Matthew Queen, 831(b) Institute advisor, attorney, and owner of The Queen Firm, LLC, gives his view on how micro-captive owners will be affected by the overturning of Chevron earlier this month
The Supreme Court’s decision to change the landscape for federal agencies indirectly affects small captive insurance companies. In short, taxpayers now possess more ammunition by which to challenge regulatory changes imposed by the IRS but wield no new power in defending which specific insurance transactions qualify as “insurance” as defined for federal income tax purposes.
Small captive insurance programs writing less than $2.8 million in gross written premiums may consider making the 831(b) election to exempt underwriting income from federal income tax.
This controversial election is the subject of intense prosecution from the IRS. The IRS dislikes the law and seeks to effectively remove it from the Internal Revenue Code by deeming it a “listed transaction.” The proposed rules to classify the 831(b) election are currently in limbo and are likely to remain so pursuant to the Supreme Court’s recent decision overturning the Chevron doctrine.
Until 2017, there was significant debate as to whether Department of Treasury regulations were subject to the same notice and comment procedures required by the Administrative Procedures Act (APA) as other agencies.
In 2016, the IRS issued Notice 2016-66, reclassifying the 831(b) election as a transaction of interest and requiring nearly every captive insurance company that made the 831(b) election in the prior decade to file a Form 8886 and significant supporting documentation. This resulted in a de facto audit of the entire microcaptive insurance industry.
This overreach resulted in a captive manager challenging the authority of the IRS to act unilaterally without any governance under the APA.
In the case of CIC Services, LLC, the Supreme Court held that the IRS’s attempt to classify the 831(b) election as a “transaction of interest” was invalid due to the IRS’s failure to adhere to the notice and comment requirements of the APA.
Several years later, the IRS revisited the 831(b) election by issuing proposed rules seeking to classify the 831(b) election as a listed transaction. In April of 2023, the proposed rules were reviewed by the captive insurance industry. Most of the comments criticized the IRS’s general misunderstanding of insurance and the proposed rules remain in limbo with no indication from the IRS as to whether the agency will jettison the proposed listed transaction or seek to publish the rules and effectively outlaw the 831(b) captive insurance company.
June of 2023 altered the legal landscape as it relates to the powers of executive agencies with the Supreme Court’s decision in Loper Bright Enterprises v Raimondo.
In Loper, the Court overruled the Chevron decision which held that federal courts were mandated to defer to administrative agencies as it relates to interpreting laws unless the law was ambiguous. Consequently, federal courts are no longer required to provide the treasury with any deference as to how to interpret the Internal Revenue Code. Rather, federal court judges are permitted to review the evidence in an even-handed manner and arrive at the result that makes the most sense according to the presiding judge.
In addition, Loper means that federal courts are similarly no longer required to provide any deference to revenue rulings, revenue procedures, or even private letter rulings (never precedential in the first place) since these IRS actions are never subject to the APA’s formal notice and comment process. While so-called IRS safe harbors for captive insurance transactions generally favor the taxpayer, the courts are not required to defer to the IRS’s interpretation of the law pursuant to a revenue ruling in the event of a dispute as it relates to a specific transaction.
The net effect of these rulings means that any Treasury regulations promulgated to govern captive insurance transactions, including the 831(b) election, are required to undergo formal notice and comment proceedings as per the Administrative Procedures Act and any interpretation of those regulations are no longer subject to deference in favor of the treasury. Taxpayers dissatisfied with the ultimate rules issued by the IRS governing captive insurance companies possess more avenues by which to challenge regulations than in the past.
Nothing in the Loper decision affects the definition of insurance. Challenges by the IRS to captive insurance transactions as lacking risk shifting, risk distribution, failing to constitute insurance in the commonly accepted sense, or lacking an insurable interest remain legal.
The case law governing small captive insurance transactions, primarily arising from the Tax Court’s Avrahami decision, is unaffected by the Loper decision. Thus, the challenging legal landscape for small insurance companies remains in effect until there is a change in the manner by which Congress defines insurance or reinsurance.
Where the legal landscape changed is whether the IRS possesses the power to outlaw the 831(b) transaction by fiat. While the IRS retains the power to publish its proposed rules to classify the 831(b) election as a listed transaction, taxpayers possess broader grounds on which to challenge it. Given the voluminous comments from the captive insurance industry outlining the deficiencies in the proposed rules, it is likely that federal courts will possess several arguments on which to overturn the listed transaction.
Practically speaking, the Loper decision makes it less likely that the IRS moves to publish its proposed rules and classify the 831(b) election as a listed transaction. Captive owners and captive managers possess the standing to challenge the rules upon publication. Given the specious nature of the rules, it is more likely than not that they would not survive challenge in federal court.
This positive news for captive insurance companies does nothing to improve the overall situation with the IRS. Even if the IRS is likely to lose the argument classifying the 831(b) election as a listed transaction, it remains empowered to challenge individual transactions as lacking some element of insurance arising out of the byzantine case law governing the definition of insurance for federal income tax purposes.
Real change for taxpayers will involve new case law arising out of federal courts or a new law from Congress addressing the definition of insurance or reinsurance. Until then, federal court precedent remains the law of the land.
