Captive Taxation

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

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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.

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. 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

    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

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

  4. 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.

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.

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.

IRS Loses Another Insurance Tax Court Case – RVI Guaranty Decision Helps Tax Position of 831(b) Captives

By | Captive insurance, Captive Taxation, IRS Audits of Captive Insurance | No Comments

The IRS has lost 3 major insurance tax cases in the last 2 years. This is very favorable for businesses who are benefiting from the use of captive insurance companies. The author suggests the burden of proof required for the IRS to modify tax reporting positions of captive insurance companies is getting more difficult, especially for US licensed and regulated 831(b) captive insurance companies.

Insert below: October 1, 2015 article of Sean King – click here to read the original article.

IRS Loses Another Case With Bearing On The Captive Insurance Industry – The RVI Guaranty Case

Last week, 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, and it comes on the heels of two major losses in captive insurance cases in 2014, Rent-A-Center (CLICK HERE) and Securitas (CLICK HERE).

While RVI Guaranty was not a captive insurance company, this decision has significant bearing on the captive insurance industry.  The Tax Court answered two key questions in its opinion, and both answers undercut arguments the IRS frequently makes when attacking self-insurance arrangements, captive insurance companies and other non-traditional insurance companies.  The first question is, “What constitutes real insurance?”  And, the second is, “Who gets to decide what constitutes real insurance?”

Brief Overview Of The Case

The U.S. Tax Court held its trial in R.V.I. Guaranty Co. Ltd. v. Commissioner (IRS) to decide whether residual value insurance policies are insurance for federal income tax purposes.  R.V.I. Guaranty Co. Ltd. (RVI), argued that its insurance policies in question fit into the insurance regulatory framework.  RVI is an insurer that offers residual value insurance, which protects insureds’ property from unexpected declines in value over the life of a contract.  Specifically,  RVI insures taxpayers engaged in the business of leasing passenger vehicles, commercial real estate, and commercial equipment.  Under the contracts, RVI is obligated to pay the insured the excess of the predicted residual value of the protected asset over the fair market value at the end of the lease.

In 2012 the IRS had issued a notice of deficiency to RVI for 2006 alleging a $55 million underpayment in taxes.  The IRS argued the insurance contracts were not insurance for federal tax purposes.  RVI argued that all state courts that have addressed whether residual value insurance is insurance for state regulatory purposes have decided that it is insurance.  The IRS argued that residual value insurance covers a loss in expectation, which is not an insurance risk.  The Service argued that the case revolves around “pure risk” and “speculative risk.”  The Service also argued that risk distribution generally requires the law of large numbers and does not exist in these types of policies because the types of events that would cause a payout would affect all insureds, not just a few of them. The Court rejected the Service’s arguments and delivered an opinion in favor of the tax payer.

To read the entire case, CLICK HERE.

Arguments Considered By The Tax Court

What Constitutes Real Insurance?

The IRS argued that residual value insurance is not insurance, at least under the circumstances of this case.  Its reasoning as to why is important to owners of captive insurance companies (CICs) because the IRS sometimes attacks CICs using the same lines of attack.

First, the IRS argued that no true insurance arrangement existed because there was no transfer of meaningful risk from the insured to the insurance company.   As it often does in cases involving captive insurance companies, the IRS argued that the insurance company’s low claims frequency, or low “claims ratio” over several years evidenced that RVI assumed insufficient  risk.  The court dismissed this argument on both theoretical and practical grounds.  The court’s theoretical argument was short, simple, and extremely important:

Both parties’ experts analogized the RVI policies to “catastrophic” insurance coverage, which insures against earthquakes, major hurricanes, and other low-frequency, high- severity risks. An insurer may go many years without paying an earthquake claim; this does not mean that the insurer is failing to provide “insurance.” [The IRS’s expert] Mr. Barrett acknowledged that, under many catastrophic coverages, the odds of a loss occurring may be quite low. He 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 respondent offers no plausible metric by which a court could make this assessment.

In short, the court stated unequivocally that, when it comes to insuring low-frequency but high-severity risks, frequency of claims and low claims ratios have very little probative value  in determining the legitimacy of the insurance arrangement.  Neither is a “plausible metric” that supports the IRS’ argument.  Low frequency risks are clearly the proper subject of insurance, and “going many years without paying…a claim” under such policies is to be expected of insurers of these risks.  The court’s conclusion on this point explicitly contradicts one of the IRS’ theories of attack against captive “risk pools”—that low claims ratios or low claims frequency is de facto evidence of a sham.

