Wednesday, July 24, 2024

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IRS continues war on 831(b) captives: When will it end?

  • Only a small number of cases brought against 831(b) owners have concluded
  • ‘Listed transaction’ fears and IRS pressure leading to “panic closures”
  • No timeline for IRS to confirm status of latest proposals
  • Legislative proposals being prepared for IRS

The Internal Revenue Service (IRS) remains at a stand-off with captives making the 831(b) tax election, and there is no indication of an imminent conclusion, with some observers believing the IRS is purposely drawing out the process.

Captive Intelligence reported in April 2023 that the IRS had proposed new regulations for ‘micro captives’, which divided opinion across America’s captive landscape, with some saying they could destroy the industry, while others have branded it a “refreshing change”.

The proposed IRS regulations would see certain 831(b) captives deemed “listed transactions,” and others labelled “transactions of interest.”

The majority of captives that recorded a loss ratio under 65% would be considered a “listed transaction.”

The 65% loss ratio threshold has been almost universally scorned. It is not uncommon for captives, whether taking the 831(b) tax election or not, and commercial insurers to perform at or better than that level.

“The Proposed Regulations would make nearly all 831(b) captives listed transactions, which is a very harsh category with strict reporting requirements,” Bailey Roese, partner at Dentons, Bingham Greenebaum, told Captive Intelligence.

“Complying with these requirements is expensive, and making mistakes is also costly.”

Nevada’s Deputy Insurance Commissioner, Nick Stosic, said some companies could still have an 831(b) captive and comply under the proposed new rules.

“It would just change to some extent the type of coverages that someone would employ in their captive,” he said.

“That would be the one challenge to make sure they are expecting over a 10-year period to have the required loss ratios.”

Daniel Kusaila, partner at Crowe, said the IRS has waged a war against 831(b)s with its latest proposals.

“If you look at the timeline, starting around 2013 to 2014, and track everything they’ve done, it’s progressively gotten worse,” he said.

“My gut reaction, without having any specific knowledge, is that the IRS just looked at it and said enough is enough.

“They dropped what I’ll refer to as a bomb, considering these are going to be listed transactions, which are essentially tax shelters.”

The IRS has a history of going after micro captives in the Tax Court, winning its most recent case at the end of last month against Dr. Patel, the co-founder of an eye surgery centre and the founder of two research centres in the West Texas area.

Beginning in 2011, Patel’s businesses supplemented commercial insurance coverage by purchasing policies from purported micro captives Magellan Insurance Company and Plymouth Insurance Company that Patel also controlled.

In short, the US Tax Court found that Magellan’s and Plymouth’s premiums were unreasonable and were aimed at maximising tax deductions, rather than incorporating actuarially sound principles.

The Court also found that Magellan’s and Plymouth’s purported captive transactions did not constitute insurance because they “failed to distribute risk and, in the alternative, did not act as an insurer commonly would”.

Case back log

Data seen by Captive Intelligence indicates that of the approximately 80 micro captive cases concluded in the US Tax Courts since 2014, no deficiencies were found in 25 of those.

Of the over 1,100 cases lodged in the US Tax Courts since 2014 for alleged unlawful 831(b) transactions, over 990 cases are still pending hearing.

Mike Raybshteyn, partner at EY, said that the firm tells all its clients and prospects that a captive structure needs to be set up properly and for the right business reasons.

“As certain recent court cases have shown, the IRS and Tax Court in those cases did not agree with the taxpayers, and that resulted in penalties and interest for applicable years under audit,” he told Captive Intelligence.

“If a company is setting up a captive for the right business reasons, at least that way such company can say it has done its due diligence, used appropriate consultants, and received the right technical advice.

“Tax authorities have the right to audit, but a client that has all the appropriate support documentation should be able to support why a particular position was taken on a tax return.”

Not worth it

As a result of the overhanging proposals, many 831(b) captives are looking to close down, and many potential new captive owners are deciding that taking the election is simply not worth the hassle.

Kusaila said that when clients are generally presented with how much they are saving from the tax election, most of them are surprised by how little the amount actually is.

“Many of them have decided to dissolve their formations,” he added. “What I’m noticing is that even those new formations that explore the potential tax savings, when you present this option, they say they do not want any part of it.

“So, from my practice alone, I’m not seeing a willingness or desire to make the election for new companies.”

