice Standards, Captive Taxation, IRS Audits of Captive Insurance | No Comments

Insert below: October 8, 2015 article of Sean King – click here to read the original article.

Has The Burden Of Proof Shifted To The IRS In Captive Insurance Cases – The RVI Guaranty Case – Part 2

When you think of legal catch-phrases in America, what comes to mind?  If you enjoy watching police detective shows, you may be thinking, “You have the right to remain silent…anything you say may be used against you in a court of law.”  And, here is another legal phrase anchored firmly in the Constitution and the U.S. legal tradition: “Innocent until proven guilty.”

It’s very easy to take this fundamental right of presumed innocence for granted.  Nevertheless, our rights as citizens are turned on their heads when it comes to tax law and civil disputes with the IRS.  You may or may not be aware that taxpayers are not presumed innocent in court when the IRS has determined via audit that the taxpayer underpaid taxes.  When the Service issues a Notice of Deficiency, the burden of proof falls on the taxpayer to demonstrate their innocence or compliance with U.S. tax laws.

The burden of proof determines who wins the case in the absence of evidence.  Said another way, if the IRS has issued a Notice of Deficiency after an audit, the case goes to tax court, and neither the IRS nor the taxpayer offer up any factual evidence to the court, the IRS automatically wins.  In the absence of proof the government wins, hence the “burden of proof” is on the taxpayer.

However, when it comes to insurance companies, the tax court seems (thanks to the RVI case) to be on the verge of adopting a shifting burden of proof, thus making things more challenging for the IRS going forward.

Last week, we reported that the IRS lost what is at least its third major insurance case in two years in U.S. Tax Court.  The case is titled R.V.I. GUARANTY CO., LTD. & SUBSIDIARIES, Petitioner v. COMMISSIONER OF INTERNAL REVENUE, Respondent.

To, to read the RVI Guaranty case in its entirety, CLICK HERE.

While RVI Guaranty was not a captive insurance company, this decision has significant bearing on the captive insurance industry, as discussed in last week’s report.  But, perhaps the most significant and most under-appreciated (so far) import of the court’s ruling in the RVI case was the court’s explicit reliance on the determinations of state regulators as to the definitions of “insurance” and “insurance company”.  This reliance was so extensive and so consistent that, once the taxpayer made out a prima facie case that the arrangement qualifies as “insurance” under state laws, or that a given insurance company is recognized and regulated as such under state laws, the court seemingly shifted the burden of proof to the IRS to prove the contrary.

For instance, in resolving question of whether the RVI policies transferred enough risk to RVI to be treated as a true insurance arrangement under Federal tax law, the court said:

“[The IRS’s expert witness] was aware of no instance in which an insurance regulator had determined that the risk of loss on a policy of direct insurance was too ‘remote’ for the product to be treated as ‘insurance’.  And [the IRS] offers no plausible metric by which a court could make this assessment.”

This quote is enlightening because, in its Notice of Determination, the IRS hadalready made the determinationthat insufficient risk was transferred and that the arrangement was not therefore “insurance”.  And, because the burden of proof in such matters is on the taxpayer, that determination should be deemed correct unless the taxpayer offers up sufficient proof to the contrary.  The Service was under no obligation to “offer [the court a] plausible metric by which the court could make this assessment”, and yet the court chastised it for failing to do so. Why?

Time and again, on issue after issue, the court seemingly accepted the findings of state insurance regulators, offered up by the taxpayer, as sufficient to meet the taxpayer’s initial burden of proof on the contested matters. Once state insurance regulators contradicted the Notice of Determination, the court no longer gave it deference by presuming its findings correct.  In fact, the court began insisting that, to win, the IRS must overcome the determinations of state insurance regulators by offering up compelling evidence of its own.  When it failed to do so, the taxpayer won.

True, the taxpayer offered up lots of proof other than just the findings of state insurance regulators, and the court took that other evidence into account, but it usually did so only to the extent needed to contradict the limited and inconsistent evidence offered by the IRS. The flow of the court’s analysis was:

Court:  In the absence of additional evidence, IRS wins.

Taxpayer:  Judge, here’s uncontested evidence that state insurance regulators deemed this to be a legitimate insurance arrangement.

Court:  IRS, the taxpayer is right, and since the states are empowered to regulate insurance, I’m inclined to rule for the taxpayer. The burden is now on you to prove state regulator’s wrong.  What say you?

IRS:  Judge, state regulators are wrong on this because of X, Y, and Z.

Court:  Taxpayer, what say you to that?

Taxpayer:  Judge, X is not X, Y is not Y, and Z is not Z.  The IRS’ evidence is therefore insufficient to overcome the presumption that the state insurance regulators are correct and this is real insurance.

Court:  I agree.  Taxpayer wins.

Conclusion

The ruling by the Court in RVI is broadly worded and appears to have shifted the burden of proof from the taxpayer to the IRS in circumstances where state insurance regulators have determined that legitimate insurance exists. In future tax court cases involving issues of defining insurance and insurance companies, it may be sufficient for taxpayers to point to the determinations of state insurance regulators in these matters, thus establishing a rebuttable presumption of legitimacy that the IRS must overcome with significant contrary evidence.  In the absence of such evidence, the taxpayer is likely to win.

In addition to licensing captive insurance companies, approving business plans and approving all insurance policies written, many domiciles also regulate, examine or approve risk distribution pools (re-insurance arrangements) often employed by smaller captives to achieve risk distribution.  Industry pundits have suggested the IRS might attack risk distribution pools using many of the same theories rejected by the tax court in RVI.  If the thesis of this article is correct, the IRS will have its work cut out for it when it seeks to attack pools that have been specifically vetted and found legitimate by state insurance regulators.

 

DISCLAIMER: The above articles are opinion of the author Sean King. Captive Experts, LLC is not and cannot provide any tax or legal guidance or opinions. Tom Cifelli also is not providing any tax or legal advice regarding this article or any other information on this website or in articles he authors as part of this website or on any affilaite website such as www.CaptiveExperts.com.