Section 831(b)

Section 831(b) is a U.S. tax law that provides specific tax benefits to certain small insurance companies, often referred to as "micro-captives". Established to encourage the formation of small insurance companies, it offers an alternative risk management solution that can supplement or even replace traditional insurance coverage.

A micro-captive insurance company, as it pertains to Section 831(b), is a captive insurance company - an insurance company entirely owned and operated by the insured - that has elected to pay taxes only on its investment income. In other words, the micro-captive’s underwriting income - the difference between earned premiums and incurred losses - is exempt from federal income tax. As of 2020, to qualify for 831(b) status, the insurance company's written premium income must not exceed $2.3 million in a given year, a threshold that is indexed for inflation.

These micro-captives enable businesses to insure against risks not typically covered by traditional insurance policies, or to increase their coverage for specific risks. Because the parent business owns the micro-captive, it has greater control over the insurance process and can tailor its policies more closely to its particular needs. These benefits, in combination with the tax deferral under Section 831(b), make micro-captives an appealing option for many businesses seeking to more effectively manage their risk.

History

Liability Crisis

The liability insurance crisis of the 1980s was a watershed moment in the U.S. insurance industry, marked by a sharp rise in the cost of liability insurance and the widespread unavailability of certain types of coverage. The crisis affected numerous sectors, from construction and daycare centers, to municipal governments and non-profit organizations.

Beginning in the mid-1980s, this period was driven by a rapid rise in both liability claim frequency and severity. Insurers, confronted with escalating costs and risk exposures, responded by substantially increasing premiums. In some cases, insurers stopped offering certain types of liability coverage entirely.

The crisis was further amplified by significant legal and legislative changes related to liability. The courts were more inclined to award large damages in liability lawsuits, creating an unfavorable environment for defendants. The growing use of "joint and several liability" rulings posed a particular challenge, as these allowed a defendant to be held 100% liable even if they were only partially responsible for the damage.

The crisis led to substantial reforms, including the passage of the 1986 Tax Reform Act which introduced Section 831(b). At the state level, many states implemented tort reform measures aimed at limiting liability and damages. These reforms, coupled with the introduction of Section 831(b), provided some relief and led to the growth of the captive insurance industry.

1986 Tax Reform Act

The Tax Reform Act of 1986 is regarded as one of the most significant pieces of tax legislation in the history of the United States. President Ronald Reagan signed the Act into law with the goal of simplifying the tax code and expanding the tax base while also ending a variety of tax shelters and preferences. This was a significant step that helped to bring more fairness to the tax code. Notably, under this legislation the top marginal individual income tax rate was reduced from 50% to 28%, the lowest it had been since 1916.

A key aspect of this Act was the introduction of Section 831(b), which specifically pertained to the taxation of certain small insurance companies, also known as "micro-captives". Prior to the Act, insurance companies were taxed on their income in a very similar manner as other corporations. However, Section 831(b) changed this by allowing small insurance companies with annual premiums of $1.2 million or less (a figure that has since been adjusted for inflation) to opt for an alternative tax calculation.

Under this new provision, qualifying insurance companies could elect to be taxed only on their investment income, rather than their underwriting income. This meant that the premiums received, up to the limit, would not be taxed, while the company's investment income would be subject to regular corporate tax rates. This created a significant incentive for businesses to establish their own insurance companies to self-insure risks that might be otherwise uninsurable or too expensive to insure on the commercial market.

The introduction of Section 831(b) in the Tax Reform Act of 1986 has had far-reaching impacts on the insurance industry, leading to a rise in the formation of micro-captive insurance companies and providing a tax-advantaged strategy for businesses to manage a broad array of risks.

2015 PATH Act

The Protecting Americans from Tax Hikes Act of 2015, commonly known as the PATH Act, was a significant piece of tax legislation in the United States. The act was designed to provide tax relief for families and businesses, and it made several tax provisions permanent.

One of the changes implemented by the PATH Act was an amendment to Section 831(b) of the Internal Revenue Code. This amendment, which took effect in 2017, was aimed at enhancing and modernizing the micro-captive insurance industry.

The PATH Act increased the annual premium limit for qualifying small insurance companies from $1.2 million to $2.2 million, adjusting for inflation. This increase in the cap allowed small insurance companies to write more business and still qualify for the benefits provided under Section 831(b), therefore providing more flexibility and adaptability for businesses leveraging captive insurance structures.

In addition to the premium limit increase, the PATH Act introduced diversification requirements to Section 831(b) to prevent abuses of micro-captives for estate planning purposes. These new rules, often referred to as the "ownership test" and the "risk distribution test," ensure that the ownership of a captive insurance company does not disproportionately benefit any single party and that risk is adequately distributed.

Overall, the PATH Act has had a significant impact on the 831(b) tax code, modernizing it to better suit the evolving needs of small businesses and bolster the integrity of micro-captive arrangements. These changes have further incentivized the use of micro-captives as a strategic risk management tool while also introducing safeguards to prevent misuse.