Second, the IRS argued that RVI did not insure “pure” risks but rather only “speculative risks” (sometimes called “business risks” by the IRS) OR “investment risks” neither of which are, the IRS argued, properly the subject of real insurance arrangements. This is consistent with the IRS’ position in its 2015 “Dirty Dozen” listing where the Service cautioned taxpayers to be careful of captive insurance companies that issue “policies to cover ordinary business risks” as opposed, presumably, to those that cover “pure risks.”

But neither the court nor the IRS’ experts could come up with any principled means of distinguishing between “pure” risk and the other more “speculative” or “investment” types criticized by the IRS in the case and its “Dirty Dozen” release.  The court concluded:

In any event, we find respondent’s attempt to distinguish between a “pure risk” and a “speculative risk” in this setting as essentially metaphysical in nature.

When the court calls your argument “metaphysical”, you can be sure that you are going to lose.  And lose the IRS did.  The court concluded:

[The IRS’s]  efforts to split hairs by disentangling the causes of “loss” are philosophically interesting.  But we do not think they carry much weight in determining whether the RVI policies constitute “insurance” for Federal income tax purposes.

Regarding whether “investment risks” (as characterized  by the IRS) are properly the subject of true insurance arrangements, the court settled things (hopefully) once and for all:

Finally, [the IRS] urges that we find the RVI policies to entail mere “investment risk” by analogizing its policyholders to investors who have purchased put options to protect their stock. The problem with this argument is that the insureds are not investors and the policies are not derivative products. Investors invariably purchase stock in the hope that it will appreciate in value, enabling them to sell the shares for a capital gain. The assets petitioner insured are not investment assets; in the hands of the lessors or finance companies, they are ordinary business assets in the nature of inventory or equipment. The insureds do not acquire these assets expecting them to appreciate in value and be sold to generate gain.

Analogizing the RVI policies to put options, moreover, is little more than a simile. In the real world, put options are typically settled for cash rather than by actual transfer of the underlying shares. At a conceptual level, many insurance products could be likened to put options. A mortgage guaranty policy, for example, could be said to give the policyholder the right to put the mortgage loan to the insurer unless the insurer pays the insured the difference between the remaining balance of the loan (the strike price) and its value on the exercise date. Even a fire insurance policy could be likened to a put on the fire-damaged house that is settled by the insurer’s payment of the damage claim.

For all these reasons, we reject [the IRS’s] contention that the RVI policies involve an uninsurable “investment risk.” These policies were designed and marketed as insurance products. Similar products were sold in the insurance market by other major insurance companies. These policies were undergirded by insurance strength ratings from the major insurance rating agencies. For more than 80 years the courts have recognized that contracts insuring against the risk that property will decline in value can involve “insurance risk.” The types of events that cause losses under these policies closely resemble the events that cause losses under policies of mortgage guaranty and municipal bond insurance. Most importantly, every State in which petitioner does business recognizes these policies as involving insurance risk and regulates them as “insurance.” Respondent is correct that these policies have some features that are atypical of what might be called “standard” insurance policies. But these differences are driven by the economics of the underlying business transaction and do not nullify the existence of “insurance risk.”

Finally, the IRS made its standard “homogeneity” argument (often used against CIC risk pools) suggesting that the pooling of different types of independent risks does not achieve risk distribution (an inherent element of any true insurance arrangement) because, according to the IRS,  “the law of large numbers” does not apply in that context. The IRS argued that for risk distribution to occur, the risks pooled by the insurance company must be the same or very similar in nature—that is, homogenous.

The Court rejected the IRS’s argument on this point, flatly noting the following:

As we have explained previously, losses under RVI policies are caused by fortuitous events outside of its control. And its policies clearly do pool [such] risks to take advantage of the law of large numbers.

