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"Micro-Captive" Tax Updates from the North Carolina Captive Conference

Tax Burden-SF
August 24, 2018

At the 2018 North Carolina captive conference, Charles "Chaz" Lavelle, senior partner, Bingham Greenebaum Doll LLP, discussed Internal Revenue Code (IRC) Section 831(b) changes over the last year. Mr. Lavelle presented the incremental cap on premiums as follows. 

  • 2016—$1,200,000
  • 2017—$2,200,000
  • 2018—$2,300,000
  • 2019—indexed in $50,000 increments

As a reminder, pursuant to the Protecting Americans from Tax Hikes Act of 2015 (PATH Act), H.R. 34, a captive with gross premium revenues that do not exceed a certain threshold may make an election under IRC Section 831(b). An 831(b) captive is taxed solely on its investment income, and the premium income is exempt from federal income tax. Otherwise, it is treated no differently from other captives. In 2017, the threshold on annual premium for an 831(b) captive was increased from $1.2 million to $2.2 million and subsequently increased to $2.3 million in 2018 because the threshold is indexed. The threshold will be indexed in $50,000 increments beginning in 2019 and going forward. 

Mr. Lavalle said there were also some clarifications for small captive insurers in the Consolidated Appropriations Act of 2018, H.R. 1625, commonly referred to as a spending bill, enacted on March 23, 2018, that cleared up questions raised about the diversification requirements. Readers may find out more about these changes in an April 2018 Captive.com article written on the topic by Saren Goldner and P. Bruce Wright of Eversheds Sutherland (US) LLP.

Small Captive Insurance Company Court Cases

Mr. Lavelle explained that in addition to the recently decided Avrahami (Judge Holmes) and Reserve Mechanical (Judge Kerrigan) small captive insurance tax court cases, three more cases have been tried, two of which have been fully briefed. 

The three cases, said Mr. Lavelle, include Caylor (Judge Holmes), for which there is no opinion yet and which involved a brother-sister arrangement and no risk pool; Wilson (Judge Holmes), which he said has been sidetracked because of motions and likely will not be due in until the fall of 2019; and Syzygy, a Delaware captive case where the Internal Revenue Service (IRS) seeks to tax both the insured and the captive insurer to deny a deduction to the insured and tax the premiums.

Commenting on Avrahami and Reserve Mechanical, copresenter Mr. Wright of Eversheds Sutherland (US) LLP said that he believes the overarching theme for both cases is related to the judges' concerns that the risk pools had no losses. 

Specifically in Reserve Mechanical, Mr. Wright said that Judge Kerrigan focused on the notion of a circular cash flow in the risk pool. The judge did not find losses, had issues with the attachment points, did not believe that any losses would reach the pool, and therefore concluded that the pool had no credibility. 

Mr. Wright pointed out that the issue for small captive insurers using pools for risk distribution [in order to be treated as insurance for tax purposes] is figuring out "what will need to be done relative to putting losses in a pool to hedge issues brought up by the tax court surrounding risk pools."

"Campaigns" and Global Settlement Initiative?

Mr. Lavelle said that the IRS's Large Business and International Division (LB&I) (large public companies down to those with $10 million in assets) has redirected its audit philosophy to focus its resources on specific issues ("campaigns"), rather than performing comprehensive general audits.   

Per Mr. Lavelle, traditionally IRS agents would continually audit large public companies, year after year, to watch successive business cycles. More recently, the IRS is moving away from this approach in favor of focusing on "campaigns." The first of these 13 "campaigns," announced on January 31, 2017, was "micro-captives," which Mr. Lavelle suggested is somewhat counterintuitive, given that the original effort was directed at large business.

The IRS is exhaustively and "exhaustingly" auditing small captives and advancing several to appeals and to court, said Mr. Lavelle. Many people think that this may alternatively lead to a global settlement initiative. Mr. Lavelle said that while this has gotten a little press, he thinks a global settlement is probably not likely. A global settlement would mean that all taxpayers that fit "X" criteria (i.e., a pure tax shelter) would be invited by the IRS to "come in" to get a one-time deal.

However, Mr. Lavelle said many individuals believe that micro-captives are not appropriate for global settlement initiative because "the IRS has consistently said that this is a legitimate transaction for risk management purposes and [they are] just concerned with a few situations that are out there."

With Notice 2016–66, Mr. Lavelle said that "the IRS [said it] really doesn't know what these situations are, they are really just trying to get their hands around these transactions." Mr. Lavelle continued, "That's why we are getting this rush of information."

Therefore, without a "good" working definition, there is no way to define what would fall into a global settlement, according to Mr. Lavelle.

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