Micro-Captive Owners Must Understand Options as IRS Pressure Grows

As the Internal Revenue Service (IRS) moves forward with the process of developing new regulations for micro-captives, a major question for owners of the small captive insurance companies or those considering forming them is what comes next.

In a webinar presented by the South Carolina Captive Insurance Association (SCCIA) titled "Micro-Captive Update: What You Need To Know,” two experts discussed the status of the proposed IRS regulations and what they might mean for micro-captives going forward.

So-called micro-captives are small captive insurance companies that elect to be taxed under section 831(b) of the Internal Revenue Code, which allows small insurance companies to be taxed only on their investment income. They have been the target of IRS scrutiny in recent years.

One webinar panelist, Allan Autry, tax partner at Johnson Lambert LLP, noted that while the IRS has ratcheted up pressure on micro-captives and new regulations might further increase that pressure, the agency doesn't have the authority on its own to overturn section 831(b).

"The 831(b) election is still available. It's still a part of the Internal Revenue Code," Mr. Autry said. "The IRS is there to enforce the Internal Revenue Code, not to make the Internal Revenue Code."

Only Congress can eliminate the 831(b) election, and right now it doesn't appear likely to do so, Mr. Autry said.

Another panelist, Bailey Roese, partner at Dentons Bingham Greenebaum LLP, offered a similar perspective. "Congress makes the Internal Revenue Code," she said. "There are many tax elections that are available in the code."

But, she suggested, the intense IRS scrutiny on micro-captives is something captive owners or those thinking about forming a captive should consider.

Ms. Roese noted that the proposed micro-captive regulations put forward by the IRS and the US Treasury Department clarify the meaning of "transaction of interest" and define how a micro-captive will be considered a "listed transaction," both of which come with reporting requirements to the IRS.

The proposed regulations, IR2023-74, come after the IRS previously attempted to take a similar step several years ago through its Notice 2016-66. But recent court decisions in the Sixth Circuit and the US Tax Court found that the IRS lacks authority to identify listed transactions and transactions of interest by notices such as Notice 2016-66 and must instead follow notice and public comment procedures applying to regulations in order to identify such transactions.

There were 110 comments filed by the June 12 deadline, primarily from individuals or organizations with a stake in the proposed regulations and what they would require from captive owners, managers, and advisers, Ms. Roese said.

The IRS held a public hearing on the proposed regulations on July 19 with six individuals registered to speak. Those speakers included Steve Kinion, captive director in the Oklahoma Insurance Department, as well as three lawyers, a CPA, and a captive owner, according to Ms. Roese. The captive owner focused on the important role of the micro-captive in the risk management program of the captive's parent, a small local bank, she said.

Discussion during the public hearing also included suggestions that the proposed regulations raised issues of the IRS overreaching into insurance regulation, which is the province of the states under the federal McCarran-Ferguson Act.

"The next step for the IRS, they do need to review and respond to all the comments," Ms. Roese said. "But at the end of the day, they're not required to make any changes."

Given the IRS pressure on micro-captives, Mr. Autry discussed some of the options available to captive owners looking to leave an 831(b) arrangement. He noted that once a captive makes the 831(b) election, it's considered irrevocable.

That said, it is possible to ask the IRS commissioner to revoke the captive's IRS election, Mr. Autry said, though "That's not as easy as just writing a letter to the IRS." Typically, such revocation is done through a private letter ruling, though there's not much precedent for that step and the process can be time consuming and costly, he said.

"Another way of exiting would be to do a loss portfolio transfer or a novation of the loss reserves that are currently sitting in the 831(b) captive to a new captive that is not an 831(b) captive," Mr. Autry said. "That has been very common." Such an approach is probably the quickest and most cost-effective way of exiting an 831(b) captive arrangement, he said.

Another way would be to simply put the 831(b) captive in runoff, Mr. Autry said. "Eventually your exposure will run out as the years pass," he said.

The captive's owner might also look to exceed the premium limits for the 831(b) election, Mr. Autry said. "Go look at what other insurance products you can put in the captive," he said.

Mr. Autry said many in the captive insurance industry are hoping that the IRS will ultimately allow a one-time option for transitioning from an 831(b) election to an 831(a) election.

Ms. Roese noted that captives looking to continue operating under the 831(b) election should be prepared to be audited. Those audits will likely include exhaustive information disclosure requests, she said.

"These are going to be extremely broad and very involved," Ms. Roese said, typically involving 45 questions asking for "everything under the sun" about the decision to create the captive.

"They are going to want to see every email you sent and received about the captive program," Ms. Roese said. The IRS will also want to see any brochures or information materials the captive parent might have received before forming the captive, who they talked to, whether they received any tax advice, and who they received that tax advice from. "They're going to want to know everything about your commercial policies," Ms. Roese said. "They're also going to want to know details about all your investments."

 "It is a large undertaking," Ms. Roese said. "It's not a simple data dump to the IRS."

Ms. Roese noted that micro-captives have been under intense scrutiny for some time, and that scrutiny is only getting greater.

"With this scrutiny, it is time for all of us to take a look, talk to your advisers; if you want to stay in, understand what the consequences of that are going forward, and if you decide to get out, understand that there are consequences to that as well," she said.