The court concluded:

The legal requirement for “insurance” is that there be meaningful risk distribution; perfect independence of risks is not required. See Rent-A-Center, Inc. & Subs. v. Commissioner, 142 T.C. 1, 24 (2014) (“Risk distribution occurs when an insurer pools a large enough collection of unrelated risks (i.e., risks that are generally unaffected by the same event or circumstance”); Harper Group, 96 T.C. at 55, 59-60 (finding sufficient risk distribution where insurer insured numerous unrelated insureds even though the risks “were not statistically independent * * *,but rather were highly correlated”); Gulf Oil Corp., 89 T.C. at 1025 n.9 (stating that sufficient risk distribution may exist if risks are independent “to some minimum extent”). We have no difficulty concluding, as respondent’s expert Mr. Cook ultimately did, that the RVI policies accomplish sufficient risk distribution to be classified as “insurance” for Federal tax purposes.

Thus the court stuck a dagger in the heart of the IRS fallacious argument, often launched at captive risk pools, that true insurance arrangements only pool “homogeneous” risks.  In the court’s mind, a pooling of unrelated risk is sufficient to achieve risk distribution, at least in some contexts.

Who Decides What Constitutes Real Insurance?

Consistent with both the Rent-A-Center and Securitas cases, the Court once again showed great deference to the determination of domicile regulators on these issues and the determination of what constitutes valid insurance.  In deciding whether risk transfer occurred in the RVI case, the court said:

[The IRS’s expert] 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 respondent offers no plausible metric by which a court could make this assessment.

In deciding that certain types of investment risk are properly the subject of valid insurance arrangements, the court noted:

Most importantly, every State in which petitioner does business recognizes these policies as involving insurance risk and regulates them as “insurance.”

Why did the court give such deference to state regulators in defining insurance?  Well, the court tells us why:

Congress has delegated to the states the exclusive authority (subject to exception) to regulate the business of insurance.” AMERCO, 96 T.C. at 42 (citing the McCarran-Ferguson Act, 59 Stat. 33, as amended, 15 U.S.C. secs. 1011-1015 (1998)). We have repeatedly emphasized the significance of State insurance regulation in determining whether an entity should be recognized as an “insurance company.” See Sears, Roebuck & Co. v. Commissioner, 96 T.C. 61, 101 (1991), aff’d in part, rev’d in part, 972 F.2d 858 (7th Cir. 1992); Harper Group, 96 T.C. at 60; AMERCO, 96 T.C. at 42; Securitas Holdings, T.C. Memo. 2014-225, at *5-6.

The “exclusive authority” vested in the states to “regulate the business of insurance” almost certainly includes (within reasonable limits) the ability to define the term, else that authority is largely meaningless.

And this may be the most significant and under appreciated (so far) import of the court’s ruling:  The court’s reliance on state regulators in this case was so extensive and so consistent that one might be forgiven for concluding that the burden of proof in such matters has now shifted to IRS.  Where the taxpayer makes out a prima facie case demonstrating that the states have characterized a certain arrangement as one of “insurance,” or  a certain corporation as a “insurance company,” the IRS will seemingly be required to offer up much evidence to prove the contrary.  In this case it was not up to the challenge.

Conclusion

The RVI Guaranty Case is a significant win for the taxpayers, captive insurance companies and businesses that are served by non-traditional risk management approaches.  The ruling by the Court is broadly worded and completely undermines the IRS’ attempts to draw an artificial distinction between “insurance” risks on one hand and “business” or “speculative” or “investment” risks on the other.  The ruling also bolstered the position of many re-insurance (or risk distribution) pools commonly employed by small captive insurance companies.  Finally, it is clear that insurance policies and companies approved by state insurance regulators will, in the absence of significant proof to the contrary, generally be respected by the Tax Court.  A well-managed captive insurance company in a well-regulated domicile is clearly on an even stronger footing today than it was two weeks ago.

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 determination that 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.

831(b) Qualifying captive insurance companies – design & tax planning guidance

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Disclaimer: Nothing herein is legal, tax, financial, insurance, accounting or investment advice. The information herein may be dated. No obligation to update or make corrections is intended or implied.

Caution: As use of captives making the 831(b) election has proliferated in recent years, the IRS too is increasing its attention and review of these transactions. IRS Associate Counsel stated the IRS does not want to chill proper use of captives but are concerned about potential abuses. This scrutiny may be warranted. Some captive promoters and managers may not know how to or do not care to follow best practice standards, but rather focus nearly exclusively on the tax benefits of captive structures. Some may lack the requisite risk management experience to design and manage them first and foremost as legitimate and effective risk management vehicles. Shortcomings in some programs may relate to weak or questionable practices regarding risk assessment, policy selection, policy pricing, policy periods, and risk pools that may not be designed and operated correctly themselves.

