www.captiveinternational.com LEGISLATION 11
a significant number of captives provide
little more than a sophisticated tax dodge
for their clients.
The IRS has the executive mandate to
hunt down tax shelters for the benefit of
the public good. Political leanings aside,
it is literally the job of the IRS to ferret out
tax shelters. Since captives have been
abused by promoters, the IRS will hound
small captives for time to come.
So, through Reserve we see Avrahami
in better light. Risk pools will survive if
they look like real insurance. If a risk pool
has a circular flow of funds with virtually
the same amount of premium going in as
coming out, then the risk pool is less likely
to be upheld. If the captive is insuring
exotic risks with no honest exposures to
the insureds, then the captive is less likely
to be upheld. In short, the Tax Court is
employing a sniff test with regard to 831(b)
captives. If it looks like insurance, and acts
like insurance, then it is insurance.
Nobody likes nebulous standards.
Honest captive practitioners should
review their captives for compliance
issues. Many 831(b) captives are perfectly
legitimate. There is nothing dishonest
about running a small insurance
company. In fact, the biggest advantage
the 831(b) election provides is that it
opens the market of captive insurance
to the middle market. But for the 831(b)
election, the costs of a captive may be way
too much for middle market companies
to afford. Consequently, the large market
companies retain their competitive
advantages. So, the 831(b) captive is not a
bad business practice.
Perhaps the great tragedy of the war on
831(b) captives is that innocent captive
managers will get sucked into needless
lawsuits against the IRS. The service is
ill-equipped to evaluate what constitutes
insurance. Yet, the IRS is the principal
body governing the essence of insurance.
This means that mistakes will be made.
Further, the Tax Court’s warpath against
831(b) companies creates the possibility
that the Tax Court will overstep its bounds
and issue a needlessly complex opinion
that harms the legitimate wing of the
small captive industry. l
Matthew Queen is chief compliance
officer and general counsel at Venture
Captive Management. He can be contacted
is an insurable risk; 2) whether there is
insurance in the commonly accepted
sense; 3) whether there is risk shifting;
and 4) whether there is risk distribution.
Scant case law directly opines as
to whether a transaction consists of
insurance in the commonly accepted
sense, but the Tax Court’s opinion
leveraged this underutilised element of
captive insurance while evaluating the
The Tax Court analysed “insurance in the
commonly accepted sense” through the
prism of a bona fide insurance company.
In other words, is the transaction at
issue in Reserve the kind of transaction
that a normal insurance company would
No. It was a sham. End of discussion.
Again, much like Avrahami, the Tax
Court focused on the back office of the
captive manager. The feasibility study
was incomplete. The actuarial reports for
reserves and rates were insufficient. The
risk pool had virtually no risk. The whole
operation appeared reverse-engineered
to arrive at a specific premium. This is
not how insurance works. Insurance
underwriters assess risks, work with
actuaries to set rates and reserves, and
pay claims on risks. Basically, none of that
occurred in Reserve and the Tax Court
rendered the captive invalid.
To be fair, the captive manager’s risk
pool was more sophisticated than
the manager in Avrahami. Further, the
manager secured scores of determination
letters from the IRS blessing similar
transactions. Yet, all the hard work was
for naught. Section 831(b) transactions
remain a Transaction of Interest for the
IRS. The service announced that it was
bringing the heat against deficient captive
insurance companies and they meant it.
Missing the point
Losses are not the definition of insurance.
The fact that the IRS focuses so much
on claims and losses represents a
fundamental misunderstanding of
insurance. Yet, it needs a place to start.
Honest captive practitioners know that
uninsurable risks across a greater pool
to insurers. Risk pools reflect one of the
central precepts of insurance: all of us are
stronger than some of us.
However, risk pools must have risk. The
Avrahami captive was struck down for a
number of reasons. Chief among them was
the fact that the risk laundering programme
used by the captive manager’s risk pool
was a sham designed to circumvent IRS
issues and create a favourable tax vehicle
for the owner of the captive.
A clearer vision
Although Avrahami failed to provide a
clear rule governing the validity of a risk
pool, the vision of the Tax Court is clarified
when the case is paired alongside Reserve
Mechanical. In Reserve, the Tax Court
considered a captive situation in a similar
The Reserve captive had lackadaisical
actuarial studies, virtually no losses,
and participated in a risk-free risk
pool, although the Reserve captive was
stronger than the Avrahami one. The risk
pool itself assumed a small amount of
third party risk by reinsuring another pool
of vehicle contracts. The specifics of the
pooling arrangement were complicated,
but ultimately meaningless.
The Tax Court barely analysed whether
the risk pool constituted a legitimate
insurance arrangement. Instead, the
analysis focused on whether the whole
transaction was one that a bona fide
insurance company would conduct.
As is par for course, the Tax Court
assessed all four elements of a captive
insurance company: 1) whether there
“The Tax Court is unqualified to
opine as to what constitutes a
properly constructed risk pool.”
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