Kusaila said some current 831(b) owners have decided that the risk is just not worth the reward.

“I’ve encountered cases where they have considered revoking the 831(b) election, which, to me, might signal to the IRS, ‘Hey, look, I’m in it for the right reasons,’” he said. “Revoking the election could indicate that, but it might not.”

Kusaila said there is a big misconception, “and I think many folks do not realise that the 831(b) is not exactly a complete permanent tax saving”.

“It’s more of a deferral with a small-rate differential, and the captive should be entered into for strictly insurance purposes.”

Stosic told Captive Intelligence last month that if the IRS backtracks on proposed regulatory changes for 831(b) captives, around 50 of the 62 captives that were dissolved in the State last year could look to re-form in the future.

He said the potential of being treated as a tax shelter led to these captives making the decision to close.

“It was something where even though it has not been adopted yet, they just wanted to get ahead of it,” he said. “I would say that we know 50 of those dissolutions were absolutely due to that.

“It was all reacting to the proposed 831(b) IRS rule, and they just felt more comfortable starting the year not having active captives. Unfortunately, we got hit with one shot with that.”

In December, members of the House Ways and Means Committee sent a letter to the Internal Revenue Service Commissioner Daniel Werfel expressing their support for small captives.

The 831(b) Institute was also launched in the US in June and is asking for clarity from the IRS around how it regulates micro-captives, arguing that it “unfairly” scrutinises them.

Instead of creating guidelines that allow for micro-captive plans to be fairly regulated, the 831(b) Institute argues that the IRS is attempting to push forward harmful regulation that will make micro-captives less effective.

When will it end?

The frustration for the captive industry in the US is that the IRS is under no time pressure to finalise its proposals.

The IRS initially told the industry that it had plans to confirm proposed regulations by the end of 2023, but this did not happen.

“Part of it is maybe a shift in priorities as the IRS has a number of things on its plate,” Raybshteyn said.

“We had follow-ups with members of the Service, and while we were told that at this point, it’s still on the table, no additional, more concrete dates were noted by which the proposed regulations may be finalised.”

Dustin Carlson, president at SRA 831(b) Admin, told Captive Intelligence that it’s “anyone’s guess” as to when the industry might get some clarity from the IRS regarding these proposals.

“The cynical side of me might think that they are just going to let it hang out there like a Sword of Damocles hanging over the code,” he said.

Roese said there are two potential explanations for what the IRS is considering. “The first school of thought is that they will finalise them at some point,” she said.

Another school of thought is that they have no plans to finalise the proposals and instead intend to leave them out there indefinitely.

“There’s no ticking timeline on it; they can just remain unresolved,” Roese said. “This is because they’re currently achieving what they want, which is panic closures.

“Many accounting firms are not working with 831(b)s because their malpractice insurers probably won’t allow it.”

Roese said that by issuing those regulations, it has had a ripple effect where captives owners are asking, “Well, now my accountant won’t work with me, what’s the point of having this 831(b)?”

“It’s tough because there are some that have been around for a long time,” Bailey added. “I receive calls from them, and they’re like, ‘look, we’ve been audited before, and the IRS didn’t charge us any more tax, so we had a good arrangement.”

“Now, the IRS will never say that, but they’re like, ‘am I really a listed transaction now? And what do we do?’ So, it’s just a tough environment. People need an iron stomach to want to stay in it.”

The captive industry has constantly been asking for guidelines from the IRS but to no avail.

“Because there’s no definition of insurance in the tax code or in the Treasury regulations, it’s all shaped by case law and judicial rulings,” Roese said.

“Then we have IRS revenue rulings that tell us certain things, but in terms of the tax tests themselves, there’s just nothing we can point to as the definitive definition.”

Although no one is certain about what the IRS plans to do next, Carlson believes that by working with others in the industry and sharing thoughts with members of Congress, the industry has a good chance at a positive outcome.

The aim is that with additional pressure the IRS will be forced to come up with some safe harbour guidance.

“In 2024, we’re starting to develop some legislative proposals,” Carlson said.

He said the first goal is to get the definition of an insurance company for tax purposes and get it clearly defined.

“As far as what I would like to see, rather than the IRS just throwing things out, it would be great for them to come to the table and discuss and bring the stakeholders together,” Carlson added.

“Let’s talk about their concerns because there have been abuses and we do not shy away from that.”