Proposed IRS Rules on Microcaptives Defy Precedent and Logic

Earlier this year, the IRS issued a new Notice of Proposed Rulemaking regarding draft regulations on 831(b) plans, often known as microcaptives. A public hearing has also been scheduled for July 19.

The agency’s approach to 831(b) plan regulations has been problematic for years, but the latest proposed rules include several contradictory and illogical requirements worth examining in detail.

First and foremost, the IRS may have backed itself into a regulatory corner and now appears to be disagreeing with both congressional intent and its own previous decisions.

Under the 2015 Protecting Americans from Tax Hikes Act, among other alternative ownership requirements, companies are eligible for the 831(b) election when the owner of an insured business holds an interest in the insurer no greater than their interest in the business. A legislative summary published by the Senate Finance Committee at the time indicated that these ownership requirements were designed to prevent abuses.

In a seemingly direct contradiction of congressional intent, the proposed regulations impose different ownership requirements on 831(b) plans from those established by the PATH Act. This contradiction is amplified by apparent internal confusion, as the IRS itself noted in a 2016 news release that the PATH Act was designed to address microcaptive abuses, leaving the need for the recently proposed rules unclear.

The proposed rules also undermine IRS Revenue Ruling 2002-89. The decision, 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. A defining feature of that ruling was that the corporation paid premiums to its wholly owned subsidiary.

Further defying logic, the agency continues to defend the notion that a loss ratio computation factor is a reasonable or reliable method of distinguishing abusive 831(b) plans. In particular, the IRS relies on health insurance loss ratios to defend a proposed 65% loss ratio. Using health insurance loss ratios as a benchmark for 831(b) plan regulations betrays the agency’s lack of understanding of the industry.

Generally, 831(b) plans experience high-severity losses on an infrequent basis. In contrast, health insurance typically covers a higher number of claims, but those claims tend to be much lower in severity. The IRS is using the opposite of what it should look for in a benchmark to determine appropriate loss ratio computation factors—if it must insist on using them at all.

Section 831(b) of the tax code was designed to empower small to mid-sized insurance companies by excluding part of their income from taxation, allowing them to better compete with larger insurance providers. While this arose from the insurance industry dynamics of the 1980s, lower insurance rates and increased competition are still necessary today.

Unfortunately, by imposing the loss ratio requirements, the IRS will incentivize small insurers to maintain minimal reserves, which will damage their financial stability and ability to compete with larger providers.

Finally, eagle-eyed readers will notice that the proposed rules include objectively inaccurate statements. For example, the agency claims, “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.”

In 2021, the IRS conceded an 831(b) case in the US Tax Court against Puglisi Egg Farms. Puglisi Egg Farms had a loss ratio below 65%, and as part of the concession, the IRS agreed not to challenge similar future contributions the company might make to its microcaptive.

In other words, just two years ago, the IRS effectively agreed that Puglisi Egg Farms’ 831(b) plan was a non-abusive transaction and had the data to realize the farm’s plan had a loss ratio below 65%. This means there is at least one public example that contradicts a central claim in the proposed rules. If the Puglisi Egg Farms case involved specific characteristics that could form a safe harbor framework for 831(b) plans, then the IRS should publicly acknowledge them.

The IRS must improve the transparency, clarity, and integrity of its enforcement of the tax code. Challenging congressional intent, imposing illogical requirements based on benchmarks from unrelated industries, and making inaccurate statements aren’t the right way to approach regulation. The IRS’s proposed rules on 831(b) plans fall far short of the mark and should be returned to the drawing board.

This article does not necessarily reflect the opinion of Bloomberg Industry Group, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.

Author Information

Van Carlson is founder and CEO of SRA 831(b) Admin. He has over 25 years of experience in the risk management industry and is passionate about helping businesses protect themselves from unforeseen risks.

We’d love to hear your smart, original take: Write for us.