Details of 831(b)

Section 831(b) of the Internal Revenue Code provides an election for certain small insurance companies to be taxed only on investment income. However, for an insurance company to qualify for this election, it must satisfy a number of conditions:

Premium Limits
As of 2023, the insurance company must receive less than $2.65 million in annual net written premiums. This limit is adjusted for inflation and may therefore change over time.

Risk Distribution
The company must distribute its risk among a sufficient number of independent risk exposures. This can be achieved either by insuring a large enough number of unrelated risks or by participating in a risk pool with other captives.

Risk Transfer
For a contract to be considered insurance for tax purposes, it must involve a risk of economic loss that is shifted from the insured to the insurer. The insurer, by accepting the premium, assumes the risk of economic loss should a claim be made.

Fortuitous Risk
The risk insured against must be fortuitous, or uncertain. The event cannot be planned or expected, and the timing and occurrence of the loss event must be beyond the control of either party to the contract.

Principles of Insurance
The arrangement must involve the common characteristics of insurance, such as an insurable interest, risk shifting, risk distribution, the establishment of a premium that is actuarially determined, and a valid and binding contract.

In addition to these conditions, the Protecting Americans from Tax Hikes (PATH) Act of 2015 introduced new diversification requirements to Section 831(b) to prevent abuses of micro-captives for estate planning purposes. These requirements are:

Ownership Test
This test requires that the ownership of the insured business and the micro-captive must not diverge by more than 2%. If the captive insures more than one business, those businesses must have identical ownership.

Risk Distribution Test
This test requires that no more than 20% of the premiums received by the captive come from one policyholder.

It's important to note that the IRS has been closely scrutinizing micro-captives due to potential abuses, and failure to meet any of these requirements could lead to a denial of the tax benefits of Section 831(b), potential penalties, and inclusion on the IRS "Dirty Dozen" list of tax scams. As a result, companies should engage knowledgeable professionals when setting up a micro-captive to ensure compliance with all requirements.

831(b) micro captives, like any insurance company, accumulate funds through premium payments from the insured entities. The accumulation of these funds can provide financial benefits, and there are several ways in which these funds can be withdrawn or utilized:

Claims Made
One of the primary reasons for establishing an insurance company is to pay claims. When a covered loss event occurs, the captive may pay the claim to the insured. These payouts are generally tax-free to the insured and are a deductible expense for the captive.

Operating Expenses
The captive insurance company can utilize its funds to pay for the normal costs of running an insurance company, such as underwriting, claims adjustment, loss control activities, and general administrative costs. These expenses are typically tax-deductible for the captive.

Qualified Dividends
If the captive has chosen to be taxed as a C Corporation, it can issue dividends to its shareholders from its after-tax profits. These dividends are generally taxed at the qualified dividend rate, which is typically lower than the ordinary income tax rate. It's important to note that these dividends are not deductible to the captive.

Shareholder Loans
In certain circumstances, a captive may lend funds to its shareholders or other related parties. These loans must be structured properly, with market-rate interest and reasonable terms, to avoid any adverse tax consequences. Also, regulatory approval may be required, depending on the jurisdiction where the captive is domiciled.

Required Distributions due to Over-Solvency
If a captive accumulates too much capital and surplus—becoming "over-solvent"—it may need to make distributions to its shareholders to avoid becoming a tax shelter. These distributions could be treated as dividends for tax purposes. Regulations concerning captives require them to maintain an appropriate level of capital and surplus to meet their insurance obligations, so this scenario may arise if a captive's capital and surplus exceed these levels.

It's important to note that these actions should be undertaken in compliance with all relevant tax laws and insurance regulations. While there are tax benefits associated with operating a captive, the primary purpose of the captive should be to provide insurance. Tax benefits are an ancillary advantage of operating a captive and should not be the main reason for forming one. Engaging a professional with expertise in captive insurance can help ensure that your captive operates within the bounds of the law.

Risk Management

Micro-captive insurance companies operating under Section 831(b) of the U.S. tax code provide several significant risk management benefits for businesses:

Coverage for Uninsurable Risks
A micro-captive insurance company allows businesses to insure against risks that are not typically covered by traditional insurance providers, or where coverage is prohibitively expensive. This could include business-specific risks unique to the company's operations or industry.

Customization of Insurance Policies
Businesses can tailor their policies to cover specific needs. This level of customization is often not available from commercial insurance providers who offer more standardized policies.

Control Over Insurance Costs
As the business controls its own micro-captive, it has more influence over the pricing of insurance policies. It can use its understanding of its own risk profile to set appropriate premiums, potentially reducing costs compared to commercial insurance.

Direct Access to Reinsurance Markets
Micro-captives can directly access reinsurance markets, potentially obtaining coverage at a lower cost and benefiting from the broader risk pooling and risk transfer capabilities of these markets.

