IRS Continues Pursuit of 831(b) Micro-captives in Tax Court Wins

The beginning of 2024 has seen the captive insurance industry met with two new tax court opinions, both of which found in favor of the IRS. These decisions, dated January 4th (Keating vs Commissioner of Internal Revenue, involving transactions from 2012 to 2014) and February 1st (Swift vs Commissioner of Internal Revenue, challenging transactions from 2012 to 2015), concluded that premium payments to the captives were not deductible. The courts determined these captives did not operate according to widely recognized insurance practices, citing the following criteria:

• Premiums: In both cases, the courts agreed with the IRS that the captives charged excessively high premiums, unsupported by an actuarial analysis.
• Claim Payments: The courts observed ambiguities in how both captives managed and paid claims, noting unclear obligations and timing.
• Risk Distribution: Both captives attempted to distribute risk through pooling arrangements, which were rejected by the courts, including one case identified as a “circular flow of funds.”

While updated regulations for micro-captives are expected from the IRS, no additional guidance has been issued yet to assist captive managers, participants, service providers, or other industry stakeholders. Those involved with captives making the 831(b) election should ensure they have a full understanding of the following in support of their position:

• Insurance First: One cannot emphasize enough the importance of the presence of an arrangement with economic substance. All factors of these transactions cannot be, or appear to be, mere formality. The captive’s operations should reflect real risk shifting and distribution supported by well-maintained books and records that validate the program’s legitimacy.
• Risk Transfer and Distribution: The transaction must provide for the transfer of risk from the insured, and the captive must distribute that risk over enough insurable units. While there is not clear guidance offered through the tax code or case law, the captive must be able to display both through its business plan and operations that it can sufficiently spread the risk(s) it is insuring.
• Actuarial Analysis: Actuaries play a key role in the proper functioning of a captive insurance program. Premiums should be determined based on the analyses of actuaries such that they support the captive’s ability to pay expected claims without being excessive.  An actuary’s opinion should be utilized in a manner that adds credibility to the captive insurance program.
• Stay Informed: With the IRS closely monitoring micro-captive transactions, especially those electing 831(b), captive owners must stay informed. Captive owners should seek guidance from legal and accounting professionals as events continue to develop.

With the IRS intensifying its examination of 831(b) micro-captives, as evidenced by these recent tax court successes, understanding the landscape and maintaining compliance has never been more crucial. If you are involved in or contemplating a captive insurance program, it’s important to stay ahead by consulting with experts like those at CRI. Their expertise provides essential insights into the rulings’ implications and strategies for captive program participants, ensuring your insurance strategy successfully aligns with current regulations and best practices.