The IRS’s War on Captive Insurance: A Flawed Definition and Arbitrary Enforcement

IRS’s War on Captive Insurance Companies Continues

The IRS has once again targeted captive insurance companies by including them on the Dirty Dozen list, sparking controversy and debate within the insurance industry. Despite this annual announcement, the IRS’s definition of insurance remains vague and inconsistent, leaving taxpayers at risk of arbitrary enforcement.

The IRS’s definition of insurance, based on a test created for life insurance companies, includes four elements: an arrangement with an insurable interest, risk shifting and distribution, and insurance in its commonly accepted sense. However, these elements are open to interpretation and have led to conflicting rulings in U.S. Tax Court.

The origins of the IRS’s insurance test date back to a 1940s case, Helvering v. Le Gierse, which addressed a tax shelter involving life insurance policies. This case established the importance of risk shifting and distribution in insurance, as well as the vague concept of “insurance in its commonly accepted sense.”

One of the main issues with the IRS’s test is the lack of consensus on risk shifting, particularly in property/casualty insurance where deductibles and self-insured retentions are common. The IRS’s presumption that captives achieve risk shifting through collateralization has been criticized as a meaningless standard.

Similarly, the requirement for risk distribution has been deemed complicated and contradictory by actuaries. The IRS’s insistence on a high number of risks for risk distribution could potentially exclude smaller captives from the market, further complicating the issue of defining insurance.

In response to these challenges, Matthew Queen, owner of The Queen Firm, proposes a more objective framework for determining insurance. His framework includes factors such as the payment of claims, the insured’s interest in the insured thing, and the insurer’s ability to pay losses, providing a more reasonable approach to assessing insurance transactions.

As the debate over captive insurance companies and the IRS’s enforcement continues, it is clear that a more coherent definition of insurance is needed to protect taxpayers and ensure fair treatment in the insurance industry. Matthew Queen’s proposed framework offers a potential solution to this ongoing issue.

Contact Matthew Queen at [email protected] for more information on this topic.