Improved Cash Flow
Under Section 831(b), micro-captives are taxed only on their investment income, not their underwriting income. This allows businesses to accumulate reserves tax-deferred (up to the premium limit), improving cash flow and creating a pool of capital that can be invested or used to cover losses.

Stability of Insurance Costs
Micro-captives can provide more predictable and stable insurance costs, insulated from the rate fluctuations of the commercial insurance market.

Greater Control and Transparency
Owning a micro-captive gives a business greater visibility into and control over its insurance operations, including claims handling and loss control measures.

While the risk management benefits can be significant, it's also important to remember that managing a micro-captive involves certain obligations and costs. Businesses must ensure that they operate their micro-captive in a manner consistent with insurance industry standards, including proper risk transfer and risk distribution, and that premiums are determined based on actuarial principles. The failure to do so can lead to scrutiny from the IRS and potential tax penalties.

Tax deferral

Section 831(b) of the U.S. Internal Revenue Code provides significant tax deferral benefits to small insurance companies, also known as "micro-captives." The section allows these companies to elect a different tax calculation method that only taxes their investment income, not their underwriting income.

This provides a considerable tax deferral benefit for businesses. Here's how it works:

Tax-Deferred Underwriting Income
Premiums paid by the parent company to the micro-captive for insurance coverage are deductible as a business expense for the parent company. At the same time, these premiums, up to the limit set by Section 831(b) (which is $2.3 million as of 2020, adjusted annually for inflation), are not considered taxable income for the micro-captive. This means that the micro-captive can defer tax on the underwriting income.

Taxed on Investment Income
The micro-captive does pay taxes on its investment income - the income generated from investing the premium reserves it has accumulated and not yet paid out in claims. However, the initial accumulation of underwriting income (premiums) is not taxed, allowing the company to build a substantial reserve over time.

Potential Long-Term Savings
Over the long term, this can result in significant tax savings for the business. The funds can be invested and grow over time, and although the investment income is taxable, the principal (premiums received) remains tax deferred, allowing for greater accumulation of premium reserves within the captive.

It's essential to note that these tax benefits must not be the sole reason for creating a micro-captive. The IRS stipulates that a captive insurance arrangement must have risk distribution and risk shifting, meaning it must operate as a genuine insurance company. Any perceived misuse of the tax code could lead to IRS audits and potential penalties. Consequently, businesses should consult with legal and tax professionals when setting up a micro-captive insurance company to ensure all regulatory requirements are met.

IRS Scrutiny

Dirty Dozen

The Internal Revenue Service (IRS) publishes an annual "Dirty Dozen" list to alert taxpayers to common scams and schemes that could lead to tax fraud or other illegal activities. This list, typically released during tax season, identifies a variety of common scams, such as phishing, false tax returns, and tax preparer fraud.

The Dirty Dozen list also frequently includes more complex tax structures that the IRS believes are being abused. One such structure that has repeatedly made the list in recent years is the micro-captive insurance company operating under Section 831(b) of the Internal Revenue Code.

Micro-captives are included on this list because the IRS has identified some cases where they have been used for purposes other than genuine risk management. Some businesses have allegedly used them to attempt to circumvent tax laws and shelter income. In these cases, the IRS alleges that the insurance contracts don't represent a valid risk transfer and that the premiums charged are unreasonably high compared to the risk insured, making the arrangement seem more like a disguised way to distribute profits rather than a legitimate insurance setup.

It's important to note that the inclusion of micro-captives on the Dirty Dozen list does not mean that all micro-captives are illegitimate. Many businesses use micro-captives in compliance with the law as a valuable tool for risk management. However, the IRS scrutiny highlights the need for proper setup and operation of these entities, including meeting risk distribution and risk transfer criteria, and setting premiums through a formal underwriting process.

Any business considering forming a micro-captive, or any that currently operates one, should work with knowledgeable professionals to ensure compliance with the law. If the IRS determines that a micro-captive is not operating in compliance with the rules of Section 831(b), the tax benefits could be denied, and substantial penalties could be imposed.

Notice 2016-66

IRS Notice 2016-66, issued in November 2016, designated certain micro-captive transactions as "Transactions of Interest," signaling increased scrutiny of these arrangements by the Internal Revenue Service (IRS). The notice was in response to the perceived misuse of micro-captive insurance companies to avoid tax obligations.

In general, a Transaction of Interest is a type of reportable transaction that the IRS believes has the potential for tax avoidance or evasion, but for which it lacks enough information to specifically label as a tax avoidance transaction.

With Notice 2016-66, the IRS was particularly interested in micro-captive insurance companies that made an election under Section 831(b) to be taxed only on investment income and where the liabilities for insured losses and claim administration expenses were less than 70% of the earned premiums, or where the captive made certain ceding payments to other entities.

The immediate impact of this notice on the micro-captive industry was significant:

Increased Reporting Requirements
The parties involved in these micro-captive transactions are required to disclose their participation to the IRS. Material advisors, such as those who provide tax advice or assistance in relation to these transactions, are also required to keep lists of clients involved in these transactions.

