Notes from the Trenches Advice for Section 831(b) Captives Who Are Not Under Audit (Yet)

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Notes from the Trenches[1]
Advice for Section 831(b) Captives Who Are Not Under Audit (Yet)

Michael E. Lloyd, Esq.

 You have a Section 831(b) Captive and your CPA has been sending you copies of the IRS latest attacks on abusive captives.  You have certainly felt the chill in the air and sense a target on your back.  But you are not under audit (yet) and your captive Manager tells you that everything is fine.  What should you do?

This article is for you.

Now is the perfect time to consider your 831(b) Captive.  Despite warnings from the IRS, the fact is that Congress created special tax benefits for 831(b) Captives and recently increased those benefits even while the IRS was starting its audit campaign[2].  The question then is whether your Captive is the type of Captive that was blessed by Congress and would be found acceptable by the IRS, or whether it would be considered abusive by the IRS.

To answer this question, you need to consider your captive formation, current operation and your captive manager. The following 15 questions will focus your attention on what you need to determine the current status of your Captive.

Your Captive Foundation.  In audit, the IRS looks carefully at the creation of your captive.  Why and how was it formed?

Question 1.  Why did you want a captive?  You should have a very clear need for insurance that was either not affordable or not obtainable that is the foundation for your consideration of a captive.  There should be a history of considering the insurable risks, including past claims and the consideration of alternative commercial coverage.  It is ok that you considered the tax benefits, but not ok if the tax deduction was the main driver.

Question 2.  Did you receive advice from an outside professional prior to creating the Captive?  It is important that you reviewed the captive transaction with an independent tax/legal or insurance expert (and maybe all three).  It is best that their views were expressed to you in writing and that you paid for them.  It is important that these experts are not related in any way to the Captive Manager or anyone else involved in the sale of the captive transaction.  It is not necessary for you to purchase a formal legal opinion (though that would be nice), but the key is that you considered it fully with an independent professional who had expertise in this area and ultimately gave his or her blessing.

Question 3. Did the underwriter who was developing your policies spend considerable time considering your business, risk history and commercial coverage?  This should have been a cooperative process where the underwriter gets to know your business and the business risks that you want to insure.

Question 4.  Did the underwriter ask you about your desired premium and then suggest policies that would have premiums equal to your desired deduction?  I often see cases where a business owner will have a real insurance need for one or two types of policies, but then accept other policies so that the total premium amounts are at the desired deduction amount.  This is a problem because the IRS will focus on the policies that weren’t needed as evidence that none of them were needed.

Question 5.  Did you choose an offshore jurisdiction because the capital and regulatory requirements were less?  The IRS sometimes perceives offshore jurisdictions as the equivalent to the Wild West with less restrictive rules and regulations.  For this purpose, it is better to show a jurisdiction with substantial capital and regulatory requirements and your compliance with those requirements.

Current Operation.  In addition to considering the formation of your Captive, the IRS will also focus on its current operation.  These questions address current operation.

Question 6.  Have you had annual or more frequent meetings to consider the filing of claims?  One of the worst factor to have in an IRS audit is for a business to pay substantial amounts in premiums for a policy and then never file claims even though the business has experienced losses.  If you are paying a high premium for a policy every year and have never had an occurrence of the insured event, that is not necessarily bad (consider flood insurance).  But it is bad if you have a policy and have claims but never file them.

Question 7.  Have you had annual or more frequent meeting to discuss your total insurance coverages?  It is important that you are not purchasing coverages from your captive that are already covered by commercial insurance for a lot less.  Each year should be a new opportunity to review whether specific policies are needed and whether they are priced accordingly.  If, for example, you are paying a $100,000 premium for a trade credit policy, but your annual bad debt averages $50,000, it will be hard to explain the need for the policy to the IRS.

Question 8. Has your Captive demonstrated risk distribution?  If you are relying on subsidiary coverages, do you have enough of those to satisfy risk distribution?  If you are relying on a risk pool, you will want to consider carefully why it is that your risk pool is providing good risk distribution when the risk pools in the most recent Tax Court cases have not.  You should also consider your number of exposure units.

