Captive insurance companies are a common business tool used by thousands of large and small employers to manage various insurance risks. Recently, small employer captives have come under increased IRS scrutiny. It is important for owners of small captives to know if their captive contains “red flags” that the IRS perceives to be abusive.
Small Captives – The “Abuse Du Jour” There is a perfect storm of reasons for the increased scrutiny that the IRS is currently giving to “micro captives” that make an election under Code Section 831(b). The first is man-power. The IRS has had its budget cut and needs to make the most of its limited audit personnel. The micro captives are perfectly suited for the IRS needs. The IRS can audit a captive promoter, obtain the customer list and then audit all of the captive promoter customers, using template legal analysis for all those who share the same promoter. Second, the IRS mass audit groups that enjoyed great success in dismantling the 412(i), and 419 promotions are now available to assist in the captive audits. Third, captives have come under increased scrutiny since being added to the IRS “Dirty Dozen List” for 2015, and more recently by virtue of legislation in late 2015 that both increased the premium limit to $2,200,000 and added a diversification requirement beginning in 2017.
Knowing the “Red Flags”. Unlike the recent perceived abusive industries of the 412(i) and 419 world, the IRS has more difficulty attacking captive life insurance companies for two reasons. First, it is clear that captives are authorized (and incentivized) under the Code and serve a useful business purpose. Second, it takes work – time and intelligence – to distinguish between an abusive captive and a captive that should be acceptable. Therefore, the IRS appears to have focused on certain captive promoters who have been determined to cut corners at best, or purposefully sell abusive programs at worst. The following is a list of red flags. This is not to say that having any single factor means that a captive is invalid, but if you own a captive and one or more of these red flags apply to your captive, you should consider them with legal counsel.
Promoter Audit. Because the IRS has a history of getting the names of people to audit from audits of the captive manager or promoter, you should pose these questions to your captive manager:
- Are you now, or have you ever been, under audit by the IRS as a promoter, captive manager, manager of a risk poolor in any other captive role ?
- If so, what is the status of the audit?
- If so, did you turn over a list of customers?
- Have you ever had a client or customer come under an IRS audit?
- If so, what was the outcome?
- Was the captive audited, or only the business?
- Was the reinsurance pool also audited? What result?
Marketing Materials. The IRS normally gets all of the ammunition it needs to kill a captive from the marketing materials of the captive promoter. Do the marketing materials you received or reviewed focus more on tax deductions and estate planning objectives than on insurance risk? If so, the IRS may be (or become) interested in that promoter.
Estate Planning. The perceived abuse identified in the 2015 Tax Appropriations Act relates to estate planning with captives. The idea is to shift income from the parent generation to the next generations by having the captive owned by the next generations (often through a trust) that accumulates assets from premiums paid by the business owned by the parent generation. If you have that situation, you will need to change the ownership for 2017, in any event to comply with the new law.
Life Insurance. Sometimes the real purpose (at least for the salesman) is to sell tax advantaged life insurance. Although life insurance is not a type of policy that can be issued by an 831(b) captive, it can arguably be an investment of the captive assets. So, some promoters will use built-up captive assets to purchase life insurance on the owner of the business.
Loans. Another practice that relates to the assets of the captive that are not used to pay claims is to lend them back to the owner of the business. In this way, the owner effectively keeps the premium dollars that received a deduction.
Reinsurance Pool Problems. Small captives most often satisfy the risk distribution requirement by participating in reinsurance pools. Sometimes the reinsurance pools are maintained by the captive promoter. Under the reinsurance pool, the captive cedes a percentage of the risk (and premiums) that it received from the business to the pool to reinsure, and also accepts an amount of risk from the other pool members. Most often, the amount ceded and the amount assumed are the same or similar. Although reinsurance pools may work to distribute the risk, common problems include –
- There is actually no sharing of risk as all claims are paid by the individual captives.
- There is a potential of risk sharing, but no claims are ever made so that there is no actual sharing of risks.
- There are guarantees or limits that effectively eliminate the risk to the pool or other captives and negate risk distribution.
Captive Formalities. Captive insurance companies are highly regulated businesses that are subject to capitalization and other requirements. A captive owner should be very confident that all of the those requirements are satisfied and that all necessary licenses have been obtained.
No-Risk Policies. The IRS is very concerned about policies that it believes do not insure a valid business risk either because the risk does not exist to a meaningful extent (e.g., typhoon insurance in Nebraska) or the cost is excessive. Taken to another level, the IRS will want answers to the following questions:
- Why are the policies of the Captive necessary to your business?
- How did you manage this risk prior to the Captive?
- Why did you change? Did you have a loss?
- Why didn’t you choose to insure this risk through your property and casualty insurer?
- Do you have any duplicate coverage?
Greatly Increased Insurance Expense or Maxed Out Limit. If a business owner increases annual insurance expense by a great multiple, or conveniently purchases insurance right at the maximum captive limit of $1,200,000, and without any obvious business reason for the additional insurance, the IRS is likely to consider that the motivation was for non-insurance reasons.
No Claims. If you have a captive insurance company and have a policy under which a claim can be submitted and would be submitted if it were an outside insurer, then you should submit a claim to the captive. If claims are not submitted, the IRS will contend that you had no reason for the insurance.
If you have any of these “red flags” call Mike Lloyd for a free consultation or email him at email@example.com
February 22, 2016