Potential Penalties
Failure to disclose these transactions could result in significant penalties. For businesses, the penalty could be up to 75% of the decrease in tax as a result of the transaction, with a minimum penalty of $5,000 for individuals and $10,000 for entities.

Increased Scrutiny
Notice 2016-66 indicated that the IRS would be closely examining these transactions. This increased the likelihood of audits for businesses involved in micro-captive transactions and could result in challenges to the claimed tax benefits.

Re-evaluation of Micro-captive Strategies
As a result of the notice, many businesses re-evaluated their micro-captive strategies to ensure compliance with IRS requirements and the proper operation of their insurance companies.

Despite the increased scrutiny and reporting requirements, micro-captives continue to be used as effective risk management tools for many businesses. However, the notice underscores the importance of operating these entities in a manner consistent with insurance industry standards and in compliance with the tax code.

CIC Services Suit

In response to IRS Notice 2016-66, CIC Services, LLC, a firm that assists with the formation and management of captive insurance companies, filed a lawsuit against the IRS and the United States Treasury Department seeking to prohibit enforcement of the notice. The company argued that the notice imposed significant reporting requirements and potential penalties without providing an opportunity for public comment and review.

Initially, the U.S. District Court and the Sixth Circuit Court of Appeals ruled against CIC Services, citing the Anti-Injunction Act, which generally prohibits lawsuits to restrain the assessment or collection of taxes.

However, CIC Services appealed the decision to the Supreme Court of the United States. In May 2021, in the case CIC Services, LLC v. Internal Revenue Service, the Supreme Court ruled in favor of CIC Services in a 9-0 decision, determining that the Anti-Injunction Act did not bar the company's suit.

The Supreme Court's decision did not immediately nullify Notice 2016-66 but allowed CIC Services to proceed with its case against the IRS on the grounds that the IRS had violated the Administrative Procedure Act by not providing a notice and comment period before issuing Notice 2016-66.

Following the Supreme Court's ruling, the case was remanded back to the district court. In December 2021, the U.S. District Court for the Eastern District of Tennessee ruled in favor of CIC Services, finding that the IRS had indeed violated the Administrative Procedure Act in issuing Notice 2016-66 without a notice and comment period. The court therefore vacated Notice 2016-66.

This court ruling has significant implications for the captive insurance industry. While the Notice 2016-66 requirements were seen as burdensome by some, it does not necessarily indicate a decrease in IRS scrutiny of captive insurance arrangements. The IRS still maintains a strong interest in these transactions due to concerns about potential abuse and tax evasion. As a result, careful compliance with all applicable rules and standards is still essential for any business involved in captive insurance.

Soft Letter Warnings

An IRS soft letter is a type of communication used by the Internal Revenue Service to inform taxpayers about changes in tax law, suggest changes to their tax reporting, provide information on their reported tax items, or identify areas where it sees potential non-compliance. Unlike a formal audit letter, a soft letter is not a binding legal demand, but rather an advisory or informational notice.

Soft letters can also serve as an indirect audit tool. They may not assert tax liability, but they signal to the recipient that the IRS is closely watching the issue at hand and might take more serious steps, such as an audit, if the perceived non-compliance continues.

In the Spring of 2020, the IRS sent soft letters to numerous taxpayers who participate in micro-captive insurance transactions, specifically those operating under Section 831(b) of the Internal Revenue Code. These letters (specifically Letter 6336) were sent to taxpayers suspected of participating in captive insurance arrangements that the IRS views as potentially abusive.

The soft letters urged taxpayers involved in these transactions to reassess their position with the micro-captive insurance structure, especially in light of adverse court decisions against certain micro-captive arrangements, and to consult independent tax advisors. The IRS letter suggested taxpayers consider whether it was appropriate to continue claiming tax benefits associated with the captive insurance arrangement and recommended that taxpayers may want to amend prior year tax returns if their position was inconsistent with recent court decisions.

The timing of the IRS soft letter (Letter 6336) in the Spring of 2020 coincided with the onset of the COVID-19 pandemic, which created an extremely challenging environment for businesses, including those involved with 831(b) micro-captives. Many of these businesses were dealing with a surge in claims related to the pandemic and disruptions to their operations, all while grappling with the implications of the IRS's scrutiny.

These dual pressures underscored the vital role that 831(b) micro-captives can play in managing business risks and providing coverage for unique, hard-to-insure risks that a pandemic like COVID-19 could exacerbate. At the same time, they served as a stark reminder of the importance of setting up and managing micro-captives in strict compliance with established insurance principles and tax laws to withstand increased scrutiny from the IRS, even during times of crisis.

Standard Settlement Offer

In early 2021, the Internal Revenue Service (IRS) issued a settlement offer for taxpayers under audit who participated in micro-captive insurance transactions, specifically those operating under Section 831(b) of the Internal Revenue Code. This came after the IRS's success in several U.S. Tax Court cases challenging these types of transactions.