INTRODUCTORY BACKGROUND

Technically there is no such thing as an 831(b) captive. 831(b) is a reference to U.S. Code, Title 26, Subtitle A, Chapter 1, Subchapter L, Part II, section 831, subsection (b), of the United States Internal Revenue Code, titled “Alternative tax for certain small companies.” Therefore 831 (b) applies only to insurance companies that are US taxpayers. You can read this 831(b) statute on the Cornell University website by clicking here.

The following chart lays out the bigger picture of the tax impacts of a captive insurance company in “for profit” enterprise groups:

Captive Tax Impacts

IRC 831(b), providing for exemption from income tax of a qualifying small insurance company’s underwriting income, is a US tax code provision enacted as part of the 1986 Tax Reform Act by Congress during President Ronald Reagan’s 2nd term. At this time the US insurance markets were a very “hard” market, meaning affordable insurance was expensive and for many companies and professionals difficult if not impossible to find. Section 831(b) specifically created a powerful tax incentive for the formation and operation of small insurance companies.  It helps US businesses create loss reserves with formalized insurance programs under their control. This tax incentive is valuable to make sure US businesses will hopefully never again find themselves in the disastrous commercial insurance market conditions existing in the mid-1980s that left 1000s of US businesses without adequate protection from or liquidity to survive high severity operational risks.

This section 831(b) election is available to qualifying insurance companies who timely make the necessary election; otherwise applicable taxes dictated by section 831(a) applies to all insurance companies except life insurance companies. All US insurance companies, whether electing 831(b) benefits or not, must file IRS tax form 1120-PC (click here to see the form, or click here to see instructions).

Section 831(b) (2) (A) limits its application only to insurance companies if:

  • The greater of net written premiums or direct written premiums do not exceed $1,200,000 in the taxable year, and
  • Such company elects the application of section 831(b) for such taxable year.

There is some disagreement and confusion on the interpretation of “written premium” in a taxable year. Some believe it is measured on a cash basis reading the statute literally, others think accrual methods control particularly where tax returns are prepared that way. The author does not believe there is yet definitive guidance.

Various Names Used for Small Captives

Increasingly the term “micro-captive” was used to describe these small 831(b) election qualifying captives from 2009 into 2014, hence why it is incorporated into the title of this book. As of 2014 the term “enterprise risk captive,” coined by some of the leadership at SIIA, is emerging as the preferred description. Suffice it to say technically there is no such thing really as a micro-captive, or an 831(b) captive, or even an enterprise risk captive.

Captives are all unique (when designed properly) and are nothing more than an insurance company licensed under an enabling insurance statute in the US or abroad whether large or small and irrespective of the types of insurance coverage it is designed to issue. Being an insurance company for US tax purposes is distinct from being a licensed insurance company for insurance regulatory purposes. Just because your captive receives approval and a license to conduct its insurance business does not mean the IRS must agree it can avail itself of favorable tax incentives and treatment afforded an insurance company under the US Internal Revenue Code.

Learn more by reading this inexpensive eBook – “831(b) Enterprise Risk Micro-Captive Insurance Companies – Design and Tax Planning Guidance.”

Also visit these leading websites: www.UScaptive.com and www.CaptiveExperts.com

For information on best practice standards today in the micro-captive industry, read this article.

Economic Substance Test of US Internal Revenue Code – Captive Insurance Impacts

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Due to the significant tax incentives afforded properly designed and operated insurance companies, the IRS is increasingly concerned many owners may have a primary tax savings, not risk management business objective, in forming small closely help captives. It is expected the IRS examiners will start to use the newly codified economic substance test and related penalties in audits of captives they feel are not designed and operated correctly or for the right business reasons. Click here to view the IRS website and form guidance on this new codified test.

831(b) captive insurance changes – 2015 US House and Senate Action Being Considered

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US IRC 831(b) amendments are not a new thing. They happen almost annually. Nothing meaningful has passed into law in recent years. However some change effective for 2016 is a real possibility. Any change will create planning opportunities and challenges (Activity summary below from http://www.captiveglobal.com/831b-legislativeupdates).