Question 9. Is your Captive compliant with all document and regulatory requirements?  You should have written policies for each policy purchased and very clear documentation about any additional risk.  Be especially concerned about outside risk that has conditions that make it so it is not really a significant risk assumed.  A third-party risk with a potential $1,000,000, but with a cap to the captive of $10,000 is not really a $1m risk.

Question 10.  Have all parties to the transaction filed IRS Forms 8886 each year for which there has been a tax benefit of the Captive transaction?  There are three bad things that can happen when the Form 8886’s are not filed completely.  The first is a penalty of 75% of the tax benefit with minimum and maximum amounts[3].  The second is that the accuracy related penalty changes from 20% with a waiver for reasonable reliance on an independent tax professional to 30% with no ability for it to be waived or reduced.[4]  The third is the practical reality that when the IRS gets a customer list from a Captive Promoter, they choose the taxpayers to audit to get the most revenue.  That is often the taxpayers who failed to file the Forms 8886.

Captive Manager Questions.  In most cases, captive audits are “targeted audits,” meaning that the IRS Agent is interested only in your Captive.  The IRS may learn of your involvement in a captive transaction from a promoter audit of the Captive Manager.  One of the first requests to the Captive Manager will be for a copy of the customer lists.  Armed with that information, the IRS will pick some number or percentage of customers of that captive manager and open up individual audits.  Thus, you should ask the following questions to the Captive Manager each year.

Question 11. Has the Captive Manager or any of their customers been audited by the IRS with respect to the captive transaction?  If so, what is the status of the audit?  Also, if a customer has been audited, was it a random audit that maybe touched on the captive transaction or an audit where the captive was especially scrutinized.  Be wary of claims from a promoter that their program has been audited and approved.  Often, what it means is only that a customer was the subject of a random audit and the IRS did not consider the captive, or did not focus on the captive part of the return.  This is very different from the IRS fully considering a captive transaction and deciding that it is compliant.

For the promoter audit, the IRS always seeks to find a false statement under which they can then retrieve a percentage of the profits from the Manager.  This is often the kiss of death for the Manager as it ends up fighting a losing battle with the IRS on the penalties, and then defending civil cases from customers who are now under audit and being told by the IRS that their captives are defective.

Question 12. If the Manager has been audited, has the Manager provided the customer list, and if so, did that list include the current captive?  It is my experience that the IRS will only audit a percentage of the customer list, depending on the level of compliance and the IRS available resources.  In most cases, the IRS does not appear to audit more than 50% of customers.  It is my experience that if a taxpayer is not chosen for audit within the time the IRS is opening customer audits, then it is likely the taxpayer will not be audited.  This may all change with the IRS commitment to 12 new examination teams.[5]

Question 13. Does the Manager have any legal or actuary opinions that the risk distribution requirements are satisfied?  If so, will they provide copies of those opinions?  It is important to see that the Captive Manager is trying to do the right thing.  Although the legal opinions issued to the Manager, may not apply to you personally, it would give your tax advisor a head start in determining the validity of the underwriting and risk distribution.

Question 14. Has the Manager filed the Material Advisor disclosure form with the IRS?  If so, what is the material advisor number for purposes of the Form 8886?  You want to see that the Captive Manager has been forthright in dealing with the IRS and has filed the appropriate disclosure forms.

Question 15.  Will the Manager pay the legal costs to defend its underwriting and risk distribution strategies?  This is a tough one, because most Captive Managers will not pay your IRS defense costs.  But, at the least, they should be prepared to answer any questions or provide any defenses with respect to the underwriting and risk distribution.

If you have questions about your Captive, call Mike Lloyd at (412) 454-0225 or email him at


[1] Michael Lloyd is an attorney who advises business owners on captive insurance programs.  Mike conducts Pre- IRS Audits, and has represented captive business owners under IRS audit in Exam, Appeals and Tax Court.  Mike is currently representing taxpayers who are considering the IRS Initiative.  Mike also has prepared more than 1,000 IRS Forms 8886.

[2] Congress increased the limit from $1,200,000 to $2,200,000.  See 12/19/15 Jay Adkisson Article in Forbes Magazine, entitled “Congress makes 831(b) Much Better and Deals with (Some) Abuses in 2015 Appropriations Bill.”

[3] Code § 6707A(b)(1).

[4] Code §6662A(c).

[5] See IRS News Release 2020-26.