This standard settlement offer represented the IRS's latest approach to resolving ongoing audits of micro-captive insurance transactions. The terms of the offer reflected the IRS’s view that a significant number of these transactions had not complied with federal tax laws. It aimed to expedite resolution and limit further administrative and legal costs for both the IRS and taxpayers.

The specific terms of the settlement offer were:

Full Disallowance of Claimed Tax Benefits
The taxpayers were required to concede the full tax benefits claimed for their micro-captive transactions, including income tax deductions for insurance premiums paid to the micro-captive insurance company.

Partial Penalty Inclusion
Taxpayers accepting the settlement offer had to agree to pay a penalty unless they could establish good faith, reasonable cause and substantial authority for their position. The penalty was less than the maximum penalty that might apply but was nonetheless substantial, reflecting 10 to 20 percent of the disallowed tax benefits.

Future Compliance
Taxpayers were required to take necessary steps to avoid similar non-compliance in the future. This could include not claiming deductions for micro-captive insurance premiums or ensuring that future transactions fully complied with the law.

No Refund Claims
Taxpayers who accepted the offer had to agree not to request a refund or credit for taxes paid as part of the settlement.

These settlement offers were only available for taxpayers currently under audit, and acceptance of the offer was not mandatory. Taxpayers who chose to reject the offer would continue to be subject to potential tax assessments and penalties under normal audit procedures. The IRS encouraged those taxpayers to consult with their independent tax advisors before making a decision.

Proposed Regulations

On April 10, 2023, the U.S. Treasury Department announced new proposed rules on micro-captive insurance. Under the draft rules, certain micro-captive transactions have been identified as listed transactions or transactions of interest under the relevant disclosure rules.

The new micro-captive insurance rules were published as a response to the agency’s loss in the case of CIC Services, LLC v. IRS. In this case, the U.S. District Court for the Eastern District of Tennessee threw out the previously published IRS Notice 2016-66. The court found that the IRS had failed to comply with the Administrative Procedure Act when publishing the notice.

This year, the Treasury Department chose to issue new rules in order to enforce more consistent disclosure requirements. Specifically, the proposed regulations modify the transactions described in Notice 2016-66.

Summary of Proposed Provisions and Differences from Notice 2016-66

Captive Definition: According to the proposed rules set forth by the Treasury Department, “captives” are defined as any organization that satisfies the following criteria: (i) chooses to make the 831(b) election under the Internal Revenue Code, (ii) provides insurance contracts to the insured or reinsures a third-party's contract for an insured, or both, and (iii) a minimum of 20% of its assets, voting power, or outstanding stock or equity is owned or controlled, directly or indirectly, by the insured, the insured's owner, or individuals who are related to either of them.

In the draft rules, the agency also determines that two transaction categories are Micro-Captive Listed Transactions:

Financing Factor: Prop. Reg. § 1.6011-10(c)(1) states that captives that transfer or lend any part of the payments under the contract to a recipient during the financing computation period are considered a listed transaction regardless of whether the contract involves a guarantee, loan, or other means of transferring the captive's capital to the recipient. This also includes any financing provided before the financing computation period that has not been repaid during the year of disclosure.

For payments to be recognized under the contract, they must surpass the captive's net investment earnings after taxes, reduced by any financing or transfers that are still outstanding. The "financing computation period" pertains to the five most recent taxable years of the captive, or all taxable years if the captive has been in operation for less than five years.

Loss-Ratio Factor: If a captive's liabilities for insured losses and claim administration expenses are less than 65% of the premiums earned during the loss ratio computation period minus any dividends paid, then it is considered a listed transaction according to the regulations. The regulations define the computation period as the 10 most recent taxable years of the captive. Captives formed less than 10 years ago are not included. The loss ratio threshold for disclosure requirements was reduced from 70% to 65% by the Treasury as a means of preventing non-abusive transactions from being caught up unnecessarily.

The Treasury requested public comment on the effectiveness of using a combined ratio to better differentiate abusive micro-captive transactions. This would involve comparing incurred losses, along with loss adjustment and underwriting expenses, to the earned premiums of the captive, minus any dividends paid to policyholders. The appropriate percentage to be used if a combined ratio were implemented is also being considered, with public input being sought.

Micro-Captive Transactions of Interest: Under the disclosure rules, captive transactions will be treated as transactions of interest in circumstances where: a captive either issues a contract to the insured or reinsures a contract that was issued to the insured by a third party; and its liabilities incurred for insured losses and claim administration expenses during the "transaction of interest computation period" are lower than 65% of the premiums earned by the captive minus dividends paid to policyholders.

The “transaction of interest computation period” includes the previous nine most recent taxable years of the captive, or all taxable years if the captive is newer than nine years old.

