State legislators to IRS: Stay out of the insurance business

The National Council of Insurance Legislators is not happy with a proposed federal regulation to crack down on micro-captive insurance companies.

The proposed regulation, put forth by the Treasury Department and the Internal Revenue Service, would identify certain micro-captive transactions as "listed transactions" and certain other micro-captive transactions as "transactions of interest."

Listed transactions are abusive tax transactions that must be reported to the IRS. Transactions of interest are tax transactions that have the potential for tax avoidance or evasion that must also be reported to the IRS. Recent court decisions forced the IRS into the regulation.

The IRS's goal is to identify tax-avoidance captive proposals. But NCOIL sees the federal government stepping into turf it does not belong.

“The proposed rule undermines the well-established and continually reaffirmed framework of the state-based system of insurance regulation,” said Arkansas state Rep. Deborah Ferguson, NCOIL president.

NCOIL submitted comments on the regulation before the June 12 deadline. The government reported receiving 174 comments and a public hearing is planned on the regulation on July 19 at 10 a.m.

NCOIL is a national legislative organization with all 50 states represented, principally by legislators serving on their states’ insurance and financial institutions committees.

Tax advantages

Captive insurers are essentially a form of self-insurance whereby the insurer is owned wholly by the insured, as defined by the National Association of Insurance Commissioners. They are typically established to meet the unique risk-management needs of the owners or members. Additionally, they provide potentially significant tax advantages, which can prove integral to longevity and company profitability.

Captive insurers can provide lucrative revenue sources and many states are competing to be captive-friendly.

If the captive insurance company has $2.45 million of gross premiums received, it is a “micro-captive” that can elect to be taxed only on its investment income and not on the insurance premiums it receives, the accounting firm EisnerAmper explained.

The company that is insured by the policies, however, is still able to deduct the full amount of premiums it pays as an ordinary and necessary business expense under the tax code.

These tax benefits make micro-captive arrangements attractive but also ripe for abuse. The IRS stepped up efforts in recent years to go after micro-captives. Since 2019, the IRS has been offering a settlement program for taxpayers who are under audit for micro-captive transactions, which had an 80% acceptance rate during its first year.

"In abusive micro-captive structures, promoters, accountants or wealth planners persuade owners of closely held entities to participate in schemes that lack many of the attributes of genuine insurance," the IRS said in announcing the proposed rule.

Lost in court

Recent court decisions in the Sixth Circuit and the U.S. Tax Court ruled that the IRS lacks authority to identify listed transactions and transactions of interest by notices, and must instead identify such transactions by following the notice and public comment procedures that apply to regulations.

"Treasury and the IRS will, however, no longer take the position that transactions of interest can be identified without complying with notice and public comment procedures," the IRS said. "Treasury and the IRS issued the proposed regulations to ensure that these decisions do not disrupt the IRS' ongoing efforts to combat abusive tax shelters throughout the nation."

The IRS has "consistently disallowed" the tax benefits claimed by taxpayers in abusive micro-captive structures. "Some taxpayers have challenged the IRS position disallowing these micro-captive tax benefits in court, but none has been successful," the agency pointed out.

Of the misuse if the captive rules, NCOIL was careful to note that it "takes no position on other than to condemn fraud in all instances."

"The IRS goes too far and seeks to insert itself into captive insurance companies’ loss ratios, an insurance business aspect which constitutes the very heart and core of 'the business of insurance' which, pursuant to the McCarran Ferguson Act, shall be 'regulated by the States,'" NCOIL said in a news release.

Senior Editor John Hilton covered business and other beats in more than 20 years of daily journalism. John may be reached at [email protected]. Follow him on Twitter @INNJohnH.

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InsuranceNewsNet Senior Editor John Hilton has covered business and other beats in more than 20 years of daily journalism. John may be reached at [email protected]. Follow him on Twitter @INNJohnH.