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831(b) Micro-Captive Challenges

Uncertainty for Captives-SF
February 08, 2017

The Internal Revenue Service (IRS) is intensely auditing micro-captive insurers that have filed for the 831(b) tax treatment election in an effort to both discourage those who have been considering forming a micro-captive and to challenge those taxpayers who are abusing the 831(b) election. Currently, there is great uncertainty as to how the IRS's challenges will be resolved. That was the starting salvo from a distinguished panel of captive insurance professionals at the 2017 World Captive Forum.

Engaging in a wide-ranging discussion of the IRS challenge and best practices to use to position a micro-captive to endure the challenge in the session titled "Micro-Captives: The Pros and Cons of 831(b)s" were Charles Lavelle, partner, Bingham Greenebaum Doll LLP; Arthur Koritzinsky, managing director, Marsh's Captive Solutions Group; and David Provost, deputy commissioner, Vermont Captive Insurance Division.

If the first word out of your mouth when thinking of creating a captive is "taxes," the panel agreed, the captive is in trouble from the beginning. Instead, micro-captives should be approached in the same manner as larger captives. This begins with defining the business purpose of the captive, considering such factors as the risks it will write, the amount of risk it will retain, and the availability of reinsurance. Good corporate governance is also important and should be much the same as that for a larger captive.

Of course, the risks the micro-captive will write are of key importance to the success of the captive and have a profound impact on the tax treatment of premiums paid to the captive. The parent company should have a genuine need for a risk finance solution for the covered risks and, to have an opportunity to secure favorable tax treatment, it should be covering "insurance risk." (See "When Are Premiums Paid to a Captive Insurance Company Deductible for Federal Income Tax Purposes?").

A very low frequency of losses or low loss ratio strongly increases the risk of IRS scrutiny. For example, the IRS is using a loss ratio of less than 70 percent to trigger "transaction of interest" reporting requirements. There should be a reasonable possibility (i.e., 10 percent and preferably 15 percent or more) of a significant loss involving the risks being covered.

The rates used to develop premiums charged to cover the risks must be adequate to cover the risk to best assure the captive remains solvent (and to satisfy the insurance regulator). On the other hand, they should not be excessive as to avoid an excessively low loss ratio. Excessive rates would imply that the program is a tax dodge rather than a legitimate risk finance program. A number of approaches can be used to develop the rates, as follows.

Market Pricing. This involves basing the rate on insurance rates used in the commercial marketplace. The rate can be developed by having a broker work with an insurer to develop rate and premium indications. Another approach is to benchmark insurance rates being used to price the coverage for other similar organizations and use those to develop a rate to charge the captive's parent.

Actuarial Analysis. Actuaries can be used to develop rates based on the organization's own previous loss data if sufficient data is available for the risk to be covered. In the event this is not the case, industry data can often be used to develop rates, at least for the less esoteric lines of coverage.

Funding To Obtain Desired Limit. For some types of coverage, the prior two methods are simply not feasible or are unlikely to yield results in which the captive owner can have a high degree of confidence. In these situations, it can be useful to set a premium that will fund a full limits loss at a given level of frequency. For example, one might fund flood coverage by setting a premium sufficient to meet a full limits loss every 2, 3, 5, or some other number of years.

Regardless of the process used to develop the premium, captive owners should expect the IRS to drill into the approach. It would not be unusual for this to include contacting the actuary who developed the rate or premium.

One of the challenges to owners of micro-captives is simply that of perception. There is a widely held belief that many of these captives were set up primarily for tax reasons—the IRS certainly seems to hold this belief. Thus, captive owners should take steps to differentiate their captives from those that may indeed be abusing the 831(b) election. One way to do this is to select a domicile that has a mix of large and small captives and a strong regulator who will encourage best practices. Another is for the captive to join the captive industry associations and participate in their activities. Most micro-captive owners apparently do not do this.

While there is a cloud of uncertainty hovering above micro-captives that have made the 831(b) election at the moment, there are cases winding their way through the courts that should eventually clarify their treatment and the best practices to employ to satisfy the tax laws. Indeed, Mr. Lavelle predicted that, in 3 to 5 years, a new equilibrium will be established around micro-captives and, one way or the other, the path will be much clearer.

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