Disclosure Requirements Apply to Substantially Similar Transactions: Transactions that are substantially similar to micro-captive listed transactions or micro-captive transactions of interest are also subject to disclosure rules. Per Treas. Reg. § 1.6011-4(c)(4), transactions are considered "substantially similar" if they are expected to have a similar or identical impact on the taxpayer, and the transaction either has a similar fact pattern or utilizes a duplicate or similar tax strategy. This definition is interpreted broadly. In other words, a transaction may be considered substantially similar to a listed transaction even if it employs unique entities or relies on alternative I.R.C. provisions.

Disclosure Requirements Modified for Captives and Insureds: The reporting requirements for captives have been reduced under the proposed regulations. Captives no longer must: (i) report which aspects of the regulations are applicable; (ii) indicate the chartering authority; (iii) detail the process for determining premiums; (iv) share the captive’s reserves that were reported on its annual statement; or (v) report the assets owned. However, the captive is still required to report: (i) the types of policies issued or reinsured; (ii) premium amounts; (iii) contact information for the transaction’s actuaries and underwriters; and (iv) the total amount of claims paid. Furthermore, the proposed rules mandate captives disclose the name and percentage interest held by individuals meeting the 20% threshold, both directly or indirectly. This was done to enable the IRS to apply the 20% relationship test. Insureds subject to disclosure requirements must indicate the funds that are treated as premiums.

Disclosure Requirement Safe Harbor for Owners: If an individual's only reason for being subjected to the disclosure requirements is their direct or indirect ownership interest in the insured, they are exempt from filing a disclosure statement. This exemption does require the individual to receive written or electronic confirmation that the insured has or will comply with their own separate disclosure obligation under Treas. Reg. § 1.6011-4(a). However, if the insured fails to make this disclosure in a timely manner, receiving this acknowledgement will not release the owner from their duty to disclose.

Limited Exception for Consumer Coverage Arrangements: A provision contained within the proposed regulations allows for certain consumer coverage reinsurance arrangements. These coverages involve providers selling products or services to customers who then purchase an insurance contract to cover any damages or losses. For example, a contract that provides consumer coverage could safeguard against damages, loss, or theft by repairing or replacing the product. In some cases, an entity related to the seller may issue or reinsure these contracts. The Treasury has realized this exception is necessary for these types of contracts, as long as the commissions paid are similar to those paid to unrelated insurers.

Effect of Proposed Regulations

Effect on Participants: If a participant fails to disclose a transaction identified by the proposed regulations, that person may be subject to penalties under I.R.C. § 6707A. Further, the IRS has authority to impose penalties related to accuracy under I.R.C. §§ 6662 and 6662A for taxpayers who understate micro-captive transactions. Should a taxpayer fail to indicate their involvement in a listed transaction, the IRS may then choose to extend the statute of limitations for penalty assessment under I.R.C. § 6501(c)(10) until said taxpayer provides the necessary information or a material advisor submits the disclosures outlined in I.R.C. § 6112.

Effect on Material Advisors: In the United States, material advisors who do not disclose micro-captive transactions could face penalties under I.R.C. § 6707. Similarly, material advisors who do not maintain the necessary lists of participants or provide them to the IRS when requested may be penalized under I.R.C. § 6708(a). Furthermore, the IRS has the authority to impose a penalty on return preparers under I.R.C. § 6694 and an abusive tax shelter promotion penalty under I.R.C. § 6700. Those who aid or abet the understatement of tax liability also open themselves up to possible penalties under I.R.C. § 6701.

Relevant Tax Court Cases

Avrahami

Avrahami v. Commissioner is a notable court case in the context of 831(b) micro-captives. The case involved an Arizona business owner, Benyamin Avrahami, and his wife, Orna Avrahami, who had set up a micro-captive insurance company named "Feedback" in the Caribbean island nation of Saint Kitts. The Avrahamis used this structure to insure their jewelry stores and other commercial real estate businesses against certain risks.

The Tax Court's decision, written by Judge Mark V. Holmes and issued in August 2017, concluded that the Avrahamis' micro-captive arrangement did not qualify as insurance for federal tax purposes. As a result, the Avrahamis' elections under Section 831(b) were invalidated, and the premium payments they had deducted on their tax returns were disallowed.

Judge Holmes identified several key issues in the case:

Risk Distribution
Judge Holmes found that Feedback did not adequately distribute risk. While the Avrahamis attempted to achieve risk distribution by participating in a risk pool (whereby Feedback exchanged insurance contracts with other captives), the court found this pool to be poorly executed and effectively circular in nature, thus not a bona fide insurance arrangement.

Risk Transfer
The court also questioned whether there was genuine risk transfer. The rulings noted that the captive did not operate like an insurance company, the claims were infrequent and suspiciously timed, and the funds in the captive were invested in illiquid, long-term loans to related parties, suggesting that the captive was not prepared to pay claims.

Insurance-like Characteristics
The court found that the transactions lacked the typical characteristics of insurance. The premiums were calculated without appropriate actuarial analysis and were significantly higher than those of commercial insurers for similar coverage. The policies contained ambiguous or contradictory terms and were sometimes issued or renewed months after they were supposed to take effect.

