Changing Tide for IRS Enforcement of Microcaptive Insurance

By Leo Unzeitig, CPA, J.D. - San Antonio

Congress passed Section 831(b) in 1986. It provides important tax benefits to small insurance companies. Namely, net premiums received are not taxed as income as long as they remain under $2.2 million.

Not surprisingly, taxpayers have availed themselves of the important benefits provided by the provision by forming insurance companies. The problem is that “insurance” is not defined by the Code. And over the last 35 years, Treasury and the IRS have chosen not to provide any of the sorely needed guidance letting taxpayers know what qualifies as insurance for Section 831(b). Instead, the IRS has listed so-called microcaptive insurance as a “transaction of interest” requiring disclosure on a Form 8886. The IRS has 12 exam teams collectively termed the “Tiger Team” who use the list of taxpayers from the Forms 8886 to open examinations, disallow the benefits provided by Section 831(b) and assert 40% lack-of-economic substance penalties. A recent American Bar Association Tax Section panel comprised of the IRS authorities on insurance confirmed that no captive insurance arrangement has been sustained at the exam level. Following a string of victories at Tax Court, the IRS has had strong winds at its back in its enforcement mandate.

However, the tide appears to be turning. In the recent case of Puglisi v. Commissioner, Dkt. No. 2796-20, the IRS conceded the deficiency determination for a microcaptive insurance company before trial. This is the first instance in recent years where the IRS has done so. The question is, does this change anything?

Like all microcaptive insurance cases, the captive insurance company in Puglisi “reinsured” risks pooled by hundreds of independent but similarly situated taxpayers (picture 100 taxpayers across the country forming insurance companies that all collectively insure each other in small part). This arrangement was previously approved by the IRS in numerous letter rulings issued in 2012. However, the IRS quickly (and without explanation) abandoned the reasoning in those letter rulings. 

Fast forward a decade and the IRS appears to be coming back around. The taxpayer in Puglisi participated in a version of a relatively common reinsurance structure that was nonetheless rejected by the Tax Court in recent cases. Thus, it is unlikely that the structure itself was cause for concern to the IRS. The distinguishing facts that the IRS may have deemed more hazardous to its litigating position are that (1) before forming the captive to insure unusual perils (i.e., losses arising from avian flu), the taxpayer sought and was unable to find the same coverage in the commercial market, and (2) the taxpayer made several significant claims. 

The distinctions in Puglisi make it a stronger case than others, but not necessarily. This is because the claims were likely reinsured by over 100 other insurers. Thus, the Puglisi’s captive insurance company likely covered some of their losses, but the rest of the unrelated insurance companies likewise covered a portion, as well. Thus, every other taxpayer participating in the reinsurance pool should arguably be treated the same as the taxpayers in Puglisi because of the effects of the pooling arrangement. They likely used the same actuary to price policies, the same management firm to manage the captive insurance companies, the same claims processer to evaluate claims, and they all agreed to assume and reinsure risks by the same arm’s-length standards. The only differences may be the extent to which the individual insureds suffered losses leading to claims.

Given the significant resources the IRS has devoted to challenging captive insurance companies and the Section 831(b) election, it is unlikely that the Tiger Team will slow or disband. But the result from Puglisi is promising in at least one regard: the IRS apparently believes that there are instances in which taxpayers may qualify for the election. Let’s just hope that someone at the IRS considers the pooling effects on other taxpayers and likewise issues reliable guidance so that taxpayers are spared the expense of more unnecessary audits and trials.

The IRS seems to believe that Section 831(b) works in some situations. It would be great if we had reliable guidance on what those situations are and might make the IRS’ enforcement responsibilities a bit easier.