The IRS has moved to put a yield sign in front of anyone creating or utilizing a micro-captive insurance company under IRC Section 831(b) by designating all (or mostly all) such micro-captives created on or after November 2, 2006, as transactions of interest which have significant notice requirements. These include the need for captive owners to file IRS Forms 8886 and every material adviser, which is anyone involved in a very broad sense who generated more than $10,000 in fees as an individual or generated more than $25,000 in fees as a business, to file IRS Forms 8918. The first filings were originally due by January 30, 2017, but this filing deadline has been extended to May 1, 2017, by IRS Notice 2017-08. See IRS Notice 2016-66 at https://www.irs.gov/pub/irs-drop/n-17-08.pdf. See IRS Notice 2017-08 at https://www.irs.gov/pub/irs-drop/n-16-66.pdf. Significant penalties may apply for failure to fully comply with these requirements.
Why do companies set up micro-captive insurance companies? Basically, by using a micro-captive related entity structure, an active business can pay its own related party entity insurance premiums to provide insurance back to the active business. By meeting IRS definitions of risk shifting and distribution and creating a qualified insurance transaction, the premiums are deductible by the active business as an IRC Section 162, ordinary and necessary business expense, and by qualifying as a micro-captive, the related entity does not pay income tax on the premiums received, but only recognizes taxable income on its investment income. Therefore, to the extent insurance claims are not made, this strategy can effectively create significant annual tax free earnings. The maximum annual premium (deductible payments to the micro-captive) was $1.2 million prior to 2017, is now $2.2 million in 2017, and will continue to be indexed for years thereafter. Prior to 2017, significant estate tax benefits could be achieved as well by the micro-captive being owned not by the owners of the active business in the same pro-rata percentage, but rather by the owners’ families or trusts on their behalf. However, as of this year, this ownership structure has been prohibited.
If it is so perfect for successful businesses, should every successful business create a micro-captive? The simple answer is “no,” however, for many successful businesses, it is a wonderful way to both effectively self-insure and/or reinsure business risks on a very tax advantaged basis.
So, why does the IRS not like them? They are concerned about the micro-captives set up basically as a tax shelter and not as a legitimate business risk management planning tool. If a micro-captive is set up and managed properly, then the micro-captive and its transactions should be respected. However, based on the IRS concern of massive abuse of this otherwise legitimate business risk management tool, it seems to have overreached in its IRS Notice 2016-66. In particular, it identifies certain facts that cause the micro-captive to be considered as a transaction of interest, with the most significant one being that the captive must have a liability to pay claims of at least 70% of premium based on a 5-year running average. In discussing this requirement with an insurance financial analyst for mostly larger captive insurance companies, he expressed loss ratios lower than 70% are quite common and in no way reflect on the legitimacy of the transaction. Given that the tax advantage of the micro-captive rests upon profits associated with the captive insurer, it would be rare for any micro-captive to be structured to have a loss ratio of 70% or more. As a result, no micro-captive (nor its various material advisers) will likely be able to avoid being treated as involved in a transaction of interest, and all will likely need to comply with these new filing requirements. Therefore, the IRS’ notification requirements will add burdensome regulation with the potential to create concern even for perfectly legitimate transactions. On the upside, the fact that so many micro-captives will need to file also means that the IRS will likely be inundated with returns, overloading their ability to scrutinize any individual company’s returns. In turn, that reduces the risk that a properly structured, properly managed micro-captive will be subject to increased scrutiny, and may not have any additional costs because of the new requirements other than the expense and hassle of preparing the needed returns.
What does this mean? First, you need to figure out whether you have been involved with any such transactions. If so, you need to immediately determine the filing and record keeping requirements and ensure that you file appropriate returns no later than May 1, 2017! The deadline for filing may be sooner if the individual or business with the filing/disclosure requirements files their 2016 income tax returns prior to May 1, 2017, so this may be a reason to apply for a tax return filing extension. Second, consider modifying any existing micro-captive insurance company activities to help reduce the risk of IRS scrutiny in future years. Third, as for the use of new micro-captives going forward, they can still be an incredibly beneficial and legitimate business risk planning tool if it is structured and managed properly, and the importance of this cannot be minimized. Both the active business entity and its micro-captive need to ensure that they follow the rules to avoid getting into trouble. This means taking steps such as hiring legitimate insurance actuaries and underwriters to help properly structure the micro-captive and the insurance contracts between it and the related active business. Such contracts need to be as similar as possible to those that would be entered by unrelated parties in an arm’s-length negotiated manner, and the policies issued must make economic sense for both the active business and the micro-captive. The terms of the insurance contracts must be followed exactly as they are written: in other words, pay premiums in a timely manner as required by the contract, and make sure all claims are legitimate, made in an appropriate manner, and paid on a timely basis. The micro-captive should create and follow best practices procedures like a normal insurance company; it should comply with applicable state insurance laws; provide proper paperwork to the insured/owner company (e.g., issuing policies and binders) on a timely basis; and ensure that the micro-captive has adequate capital and liquidity so that it can pay claims on a timely basis. Finally, the trickiest structuring issue is normally complying with the risk pooling requirements in order to satisfy the necessary risk shifting to qualify under IRC Section 831(b) as a micro-captive. This can be done, but it needs to be done with careful thought so that it will be deemed legitimate, while not creating too much risk for the micro-captive, since too much risk could mean that it does not end up serving its intended purposes in the long run. The bottom line is that there is a serious need to utilize legitimate insurance actuaries and underwriters with significant experience in dealing with both micro-captive and non-micro-captive insurance companies.
If you have questions about micro-captives, please contact us at (678) 720-0750 or firstname.lastname@example.org to schedule a no-cost, no-obligation consultation.