Examining the Implications of Proposed IRS Regulations on 831(b) Plans
Published: Jun 8, 2023
Instead of issuing meaningful regulations based on comments from all stakeholders carrying out the intent of Congress when it approved micro-captives under Section 831(b) of the Code, the Internal Revenue Service (IRS) has opted to pursue concerning tactics born out in a number of high profile lawsuits and regulatory proposals. These enforcement tactics in relation to 831(b) micro-captives have been a source of contention and concern within the industry. While the IRS's intent to address potential abuse and ensure compliance is understandable, its approach has raised significant issues. The IRS's interpretation of ownership requirements deviates from the guidelines established by Congress, leading to confusion and inconsistencies. Furthermore, the rigid loss ratio computation factor fails to consider the unique risk profiles of micro-captives, making it an inaccurate measure of compliance. These tactics not only disregard the original intent of the 831(b) tax provision but also place undue burdens on small insurance companies operating within the micro-captive framework. By imposing inflexible requirements and overlooking industry-specific nuances, the IRS enforcement tactics undermine the growth and competitiveness of small insurers while hindering the overall effectiveness of the 831(b) micro-captive structure.
The Ownership Factor
The Protecting Americans from Tax Hikes Act of 2015 brought significant changes to the income tax exclusion for 831(b) micro-captives, increasing it from $1.2 million to $2.2 million and indexing it to inflation. Additionally, the PATH Act introduced specific requirements regarding the ownership interest of these micro-captives. However, despite the clear guidelines established by Congress, the Internal Revenue Service (IRS) has outlined a different ownership requirement, leading to discrepancies and confusion in the industry.
According to the summary of the Senate Finance Committee, the goal of the ownership requirements was to prevent abuse of the special rule for 831(b) micro-captives. The provision specified that no more than 20 percent of net written premiums for a tax year should be attributable to any one policyholder. Alternatively, a company would qualify for the exception if each owner of the insured business or assets held an interest in the insurer that was no greater than their interest in the business or assets, and if each owner held no smaller an interest in the business than their interest in the insurer.
The IRS proposed regulations regarding ownership requirements differ from the guidelines established by Congress, guaranteeing litigation concerning IRS authority. This discrepancy is even contradictory to the IRS's own published news release, IR-2016-25, issued on February 16, 2016. There, the IRS states that the Protecting Americans from Tax Hikes Act of 2015 was designed to address micro-captive abuses.
The IRS's previous Revenue Ruling 2002-89, which determined a transaction to be insurance for federal income tax purposes, allowed the corporation to deduct premiums paid to its wholly owned insurance subsidiary under Section 162 of the tax code. That ruling had a defining characteristic: the corporation paid premiums to its wholly owned subsidiary. However, the proposed regulations by the IRS contradict this previous revenue ruling, creating further confusion, inconsistencies, and likely litigation.
The misalignment between the congressional guidelines and the IRS's interpretation of ownership requirements leaves business owners, tax professionals, and micro-captive industry participants grappling with uncertainty and ambiguity. This disparity also raises concerns about compliance, tax implications, and the potential impact on micro-captive structures.
In order to provide clarity and ensure fair treatment, it is essential for the IRS to address and reconcile these discrepancies. Aligning the regulations with the congressional intent would create a more transparent and consistent framework for businesses operating under the 831(b) micro-captive structure.
Loss Ratio Computation Factor
The utilization of a loss ratio computation factor as a means to identify potentially abusive transactions within 831(b) micro-captives fails to consider several critical characteristics inherent in businesses that employ such structures. The current factor's limitations become apparent when examining the comparative data used and its relevance to the unique nature of 831(b) micro-captives.
The proposal relies on the use of health insurance as a benchmark for comparison only highlighting the IRS failure to understand the industry. The approach presents an apples-to-oranges scenario, because the risks typically covered by an 831(b) micro-captive differ significantly from those covered by health insurance. While health insurance exhibits a low severity but high frequency of claims, 831(b) micro-captives often address risks that are low in frequency but high in severity. Additionally, health insurance suffers from adverse selection, as those seeking coverage are more likely to require healthcare services. Conversely, participants utilizing an 831(b) plan tend to be profitable risks for insurance companies, exhibiting strong underwriting practices, effective risk controls, and a low claims history. These distinctions highlight the discrepancy between the risk profiles of health insurance and 831(b) micro-captives, rendering the use of health insurance data as an inappropriate basis for comparison.
