Forming a small insurance company known as a microcaptive can be a great way for small businesses to reduce insurance costs and realize tax savings. Abusive microcaptive arrangements, however, have attracted scrutiny from Congress and the IRS.
Last month, the Tax Court decided an important microcaptive case, holding against the taxpayers and finding the captive invalid.
While legitimate microcaptives still offer attractive benefits, they should be carefully reviewed in light of this decision and related recent developments.
Microcaptive insurance companies are affiliates of their corporate parents formed to provide the parent with insurance. They can be formed to insure risks that are not insurable on the commercial market, or that are prohibitively expensive to insure. Because the taxpayer owns the insurance company, if the loss events insured against do not occur, the premiums remain with the corporate group. Reinsurance can be used to reduce the risk of large losses.
Taxpayer can deduct the premiums paid to a microcaptive as long as they qualify as payments for insurance for tax purposes. Microcaptives with no more than $2.2 million per year in premium (recently increased by Congress) do not pay tax on their income. Because the deduction of premium payments does not give rise to a corresponding income inclusion for the captive, microcaptive arrangements generate a current tax savings.
For premiums to be deductible, they must qualify as insurance. Classically, courts have held that insurance must involve both risk shifting and risk distribution. Generally speaking, risk shifting means that the financial consequences of the loss must be transferred to the insurer, and risk distribution means that losses must be spread among a pool of insureds.
Conceptually, it can be difficult to see how true risk shifting and risk distribution can be achieved if the captive is ultimately owned by a single parent. The IRS has, however, found these doctrines satisfied where the captive insured the risk of a dozen subsidiaries of the parent, each with between 5 and 15 percent of the assumed risks. In another easier to conceptualize ruling, the IRS blessed a group captive established by a group of unrelated businesses in which no participant paid more than 15 percent of premiums.
Microcaptive promoters offer products that are intended help satisfy the risk shifting and risk distribution requirements by allowing wholly owned captives to pool risks with other captives. While some of these pools represent legitimate efforts to share risk, others are specifically designed to look like risk pooling but to minimize the risk of ever paying third party claims.
A number of recent developments have tightened the standards for microcaptives. Amendments to the Internal Revenue Code effective Jan. 1, 2017 added a new “diversification” requirement. Among two alternative tests, a captive can meet this requirement if no more than 20 percent of the premium is attributable to one policyholder. Congress also prohibited certain illegitimate uses of captives for estate planning.
In addition, last year the IRS issued a notice classifying captives as “transactions of interest” and requiring disclosure on tax returns of captives with certain characteristics that the IRS views as markers of potential abuse. And, in March, the IRS announced a microcaptive compliance campaign.
All of this sets the stage for the August Tax Court decision in Avrahami v. Commissioner. The taxpayers in the case were successful owners of three shopping centers and “three thriving jewelry” stores. After establishing a microcaptive, their insurance bills quickly skyrocketed from approximately $150,000 to $1.3 million, suggesting that the motivation for the captive was generating tax deductions for premiums. Indeed, no claims were made on any of the insurance policies issued until the IRS began its audits, and the captive loaned almost half of its accumulated surplus back to the taxpayers.
Based on these facts, the IRS denied a deduction to the taxpayer for its premium payments and held that the captive was not a valid insurance company. In doing so, the Tax Court applied the risk distribution tests above as well as other related legal doctrines. Because the decision was based heavily on the facts and circumstances, which were somewhat egregious in this case, the case offers little in terms of a bright line rule for future taxpayers, though it certainly serves as a cautionary tale about aggressive planning.
Based on all of these developments, it is clear that microcaptive arrangements will be highly scrutinized by the IRS and the courts. This is not to say that microcaptives—when used correctly—cannot be a legitimate tax planning tool for businesses.
This is easily illustrated by the group microcaptive, in which a small group of unrelated businesses join together to pool common risks. These businesses may wish to pool risks with each other rather than the general population as they can select known partners with better loss histories than the overall population and can implement shared risk management. In addition to pooling their risks together, they can reinsure catastrophic risks through the reinsurance market.
The recent law changes establish new rules for the required diversification of group microcaptives, but the level of risk distribution required is probably something that would be desired as a commercial matter anyway if the goal is really insurance and not tax savings. Among the recent law changes, Congress also increased the permitted microcaptive size by $1 million per year in premium—indicating that legitimate microcaptives are not disfavored.
In light of these recent developments, it is clear that all existing microcaptive arrangements should be reviewed for compliance and that businesses should approach pitches by microcaptive promoters with a healthy dose of skepticism. While there are legitimate uses for microcaptives, the IRS has its eye out for their use for improper tax avoidance.
Josh Gewolb is a tax partner at Harter Secrest & Emery LLP.