Micro captive, micro problem

Micro captive growth has slowed down considerably as potential owners digest the implications of IRS maneuvers against the industry. But the presence of a few bad apples should not detract from the good work done by most captives, says Jeremy Colombik of Management Services International.

It has been an interesting year for captives electing Internal Revenue Code section 831(b) status also known as small captives or micro captives. So far this year, the Internal Revenue Service (IRS) has kept these types of captives on its annual Dirty Dozen list of tax scams, and has won yet another legal case against an 831(b) elected captive.

More recently, the IRS has sent out a settlement offer to certain micro captives under audit that it deems abusive.

What does this all mean to the marketplace for micro captives? Should small to medium-size businesses, which are the general clients for the micro captive solution, be worried?

The market for captives electing 831(b) status is currently cautious, based on the events of this year. While the market continues to grow, the pace of growth has slowed. More clients and their advisors are researching the possibility of launching captives, which is good, but some clients are put off by the potential risk.

Captives are a great solution for many of these types of businesses, if done for the right purpose, so it is unfortunate if they are being discouraged in this way. If a captive acts as a true insurance company, the client should be fine.

Slowing down

Three events this year have given clients that might have been moving forward with plans for forming micro captives cause to hit the brakes.

First, micro captives are on the IRS annual Dirty Dozen list of tax scams. This is not saying that all micro captives are bad, but rather that some micro captives are abusive. Captives are supposed to act like insurance companies, but some do not, and therefore will not receive insurance company taxation benefits.

This is true for the captive insurance industry, and other industries as well. People sometimes form structures for tax benefit purposes only, and this is certainly true in the world of captives, but tax is only one of the main benefits a captive can offer. If structured properly, a captive can receive the benefit of insurance company taxation, as well as other benefits.

The IRS seems to be saying that not all micro captives are bad, but they need be sure they are set up and run correctly. Specifically, this means that a captive which is an insurance company should have basic items, such as actuarial pricing for policies, claims procedures, proper capital and surplus to pay claims.

The second big event is the IRS legal win over Syzygy. Most of the professionals working in this industry were not surprised by this decision, which goes back to the previous point about a captive needing to act like an insurance company to be eligible for insurance company benefits.

Syzygy was doing a lot of things wrong: no claims procedures; no actuarial computations to determine policy premiums; no timely issuance of insurance policies; no real holdbacks on premiums for claims; and reserves frequently invested in illiquid assets that would make claims payment impossible. Basically, a company was set up for tax purposes only and it was called a captive to optimize the tax benefits.

The Syzygy case entailed the business owners paying premiums to a micro captive and deducting these payments to the business as it was purchasing insurance policies. However, the Tax Court determined the premiums that the business paid to the captive were not deductible, on the basis that the micro captive was not an insurance company. If the captive had been doing the items previously mentioned having claims procedures and actuarial computations for premiums, etc., there would likely have been a different outcome.

An offer they can't refuse

Finally, the IRS has announced that it is offering a settlement to approximately 200 captives currently under audit that have not yet gone to Tax Court or other litigation. This settlement offer was made in September 2019, for micro captive insurance schemes: captives that the IRS believes are schemes that do not operate as insurance companies.

While this may seem like a lot, there are around 4,000 to 6,000 captives in the US alone. Comparatively speaking, 200 is a very small number. The identity of the captives in question is not public information, and it is likely some of them are clients of the captive risk pools that the IRS has already beaten in court. Such captives would be expected to lose against the IRS. For a captive client whose captive risk pool had lost against the IRS, this IRS offer would be very attractive.

For any captive client that has received this offer and is not associated with a risk pool that has lost against the IRS it comes down to a cost benefit calculation. This settlement offer is a way for the IRS to collect money without using its limited resources to litigate each case.

If a captive client is doing everything right with regard to documentation and processes, it should be able to demonstrate that it is a legitimate insurance company, entitled to the benefits of insurance company taxation.

While there have been negative outcomes for micro captives this year, one must stand back and analyze these events. These negative outcomes are the result of bad apples in the industry, calling themselves captives to collect benefits, without doing the work associated with real captive insurance companies.

The IRS does not seem to believe that all captives are bad. But like any industry, there are people that abuse them, and they need to go. The events this year confirm that statement.

These events have slowed micro captive growth as people become more cautious, but growth continues. Captives are a great business solution for companies and micro captives are generally good for small to mid-size business owners.

Let's hope that after the IRS loses some public cases it will turn its attention elsewhere.