Furthermore, the proposal relies on data from the National Association of Insurance Commissioners (NAIC) to establish a benchmark loss ratio of 72.5 percent for property and casualty companies in 2021. However, it is important to note that this data may not be limited to commercial insurance rates. Moreover, it fails to account for the fact that participants utilizing an 831(b) plan often represent profitable risks for insurance companies, characterized by sound underwriting practices, effective risk controls, and a history of low claims. A significant motivation for businesses to adopt an 831(b) micro-captive structure lies in the desire to address the burden of escalating insurance premiums, despite having minimal or no claims. These businesses aim to avoid subsidizing the losses of other customers of the insurer, as they exhibit good risk management practices and maintain a low claims history. While the NAIC data may offer some insights, it still presents an imperfect apples-to-oranges comparison.
As we strive for a more accurate and comprehensive evaluation of 831(b) micro-captives, it is crucial to acknowledge and address the limitations of the current loss ratio computation factor. A more nuanced approach should consider the unique risk profiles of micro-captives, distinguishing them from health insurance and incorporating industry-specific data that reflects the favorable risk characteristics exhibited by participants utilizing 831(b) plans.
By refining the loss ratio computation factor to align with the specific dynamics of 831(b) micro-captives, regulators and policymakers can better ensure a fair assessment of these structures. Such adjustments will contribute to a more accurate representation of the risk landscape, enabling businesses to leverage the benefits of micro-captives while preventing abusive practices. Ultimately, a balanced approach will foster innovation, promote responsible risk management, and protect the integrity of the 831(b) micro-captive framework.
Unintended Consequences of the IRS's Approach to 831(b)
Born out of the insurance liability crisis that gripped the 1980s, the 831(b) tax code emerged as a promising solution, designed to empower small insurance companies and facilitate their swift accumulation of reserves through an income exclusion provision. By granting these companies the ability to exclude a portion of their income from taxation, the aim was to level the playing field, enabling them to compete more effectively with larger insurance providers. The ultimate goal was to foster competition, drive down rates, and expand coverage options for consumers. However, despite its well-intentioned purpose, the Internal Revenue Service (IRS)'s application of the loss ratio computation factor threatens to undermine the original intent of this tax provision, creating unintended consequences.
The IRS's requirement of a 65% loss ratio, coupled with its suggestion of including shareholder distributions to meet this threshold, poses a significant challenge for small insurance companies operating under the 831(b) tax code. Rather than encouraging these companies to build robust reserve balances as initially envisioned, the IRS's approach unintentionally incentivizes them to maintain minimal reserves. This not only runs counter to the objective of the income exclusion provision but also undermines the financial stability and competitiveness of these small insurers.
By imposing a rigid loss ratio requirement, the IRS overlooks the intricacies and unique characteristics of small insurance companies operating within the 831(b) framework. The 65% loss ratio, originally intended to flag potentially abusive transactions, fails to consider the specific risk profiles and business models of these insurers. It disregards the fact that participants utilizing the 831(b) provision often exhibit prudent underwriting practices, effective risk controls, and low claims history, making them profitable risks for insurance companies.
Furthermore, the IRS's suggestion of including shareholder distributions to achieve the desired loss ratio further exacerbates the issue. Instead of allowing small insurance companies to accumulate reserves to enhance their financial stability and ability to compete, this approach encourages the distribution of profits, leaving them with limited resources to withstand unforeseen challenges or invest in growth opportunities. To truly uphold the original intent and purpose of the 831(b) tax code, it is imperative for the IRS to reassess its current approach to the loss ratio computation factor.
Fails To Address the Internal Revenue Service's Stated Concerns
In IR-2016-25, the Internal Revenue Service (IRS) explicitly outlines its concerns regarding the 831(b) tax provision, citing implausible risk coverage, lack of underwriting, and exorbitant premiums aimed at maximizing deductions. These concerns were further emphasized by Alexis MacIvor of the IRS Office of Chief Counsel in a January 2021 American Bar Association webinar titled "A Practitioner's Guide to the IRS Micro-Captive Insurance Campaign." MacIvor highlighted the absence of key attributes found in traditional insurance, such as covering implausible risks, failing to meet genuine business needs, duplicating commercial coverage, lacking underwriting or actuarial analysis, utilizing premiums geared solely towards desired deduction amounts, exhibiting higher premiums compared to commercial coverage, and containing policies with vague, ambiguous, or deceptive terms.