Spring 2015 Action in US House and Senate on 831(b) Legislation

This page will supply a running account of important activity in both the House and Senate on amendments to existing 831(b) legislation that will impact small insurance companies, including captives.  It is likely to become long, with the most recent updates at the top.  We think that it makes sense to keep everything on a single page throughout the coming weeks. We will supply dates for each update.

CaptiveGlobal.com wishes to thank Ryan Work, Senior Director of Government Relations, Self-Insurance Institute of America, Inc. (SIIA) for supplying these updates from Capitol Hill.


July 22, 2015: BREAKING NEWS FROM WASHINGTON, DC:  Follow this link to download  the 831(b) specifications (‘specs’) issued from the Joint Committee on Taxation (JCT).

In summary, JCT is proposing an outright ban on captive ownership based on familial relations, with a 5% de minimis exception. This prohibition looks to be much broader than  trusts, and goes into additional entities and corporate structures. The spec includes language outlining a “consideration” for a broader family rule. Congressional staff is currently reviewing the specs to determine if this proposal adversely affects certain constituencies, particularly family owned mutual companies.

JCT specs are typically issued as a recommendation or response to legislative proposals. It is important to note that JCT’s specs are not an indication that 831(b) legislation is moving any time soon. As previously reported, if any 831(b) legislation were to move at all, the proposal would be most likely be included in the Highway Trust Fund Reauthorization currently being negotiated by the House and Senate,  or other end of year tax legislation. Currently, staff does not know whether and when these two legislative vehicles will move, and whether an 831(b) proposal would even be added to these vehicles as they are processed through Congress.  As the process continues, we will provide additional updates.

April 29, 2015: House bill HR 1788 was introduced a week or so ago, and was a reintroduction of a bill dropped last Congress.

Shortly after Chairman Hatch introduced captive legislation in the U.S. Senate, Reps. Erik Paulsen (R-MN) and Ron Kind (D-WI) introduced a variant captive bill in the U.S. House of Representatives, which was reported to the Committee on Ways and Means. This legislation, HR 1788, proposes an 831(b) threshold increase to $2.2 million tied to an inflation index with no Treasury study language.

The House legislation is not unexpected and, like the Senate bill, was introduced to assist farm mutuals, which are heavy in both co-sponsoring Member states. Also important, it is a reintroduction of a similar bill introduced last Congress, HR 4647, partly to counter then Ways and Means Chairman Dave Camp’s (R-MI) proposal to eliminate IRC 831(b) as part of his tax reform package. As previously discussed, Ways and Means Committee staff, as well as the Joint Committee on Taxation, have both expressed concerns in the past over captive abuse and have proposed placing restrictions or prohibitions on its use.

With legislation being introduced in the House, it does bring the issue into both chambers as we had expected. Now dealing with two different bills, and not mirroring legislative text, questions remain as to which one will be the main legislative vehicle and how might it be changed during the process. As in the Senate, the House bill may be modified at both the committee level and on the floor under the amendment process. Any differences between House and Senate legislation would require a conference committee or, more likely, an agreement on legislative language that could be attached to a general revenue bill that may come up for consideration.


April 14, 2015 –  Legislation is currently being considered in  both the U.S. House of Representatives and the Senate that seeks to increase the written premium threshold of IRC § 831(b) from the current $1.2 million to $2.2. Million.  There is also the  potential for language restricting the future of captive usage.

Background
When Congress first placed IRC § 831(b) in the code in 1986, it intended to extend the tax benefits previously given only to mutual insurance companies to all small insurance companies, encouraging companies to build up reserves to protect against losses, a tool critical to most small and mid-sized businesses.

Recently, concerns have been raised to Congress by the IRS/ Treasury that some of these small captive insurance companies are being marketed for abusive purposes. Instead of the risk management and insurance purposes outlined above, the concern is that some small captives are being marketed only to accomplish estate planning benefits.  While structuring the ownership of captives to achieve estate planning benefits is neither unreasonable nor prohibited, the intent of Congress was not to excessively promote that usage.

