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The IRS defines a captive insurance company as a “wholly owned insurance subsidiary.” Insurance can be defined by three basic tenets initially derived from Harper Group v. Comm’r [96 T.C. 45, 47 (1991)], which states that all captives must comply with the following three factors: 1) the arrangement involves the existence of an insurance risk, 2) there is both risk shifting and risk distribution, and 3) the arrangement is for insurance in its common accepted sense. United States Tax Court decisions have, over time, brought clarity to captives established in a compliant manner.
Because of the prevailing state insurance regulations in the 1950s, Reiss’s initial captive insurance company was established in Bermuda. Thus, the initial growth of the captive insurance industry was offshore, and many still believe that captives are a strictly offshore business phenomenon. The IRS initially questioned the concept of deductible “self-insurance” and, in 1977, issued Revenue Ruling 77-316, which denied the deductibility of captive insurance premiums based on what was referred to as the “economic family” doctrine. This doctrine, which called into question the basic tenets of risk shifting and distribution established in 1941, was fought in the courts and ultimately repudiated.
In 1978, Revenue Ruling 78-338 defined the number of participants in a “group” captive that were needed to create deductible insurance premiums: “A ‘group’ Captive is an insurance company formed by multiple corporations seeking to insure similar risk, i.e. … workers compensation, health insurance, employee benefits, etc.” This decision would later help clarify the risk distribution components of stand-alone captives (Revenue Ruling 2002-90).
The federal government had defined the necessary components of insurance in Helvering v. Le Gierse [312 U.S. 531 (1941)], which established the principle that both risk shifting and risk distributions are required for a contract to be treated as insurance. Many court cases followed this initial decision, but clarity is still being sought, particularly as it relates to captive insurance. This is important because, as discussed below, almost every state government sponsors the development of captive insurance companies.
The court battle over captive insurance continued for over 20 years after Revenue Ruling 77-316. In Revenue Ruling 2001-31, the IRS finally acknowledged that it would no longer evoke the economic family doctrine to challenge the deductibility of captive insurance premiums. Instead, it began to fight selective battles, believing that the basic premise of insurance as defined and understood by the courts needed further clarification.
In 2014, the IRS suffered another major defeat in Rent-A-Center, Inc. & Affiliated Subsidiaries v. Comm’r [142 T.C. 1 (2014)], and Securitas Holding, Inc. & Subsidiaries v. Comm’r [T.C. Memo 2014-225 (2014)]. Following these setbacks, the IRS responded by placing captive insurance companies on its “Dirty Dozen” list of possible tax scams. By 2016, the IRS required captives under IRC section 831(b) to be treated as “transactions of interest,” requiring disclosure by owners, managers, and material advisors as to their role in all captive transactions. IRS Notice 2016-66 required IRC section 831(b) captive owners to file a Form 8886, “Reportable Transaction Disclosure Statement,” and their material advisors to file Form 8918, “Material Adviser Disclosure Statement.”
After reexamining the risk requirements and the needs of businesses affected by IRC section 831(b), and in spite of the IRS including captives on its “Dirty Dozen” list, Congress increased the section 831(b) annual deductible insurance premium limits from $1.2 million to $2.2 million and further indexed this amount for inflation under the 2015 Protecting Americans from Tax Hikes (PATH) Act. In addition to the premium increases, the PATH Act also provided specific language preventing IRC section 831(b) captives from being used as estate tax planning vehicles. Although only a small number of captives was being used in this manner, Congress essentially decided that the ownership of each captive should mirror the ownership of the sponsoring businesses.
Captive arrangements can increase the probability of success by incorporating the use of independent advisors, including tax advisors, legal counsel, actuaries, risk managers, and captive managers.
On August 21, 2017, the Tax Court rendered a decision in Benjamin and Orna Avrahami v. Comm’r [149 T.C. No. 7 (2017)] that expanded the points made in its initial decision rendered in Harper. In Avrahami, the court denied deductions for premiums paid to an offshore insurance company and determined, among other things, that elections made under IRC section 831(b) were invalid and premiums paid did not qualify as insurance premiums for federal income tax purposes.
While the fact pattern in Avrahami is not indicative of how compliant captive insurance companies should be structured or managed, the case does bring more clarity to the use of IRC section 831(b) arrangements. This decision followed years of consistent precedent by stating the following:
- Risk distribution is vitally important. Pools that do not constitute insurance in the commonly accepted sense will not be able to provide risk distribution. Drafting coverage in a manner that precludes or eliminates meaningful actual claims is not insurance in the commonly accepted sense.
- A captive with no claims experience is a problem. From 2007 through 2013, there were no direct claims filed with the Avrahami captive insurance company. In addition, no claims were filed with the risk pool either, in spite of the fact that 50–75 clients participated in the arrangement.
- Claims review and payment methodology was not done in an organized manner. The essence of an insurance company is to handle claims when they come due; ad hoc claims treatment and inconsistent review and approval procedures are problematic.
- The court will criticize a lack of actuarial experience and inappropriate or inexplicable pricing or methodology. The Tax Court determined that “actuarial pricing of the policies issued by the Avrahami captive were utterly unreasonable.”
- Captive arrangements can increase the probability of success by incorporating the use of independent advisors, including tax advisors, legal counsel, actuaries, risk managers, and captive managers.
- Arm’s-length, bona fide arrangements and transactions must be utilized.
- Adherence to capitalization requirements as instructed by domicile regulators is essential.
- Investments and loans will be reviewed in an overall context of reserves and surplus; loans should not be encouraged. The Tax Court found that in Avrahami, “the insurance company had invested more than two-thirds of its assets in long-term, illiquid, and partially unsecured loans to related parties and failed to obtain advance approval from its regulators for such loans.”
This decision, together with the many years of history outlined above, provides a clear picture of what not to do when structuring and managing an IRC section 831(b) arrangement. But it also reaffirms years of best practices that have helped many businesses achieve a greater level of risk protection than previously envisioned.
Captives must carefully abide by all risk shifting, risk distribution, insurance pricing, claims adjudication, and state and federal compliance.
Captives must carefully abide by all risk shifting, risk distribution, insurance pricing, claims adjudication, and state and federal compliance outlined over the past decades. Only then can commercial insurance be integrated with private coverage to create the optimum risk management solution.
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