New Tax Court rulings provide insight for taxpayers to help avoid tax compliance issues related to microcaptive insurance arrangements.
In two recent cases, Keating v. Commissioner, T.C. Memo 2024-2, and Swift v. Commissioner, T.C. Memo 2024-13, the Tax Court determined that microcaptive insurance arrangements didn’t qualify as insurance and couldn’t take advantage of the preferential tax treatment offered under Internal Revenue Code (IRC) Section 831(b). This is a continuation of a spate of rulings against such arrangements by the same court over the last several years.
Learn how the rulings impact the definition of insurance in such arrangements, and considerations to take for your tax approach.
Why Are Microcaptive Insurance Arrangements Coming Under Scrutiny?
Microcaptive arrangements have been under increasing scrutiny by the IRS in recent years due to their potential for abuse by unscrupulous promoters and taxpayers.
A major reason for potential abuse is the lack of a definition of insurance under the IRC and corresponding Treasury Regulations.
What Do Taxpayers Need To Know?
With the court rulings, as well as IRS scrutiny, including through the release of proposed regulations in April 2023, taxpayers need to be aware of how to properly structure a microcaptive to avoid tax compliance issues.
The Section 831(b) exception, the requirements under case law to properly characterize a microcaptive as insurance, and the proposed transaction reporting regulations from the IRS should be a key focus.
Section 831(b) Small Company Exception
An exception to the customary federal income tax rules applying to insurance companies exists for certain small companies under Section 831(b). This alternative taxing system is available to domestic insurance companies collecting net written premiums or direct written premiums per year not exceeding $2,200,000, as annually adjusted for inflation—$2,650,000 for the 2023 tax year.
Under the rules, the company only pays tax on its investment income.
Requirements for 831(b) Qualification
The following requirements also apply in determining whether the small company qualifies for the exception:
- Companies domiciled in a foreign jurisdiction must qualify and make an election under Section 953(d) to be treated as a domestic insurance company
- No more than 20% of the greater of net written premiums or direct written premiums of the company for a tax year are attributable to any policy holder; this is known as the diversification requirement
This exception for small companies applies regardless of whether the company is owned by a company it insures; however, utilizing the exception to create a microcaptive arrangement provides a tax advantage.
This advantage stems from the fact premiums paid by a company owning a microcaptive can be deducted whereas premium income earned by the microcaptive escapes federal income taxation.
What Is Considered Insurance?
For a microcaptive insurance company to qualify for the 831(b) it must be considered insurance. Insurance isn’t defined under the IRC or corresponding regulation. As a result, one must look to case law to determine the requirements for an arrangement to qualify as insurance. This is outlined extensively in the Keating and Swift cases.
Specifically, in both Keating and Swift, the court looked at four criteria utilized in previous cases in deciding whether the microcaptive arrangements at issue constituted insurance.
These criteria are as follows:
- Insurance risk exists
- Liability for the risk of loss shifts to the insurer
- Risk is distributed among policyholders
- The arrangement is insurance in the commonly accepted sense
Insurance Risk
Insurance risk refers to an unexpected occurrence of a specific loss, such as a fire occurring at a warehouse.
A risk isn’t insurable if it’s already in progress or substantially certain to occur.
Risk Shifting
Risk shifting means the liability for a potential economic loss is transferred to the insurer.
This means losses won’t impact the insured party as the losses will be offset by reimbursement from the insurer.
Risk Distribution
Risk distribution refers to pooling the risks among numerous policyholders. This means the potential liability of a single policyholder is shared among others.
This reduces the possibility that any claim will exceed the amounts received by the insurer and set aside for payment of claims.
The distribution of risk was a major issue in the Swift case. Unlike other cases where captive insurance was ruled to have met a proper risk distribution standard, the microcaptive didn’t have sufficient scale to properly distribute its risks. It only provided insurance to 28 locations with no more than 530 employees in total. In addition, the policies didn’t provide insurance for independent risks with many of the policies insuring overlapping risks. The risks being insured also lacked geographic and industry diversity.
Although the microcaptive in Swift was ruled deficient in its risk distribution, the taxpayer in the case argued that the participation in reinsurance pools by the captive led to proper risk distribution.
The court rejected this argument for three reasons:
- First, a circular flow of funds existed as over 95% of the premiums paid to reinsurers were quickly ceded back to the microcaptive.
- Second, the lack of arm’s length dealing in the negotiation of contracts.
- Finally, no evidence existed to support an actuarial determination of premiums and other evidence existed to the contrary, specifically, loss ratios for the reinsurance pools were significantly less than the average loss ratios in the industry.
Insurance as Commonly Accepted
In determining whether the arrangements in Keating and Swift were insurance as commonly accepted, the court analyzed five factors.
Specifically, the court focused on whether:
- The microcaptive was organized, operated, and regulated as an insurance company
- The microcaptive was adequately capitalized
- The policies it issued were valid and binding
- The premiums charged were reasonable and the result of an arm’s-length transaction
- Claims made under the policies were paid
In terms of operation, the microcaptives in both cases observed the formalities of insurance. However, in both cases the court described the captive insurers as acting in “an unthinking” manner.
In Keating, insurance contracts were completed retrospectively, rather than prior to the issuance of the policies whereas in Swift the taxpayer conducted no due diligence into the need for the microcaptive arrangements and heavily invested premiums in illiquid assets.
Adequate capitalization is met by simply meeting the minimum capitalization requirements set by regulators. This bar was met by the microcaptives in both cases.
As to whether the insurance contracts were valid and binding in both cases, the court noted in previous rulings that this generally occurs when a policy identifies the insured, sets an effective period for the policy, specifies what the policy covers, states the premium amount, and is signed by authorized representatives of the parties.
This didn’t occur in the Keating case as policies were delivered well into coverage periods without binders preventing significant changes to the policies.
Additionally, board resolutions were utilized to pay claims when the terms of policies didn’t support such claims. As noted in Swift, ambiguous and contradictory wording are also indicative of a non-valid and non-binding insurance contract when paired with the late issuance of policies.
When it comes to the determination of the reasonableness of the premiums charged, the court noted that the microcaptives in both cases set premiums suspiciously close to the written premium limit under Section 831(b) and such premiums weren’t determined through an underwriting process using proper actuarial methods and were contrived to maximize tax benefits.
As noted in both cases, the court has typically looked at the process utilized to pay claims in determining whether an insurance arrangement existed. Although this process was somewhat lacking in Swift, it was egregiously deficient in the Keating case. In Keating, policies would be altered or added retroactively to permit the payment of filed claims.
April 2023 Proposed Regulations
On April 11, 2023, the IRS issued proposed regulations (REG-109309-22) identifying certain microcaptive transactions as listed transactions or transactions of interest. This requires disclosure in tax fillings by taxpayers and their advisors when engaging in such arrangements.
We’re Here to Help
To learn more about microcaptive insurance arrangements, their requirements and the IRS scrutiny involving these arrangements, please contact your Moss Adams professional.
Additional Resources
Special thanks to Daniel Quintana, associate, Tax Services for his contributions to this article.