Reasonable and Customary Terms
The court also noted the arrangement did not follow the normal patterns of insurance. For example, Feedback loaned all of its initial capital back to Mrs. Avrahami, and it invested its surplus in long-term, illiquid loans to related parties, which is not typical of a bona fide insurance company.

These issues led Judge Holmes to conclude that the Avrahamis' arrangement was not insurance in the commonly accepted sense, but rather a scheme designed to sidestep tax liabilities. As a result, the premium payments were not deductible as business expenses, and Feedback did not qualify for the tax benefits of an insurance company under Section 831(b) of the Internal Revenue Code. The court's decision in Avrahami v. Commissioner has significantly impacted the micro-captive insurance industry, highlighting the importance of meeting the risk distribution and risk transfer criteria, setting actuarially sound premiums, and operating in a manner consistent with insurance industry standards.

Reserve Mechanical

Reserve Mechanical Corp. v. Commissioner is another pivotal case concerning 831(b) micro-captives. Reserve Mechanical Corp. (Reserve), an Anguilla-based captive insurance company, was owned by Capstone Associated Services. The case essentially centered around whether Reserve's election to be taxed only on its investment income under IRC Section 831(b) was valid.

In June 2018, Tax Court Judge Albert G. Lauber ruled against Reserve Mechanical, finding that the company did not qualify as a bona fide insurance company for federal income tax purposes and therefore could not make an 831(b) election.

There were several reasons for this decision:

Risk Distribution
Similar to the Avrahami case, Judge Lauber found that Reserve did not meet the criteria for risk distribution. The court determined that there was not enough distribution of risk to constitute insurance because the pool of insured risks was too small and too closely related.

Risk Shifting
Judge Lauber also found that Reserve failed to adequately shift risk because the reinsurance agreements it was a part of did not constitute "insurance" in the commonly accepted sense. The court examined the structure of the risk pool and found it to be essentially circular, not allowing for adequate risk shifting.

Insurance in the Commonly Accepted Sense
The court determined that Reserve did not operate as an insurance company in the commonly accepted sense. Factors contributing to this conclusion included the company’s failure to meet regulatory standards, inconsistent issuance of policies, charging unreasonable premiums, and making loans to related parties.

Reasonable and Customary Terms
Additionally, the court noted that Reserve did not conduct itself in a manner consistent with traditional insurance practices, pointing to the company’s late issuance of policies, inconsistent claims handling procedures, and absence of arms-length contracts.

These factors led the court to determine that Reserve was not a bona fide insurance company and was therefore ineligible to make an 831(b) election. This case, like the Avrahami case, underscored the importance of proper risk distribution and risk shifting, regulatory compliance, and operating as an insurance company in the commonly accepted sense in order for a captive insurance company to be recognized for tax purposes.

Syzygy

Syzygy Insurance Co. v. Commissioner is another influential case in the micro-captive insurance space. Syzygy Insurance Co. (Syzygy) was a micro-captive insurance company owned by three subsidiaries of Highland Tank & Manufacturing Co. and its owners, which provided coverage to Highland and its subsidiaries. The central question of the case was whether Syzygy qualified as a bona fide insurance company, thereby allowing it to elect taxation under IRC Section 831(b).

In April 2019, Tax Court Judge Joseph Goeke ruled against Syzygy, determining that it did not qualify as a bona fide insurance company for federal income tax purposes and thus could not make an 831(b) election.

Several key issues contributed to Judge Goeke's decision:

Risk Distribution
As with the Avrahami and Reserve Mechanical cases, Judge Goeke found that Syzygy did not meet the criteria for risk distribution. The court concluded that there was insufficient risk distribution because the pool of insured risks was too small and interrelated, and Syzygy was found to be providing coverage primarily to the parent and its subsidiaries.

Insurance in the Commonly Accepted Sense
The court also found that Syzygy did not operate as an insurance company in the commonly accepted sense. Indicators of this included charging unreasonable and inconsistently determined premiums, a failure to operate in a manner consistent with industry standards, a lack of an arm's length relationship with its parent company, and an absence of adequate claims handling procedures.

Capitalization and Investments
Another issue highlighted in the case was Syzygy’s capitalization and investment practices. It was discovered that a significant portion of Syzygy’s assets were tied up in long-term, illiquid loans to Highland, the company's parent, which could potentially limit Syzygy’s ability to satisfy insurance obligations.

These factors led the court to conclude that Syzygy was not a bona fide insurance company and therefore could not elect to be taxed under Section 831(b) of the Internal Revenue Code. This case once again affirmed the importance of meeting stringent risk distribution criteria, operating as an insurance company in a commonly accepted sense, and having an appropriate capital and investment strategy for micro-captives to be considered legitimate for tax purposes.