Because of these concerns, legislative text was considered by the Senate Finance Committee in February of 2015 that, along with a non-controversial goal of increasing the threshold for written premiums under IRC § 831(b) from $1.2 to $2.2 million, would place potentially devastating limitations on the use of captives by businesses. These original restrictions — subsequently removed from the legislative text due to deep seated industry concerns from SIIA and others — would have prohibited the use of reinsurance and limited 20% of net written premiums to a policyholder under a single taxable year for purposes of IRC § 831(b).

The final legislative text passed unanimously by the committee, and introduced earlier this month by Senate Finance Chairman Hatch (R-UT), S. 905, would increase the written premium threshold to $2.2 million without additional restrictions. The legislation also calls for a U.S. Treasury study on the use of captives as an estate planning tool and requests specific legislative language to address abuse, to be completed no later than February of next year.

In terms of additional Congressional action, Chairman Hatch’s bill was simply the formal filing of the legislative language and report passed out of the Finance Committee and has no bearing on the opposition or acceptance of additional restriction language, or an indication that a clean bill is a certainty. It does indicate, however, that the 831(b) proposal is now one step closer to floor consideration, where additional changes and/or amendments to the legislation can and will be proposed.

SIIA Captive Industry Proposal

Understanding the concerns surrounding the potentially abusive usage of captive insurance for estate planning purposes, SIIA and industry participants believe that instead of a broad brush approach that would inadvertently damage an industry that is working well, it would be beneficial if incentives for abusive estate planning designs were curbed in two key areas.

  1. First, restrict certain ownership structures of captives that use irrevocable trusts to avoid the estate tax.  Ownership by a trust that does not accomplish estate tax avoidance should not be restricted.
  2. Second, restrict the purchase of life insurance using the assets of the captive.  Because the premium paid to the captive is deductible by the insured business and not taxed in the captive, a business owner could use this technique to indirectly purchase life insurance with pre-tax dollars.

While putting in place restrictions, the SIIA group believes that it also makes sense to grandfather those who previously entered into captive arrangements within the current parameters of the law. Such a grandfather provision would ensure that small and mid-sized businesses that formed insurance companies before this proposal was enacted are not penalized.

Medical Marijuana Captive Insurance Companies for Cannabis Dispensaries and Cultivators

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Advanced Legal, Tax, Financial & Insurance Planning for Medical Marijuana Industry Businesses

Summary

Of all the industries in the US, medical marijuana businesses face the greatest operational challenges today. The legal regulatory environment for any medical marijuana enterprise is full of landmines. This article addresses strategic methods to retain and protect more of the income and wealth being accumulated by successful businesses in the burgeoning medical cannabis industry.

Introduction

All successful entrepreneurs who make a lot of money building valuable enterprises start to worry and lose sleep over income taxes, estate taxes and losing everything they worked so hard to build due to disputes, mistakes or catastrophic events beyond their control.

 

Some experienced lawyers can help you recognize the issues and implement well established strategies and techniques involving tax, asset protection and estate planning. Few lawyers however also have experience in designing advanced risk management science structures, precisely what is needed by medical marijuana industry businesses in light of the complex and controversial legal environment they must navigate.

Asset Protection/Estate Planning

Asset protection involves techniques designed to prevent a loss of assets in the event of catastrophic unfavorable litigation, bankruptcy and even potentially protecting assets from government forfeiture proceedings. Estate planning involves techniques to efficiently manage and fairly distribute tax efficiently accumulated wealth during one’s lifetime and on one’s death.

Implementing asset protection techniques after you know about a problem threatening your assets is usually not effective due to fraudulent conveyance statutes and similar case law created judicial doctrines that make it improper to move or hide assets once you know they may be needed by a 3rd party who has claims against you. Basically if you procrastinate and delay planning until your assets need protection from a known 3rd party, it is likely already too late to assure success. In fact it could be criminal to attempt to hide assets after someone makes a rightful claim against you or their right to has already arisen due to something you or your business did that injured or damaged them.

Typical asset protection techniques include but are not limited to:

  • planned systematic gifts of personal and business assets to children or others directly or indirectly through complex trusts and other vehicles;
  • creation of affiliate businesses owned by children or family trusts;
  • taking advantage of special protective legislation, such as homestead exemptions excluding the value of personal residence from creditors.

