January 15, 2016
Captives: Congress Shoots, Misses
by James Landis
Congress tried to eliminate abuses in the formation of small captives but failed -- and may have made the problem worse.
In late December, Congress put together a last-minute “tax extender” package that, among many other things, made some changes to section 831(b) of the Internal Revenue Code. That section allows “small” captive insurance companies to elect to exempt from income tax all of their insurance income.
These small captives have been widely used in recent years by owners of large, privately held businesses to allegedly add to their existing insurance coverages while enjoying immediate income tax reductions. Further tax benefits could include conversion of ordinary income to capital gains and a potential estate transfer benefit, depending on the ownership of the captive.
Congress has changed those benefits a bit, by eliminating any estate planning benefits, starting in 2017. But Congress failed to address the true levels of abuse that this code section has spawned and, indeed, may have made things worse.
These “enterprise risk” or “micro” captives are primarily used as a form of tax shelter, notwithstanding the pious claims of captive managers that they are meeting legitimate insurance needs. While such needs certainly may exist in some clear cases, the vast majority of entrepreneurs forming these captives care much more about the tax benefits than any increased insurance coverage.
The IRS knows this and has stepped up both audits of individual companies and larger, promoter audits of captive managers in an effort to crack down on captives that are being formed without the intent to form an insurance company. In addition, the IRS is well aware that unscrupulous captive managers create vastly inflated “premiums” payable by the operating company to the captive to maximize the tax benefits of owning such a small captive. These premiums often bear no relation to third-party market costs, nor can they be justified by a reasonable actuarial analysis of the actual risk being insured by the captive.
Another abuse is found in captive managers’ offering the new captive owner what the IRS would call a sham “pooling” arrangement, to comply with certain “risk distribution” requirements of court cases and revenue rulings.
There are many cases pending in the Tax Court that attempt to corral these abuses. Their outcome is, of course, uncertain.
So the Treasury Department went to the Senate Finance Committee in early 2015, hoping to obtain legislation that would gut section 831(b) (and put a lot of captive managers out of business).
Instead, the department got legislation that only stops these captives from being used as estate planning tools.
The legislation also increased the annual allowable premium paid to such captives, from $1.2 million to $2.2 million, indexed for inflation. The reasons for this failure have a lot to do with Sen. Chuck Grassley of Iowa, who has long wanted an increase in premium to benefit certain farm bureau captives in his state. He needed some revenue offset to allow for the increase, and, by closing this “estate planning loophole,” he can claim that tax revenues will increase.
That claim may be doubtful (only about 1% of taxpayers end up being subject to the estate tax), and captive managers now have a new, higher goal of $2.2 million for the “premiums” to be paid to these small captives.
It is also clear that this new legislation will have no effect on the current robust enforcement actions underway by the IRS. The issues of inflated premiums, sham pooling arrangements and lack of substance in the alleged insurance transaction remain in force and subject to serious scrutiny.
It is unlikely that Congress will bother to look at this code section again any time in the near future.
As a result of this new legislation, section 831(b) captives can generally no longer be owned by the entrepreneur’s spouse, children, grandchildren or trusts benefiting them. (Details about how the legislation achieves this change can be found in other sources).
Perhaps as many as half of all existing micro captives were formed with estate planning in mind. These captives will have to change their ownership or dissolve before the end of 2016. Tax professionals should review all captives owned by their clients to ensure that they remain complaint with the changes in the law. Relying on the captive managers may not be sufficient.