Caylor Land Development

Caylor Land & Development v. Commissioner is another notable case involving micro-captive insurance companies and their eligibility to elect taxation under IRC Section 831(b). Caylor Land & Development established a micro-captive insurance company called Consolidated, which provided insurance coverage to various Caylor-related entities.

In May 2021, Tax Court Judge Emin Toro ruled against Caylor, determining that Consolidated did not operate as a bona fide insurance company for federal income tax purposes and thus was ineligible for the 831(b) election.

Several critical points informed Judge Toro's decision:

Risk Distribution
Judge Toro found that Consolidated did not meet the necessary risk distribution criteria. While Consolidated tried to achieve risk distribution by reinsuring third-party risks, the court found that the third-party risks were illusory and did not contribute to risk distribution.

Insurance in the Commonly Accepted Sense
The court determined that Consolidated did not operate as an insurance company in the commonly accepted sense. Factors contributing to this conclusion included inconsistencies in issuing policies, a lack of a formal claims handling process, unreasonable and inconsistently calculated premiums, and a failure to follow regulatory standards.

Arm's-Length Contracts
The court pointed out that Consolidated’s transactions with Caylor did not occur at arm's length, which is a requirement for a transaction to be considered insurance for tax purposes. Instead, the court found that the insured entities and the micro-captive were not acting as separate, independent entities.

Claims Handling
The judge noted that the process for handling and paying claims was not handled in a way that would be typical of an insurance company, contributing to the determination that Consolidated was not operating in a manner consistent with insurance practices.

These findings led the court to conclude that Consolidated was not a bona fide insurance company and therefore could not elect to be taxed under Section 831(b) of the Internal Revenue Code. This case reinforced the importance of meeting risk distribution criteria, operating in a way consistent with commonly accepted insurance practices, conducting transactions at arm's length, and having appropriate claims handling procedures in order to be recognized as an insurance company for tax purposes.

Reserve Mechanical Appeal

The Reserve Mechanical appeals case centered around the determination of whether Reserve Mechanical operated a bona fide insurance company and qualified for the 831(b) election. The United States Tax Court ruled that Reserve Mechanical did not qualify as an insurance company and therefore did not meet the requirements to elect under 831(b).

Reserve Mechanical Corp., formerly known as Reserve Casualty Corp., appealed the Tax Court's decision. The case was heard by the United States Court of Appeals for the Tenth Circuit. On May 13, 2022, the Tenth Circuit issued its opinion, upholding the Tax Court's decision. The decision affirmed the IRS's position that the microcaptive insurance transactions conducted by Reserve Mechanical were abusive and not legitimate insurance arrangements.

The Tenth Circuit's ruling was a significant one for microcaptive insurance companies. The court analyzed the various factors that contribute to determining whether an arrangement should be considered insurance or not. It looked at whether there was genuine risk transfer, risk distribution, and whether the arrangement was operated like a traditional insurance company.

In the case of Reserve Mechanical, the court concluded that the arrangement did not meet these criteria. The court found that the company did not assume insurance risk, but rather was engaged in an investment scheme. The premiums paid to Reserve Mechanical were not for genuine insurance coverage, but instead were part of a tax-avoidance strategy.

In summary, the Reserve Mechanical appeals case involved a determination of whether Reserve Mechanical operated as a bona fide insurance company. The Tenth Circuit upheld the Tax Court's decision that Reserve Mechanical did not meet the requirements to elect under 831(b), as the arrangement was found to be an abusive microcaptive insurance transaction without genuine risk transfer or distribution.

Puglisi Egg Farms

The Puglisi Egg Farms vs. Commissioner case involved a dispute between Puglisi Egg Farms and the IRS regarding Puglisi's eligibility to elect under 831(b). The case eventually led to the IRS conceding and agreeing not to challenge future similar transactions made by Puglisi to elect under 831(b).

Puglisi Egg Farms, a family-owned business engaged in egg production, elected to be taxed as a small insurance company under Section 831(b) of the Internal Revenue Code. This provision allows qualifying insurance companies to be taxed on their net investment income at a lower rate. However, the IRS challenged Puglisi's election and claimed that it did not meet the requirements to qualify as an insurance company and therefore could not elect under 831(b).

The case was initially heard by the United States Tax Court. During the proceedings, the IRS argued that Puglisi's arrangement lacked the necessary risk distribution and risk shifting characteristics of a valid insurance company. The court's attention focused on whether Puglisi had properly pooled the risks of unrelated parties and whether there was genuine insurance risk involved.

As the case progressed, the IRS recognized potential consequences if they were to proceed with challenging similar transactions. They realized that if they were to lose the case, it could set a precedent that may have significant implications for other similar taxpayers who had elected under 831(b). In light of this, the IRS decided to concede the case and reach an agreement with Puglisi.

Under the terms of the agreement, the IRS agreed to not challenge future similar transactions made by Puglisi to elect under 831(b). This agreement provided certainty to Puglisi regarding their tax status, allowing them to continue operating under the elected tax treatment.