 

Typical estate planning techniques often considered include but are not limited to:

  • (basic plan) having a revocable living trust, a will, one or more powers of attorney, a living will and some manner of testamentary instructions;
  • (more advanced) one or more irrevocable trusts in combination with the above;
  • structured business ownership interests with varying classes of ownership, buy-sell agreements, options to acquire and other complex business transaction agreements.

The most important thing about effective asset protection and estate planning is to get started early with fact finding and due diligence followed with documenting alternative solutions and associated costs to implement and maintain.

Risk Management & Finance  – Custom Privately Held Captive Insurance Company Solutions

Good insurance for medical marijuana operations has always been difficult to find, and was expensive. This is more the case now than ever. On June 3, 2015, Lloyd’s of London announced a ban on its insurance broker syndicates writing any new policies in the USA to businesses growing or selling medical marijuana. Lloyds was not the only source for insurance but they were the most competitive. Other insurance carriers may follow since cash generated from the sale of marijuana, even when used to buy insurance, invariably implicated federal Anti-Money Laundering laws, even though for the time being the US federal government has indicated an intention not to enforce them against businesses operating legally under state medical marijuana laws.

Fortunately there exists a well established method of addressing risk management and risk finance objectives of medical marijuana businesses – closely held captive insurance companies, known as CICs. CICs are now licensed by over 30 US states. CICs are designed to provide custom insurance coverage that is not available from commercial insurers, is too expensive, or is simply not adequate in coverage design or claims handling to meet business needs.

Most of the Fortune 1000 have had CICs for some time. In the past 10 years, more and more successful closely held businesses in nearly every industry have formed their own affiliate CIC.

 

The benefits of CICs are many and are most easily understood when compared to retail insurance and self insurance as shown in the chart below:

CICs are licensed insurance companies, under special provisions that allow them to sell insurance to affiliated businesses, but not the general public. This allows them to be more economic to form and operate, as compared to traditional insurance companies.

Because the tax advantages of CICs can be substantial, the IRS has made it clear they do not like CICs. Nevertheless designed and operated correctly, provided your primary reason is to improve enterprise risk management, and not tax avoidance, your CIC could very well create significant income and estate tax savings, not to mention if claims losses are controlled, accumulate significant investment reserves assets that could also be asset protected. CICs certainly allow far greater control over your insurance and claims handling practices then does commercial insurance even if affordably available.

Types of Insurance Coverage a CIC Can Write to Protect a Medical Marijuana Business

CICs can write a host of insurance policies. The following are some of the types of insurance a CIC can write that are particularly appropriate for medical dispensaries and cultivators:

  • crop insurance
  • loss of producing plants
  • product liability
  • product recall
  • intellectual property
  • unfair competition
  • legal defense
  • regulatory liability risks
  • crime
  • employee theft

IRC Section 831(b)

One special tax provision designed to encourage use of CICs to finance insurable risks is known as section 831(b). This special income tax provision allows all underwriting income of a qualifying CIC to be exempt from federal income tax. This results in premiums paid by the operating medical marijuana business to deduct the insurance premiums paid the CIC if they qualify under section 162 (ordinary and necessary business expense), yet not be subject to income tax by the CIC. This creates a more economically efficient  method to build loss reserve investments inside the CIC over self insuring risk.

IRC Section 280E

Another special obstacle medical marijuana businesses face is the US Treasury I.R.C. Section 280E provision, pertaining to expenditures in connection with the illegal sale of drugs, which states in part “no deduction or credit shall be allowed for any amount paid or incurred during the taxable year in carrying on any trade or business if such trade or business … consist of trafficking in controlled substances….”

Most tax advisers believe expenses which comprise cost of goods sold (COGS) are deductible under 280E. It is important when designing a CIC for a medical dispensary or cultivator to be aware if 280E and maximize insurance coverage which can be included as COGS.

Conclusion

Medical marijuana dispensaries and medical marijuana cultivators have great need to do advanced planning to address acute problems they face involving legal, tax, financial and insurance impacts of their business operations. Opportunities for effective solutions exist if you contact qualified professionals. We encourage readers to discuss the above topics with their legal, tax, financial and insurance advisers.

About the Author:

 

Thomas A. Cifelli is an Arizona attorney and also owns a specialty captive insurance solution provider firm. Visit www.TomCifelliLaw.com and www.CaptiveExperts.com for more information.