House of Cards- 831(b) Small Insurance Companies

Don’t get me wrong….I’m a big fan of 831(b) Small Insurance Company structures.  Under this unique IRS rule the underwriting income for certain small insurance companies is tax-free to the insurance company.  Provided the ceded premium to the company is under $1.2M annually and there is real insurance risk transfer and risk distribution happening,  the company would only pay taxes on its investment income.

The difficulty isn’t in the structure, its how its being used.

The ancestor of 831(b) was the 501(c)(15) insurance company.  Provided there was real risk transfer and distribution and the ceded premium was less than $600K per year this company paid no taxes on its underwriting or investment income.  A nice structure for legitimate insurance transactions.  The structure was abused be zealous financial planners who “stuffed” millions of dollars of capital into the insurance company to support a small amount risk premium.  It wasn’t about insurance at all, but a mechanism to defer taxes on investments.  At the end of the day the IRS nailed down the abuses in 501(c)(15) companies and they have faded in popularity as a result.  This same crowd sees an opportunity in 831(b) to defer income on the underwriting of business risk.  It has become the financial wealth management tool de jour, only there are some problems associated it.

Typically these programs are put together upside down.  What I mean by that is that they are created primarily for the purpose of deferring taxation and not for any legitimate risk management purpose.  In order to make this financial planning tool work the consultants that use them must overcome two hurdles.  How do I create a risk coverage that I honestly hope will never have a loss and how do I create a risk sharing mechanism so that my client’s program satisfies the letter of the law regarding real insurance?   The first question is answered by creating coverages like terrorism coverage for medical practices or pandemic coverage for a manufacturer or stubbed my toe on the first Thursday of the month coverage (I made that one up!).  See, the question isn’t whether or not it could ever happen and if it did would it represent a significant risk to the policy holder, but rather that there is a policy that has been issued that I can put premium into my captive for.  Remember, this isn’t about risk management, it’s about tax and wealth management.

The second question is answered by allowing all the 831(b) companies that I have put together to share risk with each other on these sham policies.  Here is where the dangerous upper levels of the house of cards is built.  Should just a couple  of the coverages in one of the programs be challenged it could literally take down every one of the captives that share that questionable coverage’s risk.

I know, it doesn’t really sound like I’m really a big fan of 831(b) structures at all does it!  Well, I am, under certain conditions.  831(b) is an insurance company.  It’s business should be conducted like an insurance company; assuming real risk in exchange for a reasonable premium and for a legitimate purpose.  The process should start with risk and insurance and if there is some tax deferral advantages as an aside, then all the better.  It has to be built right side up and not purely as a scheme to beat the tax man.  We saw how well that went for the owners of 501(c)(15) companies, and if we think that the IRS won’t be looking at abuses in 831(b) as a means to enhance revenue we are only fooling ourselves.  If 831(b) is going to stand up to IRS scrutiny it has to be built on a foundation that is rock solid, with legitimate insurance coverages that can be shared without worry with other similarly structured captive insurance entities.

If you are contemplating this kind of structure at least seek out the services of an insurance professional who can point you in the right direction from a risk management perspective.  831(b) is a powerful tool when used properly, but if will only yield frustration and heartache if it is abused.

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