While the proposed regulations regarding 20% ownership and the financing computation seek to address certain aspects of the 831(b) landscape, they fall short of adequately resolving the IRS's stated concerns. Although the loss ratio computation may appear to tackle the issue of plausible risk coverages, it fails to consider the unique nature of the risks covered by 831(b) micro-captives. Many of these risks, such as pandemic-related business interruption losses witnessed during the COVID-19 pandemic, are characterized by low frequency but high severity. Applying a standard loss ratio computation may not accurately capture the true risk profiles and needs of businesses utilizing 831(b) micro-captives.
Puglisi Egg Farms Conundrum: Unanswered Questions in Proposed 831(b) Regulations
Within the proposed regulations, a statement caught the attention of industry observers: "Regarding the reduction of the loss ratio threshold from 70 percent to 65 percent, the Treasury Department and the IRS are not aware of any non-abusive transactions for which disclosure was required under Notice 2016-66 as a result of the 70-percent loss ratio factor set forth herein." This statement is inaccurate.
In 2021, Commissioner Rettig conceded a related case in the US Tax Court involving Puglisi Egg Farms. This raises important questions about the validity of the statement made in the proposed regulations. If the Treasury Department and the IRS truly had no knowledge of non-abusive transactions with loss ratios below 70 percent or 65 percent, why did they concede the case to Puglisi Egg Farms, whose loss ratio fell below both thresholds? Furthermore, why did they agree not to challenge similar future contributions that Puglisi Egg Farms may choose to make to their 831(b) micro-captive?
The concession made in the Puglisi Egg Farms case raises significant concerns and highlights the need for clarity and consistency in the treatment of 831(b) micro-captives. If Puglisi Egg Farms was deemed non-abusive, it begs the question: What were the specific characteristics of their 831(b) micro-captive that satisfied the IRS? These characteristics, which led to the concession, remain unaddressed in the proposed regulations and fail to provide safe harbors based on such qualifying criteria.
To restore confidence in the 831(b) landscape, it is imperative that these unanswered questions surrounding the Puglisi Egg Farms case be addressed. This gets to the heart of the tactics employed by the IRS in regulating these transaction. Transparency is crucial in maintaining the integrity of the tax code and ensuring fair treatment for all taxpayers. Industry stakeholders, regulatory authorities, and the IRS should collaborate to shed light on the specific aspects of Puglisi Egg Farms' micro-captive arrangement that led to a determination of non-abusiveness. By incorporating these characteristics into the proposed regulations or creating safe harbors based on similar criteria, the IRS can establish clear guidelines for compliant and legitimate 831(b) micro-captive structures.
Taxpayer Burden of Proposed 831(b) Regulations
Within the proposed regulations, a seemingly dismissive statement caught the attention of taxpayers: "…this small amount will not pose any significant economic impact for those taxpayers now required to disclose under the proposed regulations." However, a closer examination reveals a different reality and sheds light on the true burden that small businesses may face.
According to information gathered by Notice 2016-66, a staggering 79 percent of participants in 831(b) micro-captives have annual gross revenues below $5 million. The proposal estimates that the filing requirements imposed by the proposed regulations will result in an average cost of $1,667.27 per filing. It is important to note that this estimate alone would effectively double the cost of annual tax preparation and filing for the majority of participants in this income bracket.
To suggest that doubling the costs of annual tax preparation is a negligible amount that will not impose any significant economic impact on these small businesses is a concerning oversight. For entities with limited resources and tight budgets, such an increase can have profound consequences. Small businesses, already grappling with numerous financial challenges, may find it difficult to absorb these additional expenses without significant strain on their operations.
In conclusion, the discrepancies and confusion surrounding the ownership requirements and loss ratio computation factor in the 831(b) micro-captive industry highlight the need for clarity and consistency. The misalignment between congressional guidelines and the IRS's interpretation of ownership requirements has created uncertainty and raised concerns about compliance and the potential impact on micro-captive structures. Similarly, the current loss ratio computation factor fails to consider the unique risk profiles of micro-captives, leading to inappropriate comparisons and potential unintended consequences. The IRS's approach to the loss ratio computation factor, coupled with the failure to address its stated concerns about abusive transactions, further compounds the challenges faced by small insurance companies operating under the 831(b) tax code. The unanswered questions surrounding the Puglisi Egg Farms case and the taxpayer burden of the proposed regulations add to the need for clarity and fairness in the treatment of 831(b) micro-captives. By addressing these issues and establishing clear guidelines based on industry-specific characteristics, regulators and policymakers can foster innovation, promote responsible risk management, and protect the integrity of the 831(b) micro-captive framework, ultimately benefiting businesses and taxpayers alike.