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IRS proposed rule on micro-captive insurance may limit alternatives for small businesses

The Internal Revenue Service is proposing to restrict access to micro-captive insurance as a way to crack down on tax fraud, but at a time when some traditional insurance providers are backing away from offering coverage in states like California that have been experiencing natural disasters, some worry the proposed rule could make it even more difficult for small and midsized businesses to obtain coverage in case of disaster.

The IRS held a hearing in late July to discuss Proposed Rule 109309–22, which would identify certain micro-captive transactions as listed transactions and transactions of interest (see story). Some advisors and participants would be required to file disclosures with the IRS and be subject to penalties if they failed to disclose the transactions. The IRS has been cracking down on the abuse of micro-captive insurance over the years, but has also faced setbacks in court.

In May 2021, the Supreme Court ruled in favor of CIC Services, a company in Knoxville, Tennessee, that specializes in helping small and midsized business owners set up their own captive insurance companies to protect their assets (see story).

CIC successfully argued that the IRS hadn’t followed the proper procedures under the Administrative Procedures Act when it issued a notice in 2016 designating a micro-captive transaction as a “transaction of interest.” This time the IRS is making sure to go through the proper procedures, including issuing a notice of proposed rulemaking and holding the public hearing in July. The outcome of the hearing hasn’t been determined yet, but proponents of micro-captive insurance argue that it could have a dire effect on small and midsized businesses. With insurance carriers pulling out of various states, businesses could be forced to turn to alternative ways to mitigate their risks. 

IRS headquarters in Washington, D.C.
IRS headquarters in Washington, D.C.

Andrew Harrer/Bloomberg

Small and midsized businesses use micro-captive insurance plans under Section 831(b) of the Tax Code to set aside tax-deferred dollars to mitigate risks not covered by traditional insurance so they can be more self-reliant in case a catastrophe occurs and don’t have to depend on aid from the Federal Emergency Management Agency. The proposed regulations would limit certain 831(b)-electing captives by lowering the loss ratio requirements from 70% to 65%. 

Section 831(b) came into existence in the Tax Reform Act of 1986, at a time when the insurance market was also experiencing disruptions.

“What was happening in 1986 is very similar to what’s happening today,” said Van Carlson, CEO of SRA 831(b) Admin, a company in Eagle, Iowa, that administers micro-captive insurance plans. “Traditional insurance carriers were not renewing and getting out of the market, substantial rate increases, tightening up of coverages, being non-renewed if you had claims, forcing you to go to a secondary market to try to get insurance. Fast-forward from 1986 to 2023, and now you’ve got probably bigger [catastrophic] losses than we’ve ever had. Hawaii just experienced it with Maui. And you have reinsurance markets now pulling out of the market.”

The PATH Act of 2015 increased the maximum annual premium limitation for micro-captives from $1.2 million to $2.2 million, but also sought to eliminate some of the abuses that had sprung up with the arrangements.

Carlson believes 831(b) micro-captive arrangements like the kind his company administers should still be available to small businesses that are having trouble getting traditional insurance coverage.

“We think it needs to become a normal business practice, where all businesses should have the ability, no different than having a 401(k), to put away funds on a tax-deferred basis to handle risks they can’t transfer through traditional insurance,” he said. “Given the state of the insurance market, exclusions are going to continue.”

He noted that back in 1986, when Section 831(b) was added to the Tax Code, few businesses needed to worry about cyberattacks and data breaches. Now, many business insurance policies exclude cyberattacks from coverage. Many traditional insurance policies have other exclusions as well, such as business interruption after events like the COVID-19 outbreak of 2020. As a result, many businesses have been forced to self-insure to protect against such risks.

He objected to the IRS’s proposed regulation, noting that under the McCarran-Ferguson Act of 1945, the insurance industry was exempted from most federal regulation, and states were given the right to regulate the industry.

“We feel like the IRS is starting to take the federal role of regulating insurance,” said Carlson. 

The proposed regulations would lower the loss ratio from 70% to 65% and require micro-captives to be reported on a Form 8886. “It’s really designed to have a taxpayer take a pause and ask should I be doing this program or not?” said Carlson. “The IRS is looking at these, and I’m going to have to file some additional paperwork. Does it give me exposure to audits?”

He pointed out that the PATH Act added an ownership test and he believes the new regulations would go against those provisions and discourage use of the micro-captives. “Congress created the incentive to do this, and we feel as a whole in the industry that it’s an overreach by the IRS to start putting in these additional regulations that are not part of the 831(b) Tax Code,” said Carlson.

Getting tougher

The IRS announced plans last week to start using artificial intelligence technology to uncover tax evasion by high-income taxpayers, large corporations and partnerships (see story). Such technology could potentially be used with micro-captives.

“We have much more coming up and other targeted areas for compliance,” said IRS Commissioner Daniel Werfel during a news conference last week. “Some of these you’ve heard of before, like abusive micro-captive insurance arrangements and syndicated conservation easement abuses. But much more work continued behind the scenes on other issues. Many of these are areas where the IRS in the past has not had enough resources to tackle these issues.” 

Accounting firms can expect to see more activity in this area, even when clients are complying with the Tax Code. 

“There are perfectly legitimate reasons for a business to have a captive insurance policy, and plenty of clients do,” said Colin Walsh, a tax principal and practice leader of the tax advocacy and controversy services group in the specialty tax team at Top 10 Firm Baker Tilly. “But where AI becomes interesting is rather than just saying this income tax return reports a captive insurance company, let’s go select it for exam. Now they might look at things like geography, industry, to the extent that there’s information that needs to be reported on those captives that the premiums that are paid, and things of that nature and say, OK, now let’s target these captives based upon where the data is leading us, as opposed to just previously without that data, selecting it because it happened to have a captive on it. So, it’s smarter, more sophisticated, it’s streamlined. In that respect, I guess the hope would be that the legitimate captives would have less to worry about.”

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