At the heart of the I.R.S. effort to restrict and even eliminate the 831 (b) small insurance company election lies a fundamental flaw. The federal government simply does not regulate the business of insurance. That function lies almost exclusively with the state governments pursuant to the provisions of the McCarron Ferguson Act of 1945. Under the regulatory regime established by the McCarran-Ferguson Act, insurers are subject to a vibrant, comprehensive state-level system of regulation, consumer protections and antitrust enforcement. States regulate virtually every aspect of insurance from licensing to market practices to financial solvency, and all insurance activity is subject to regulatory supervision. In addition, every state has an Unfair Trade Practices Act providing authority to investigate, and if appropriate, correct and punish a variety of unfair practices.
Since its inception efforts have been made to undermine the exemption from federal regulation, but by and large those efforts have failed. Attached is a 1973 article that examined efforts fifty years ago to erode McCarron Ferguson. The author expressed concerns for where those efforts might lead. Fifty years later the McCarron Ferguson Act remains intact. With the notable exception of the 1981 Federal Risk Retention Act and its 1986 amendment that expanded its reach, the federal government, except for the I.R.S., has not tried to regulate insurance.
This entire small captive structure is under attack by the I.R.S as it attempts to invalidate a legal right to self-insure that has not only been approved by Congress but has been consistently reaffirmed. Since 1986 Congress has consistently raised the limit a small insurance company can write without being taxed on premium income. Commissioner’s Opinion #1 discusses the definition of insurance. It is a basic definition. The definition applies to reinsurance companies as well. In an effort somehow regulate the business of insurance, the I.R.S. in conjunction with federal tax courts has fashioned a requirement that captive insurance must resemble insurance in the “common ordinary sense.” Under this ill-defined standard the I.R.S. seeks to control the terms of insurance agreements, the way claims are paid, where and from who a person can buy insurance, and other basic aspects of an insurance transaction.
Domiciling a direct write or reinsurance company on a federally established and recognized tribal jurisdiction offers clear benefits. Small business owners have the freedom to manage their insurance risks in a regulated environment that provides a clear structure but does not overly inhibit the ability of the parties to tailor their insurance coverage to their actual needs. The IRS attack on the captive industry, while a clear effort to undermine state regulation and the McCarron Ferguson Act, also threatens tribal domiciled companies.
15 U.S.C. §§ 1011-1015
“Reinsurance is an agreement between an initial insurer (the ceding Company) and a second insurer (the reinsurer), under which the ceding company Passes to the reinsurer some or all of the risks that the ceding company assumes.
Through the direct underwriting of insurance policies. Generally, the ceding Company and the reinsurer share profit from the reinsured policies, and the reinsurer agrees to reimburse the ceding company for some of the claims that the Ceding company pays on those policies.” Trans City Life Ins. Co. v. Commissioner, 106 T.C. 274, 278 (1996).
26 CFR Ch. I (4–1–11 Edition) §301.7701-2, Notice b (1) and b (4)
Thankfully there are concerted efforts in both the public and private arenas to combat the I.R.S. efforts. Congress has demonstrated a willingness recently to confront these issues. Private lobbying efforts are making lawmakers more aware of the threat. Perhaps more important, the owners and operators of small captive companies are refusing to bend to I.R.S. efforts to disallow their deductions. As of the date of this opinion there are almost 1100 contested cases on the tax docket that the I.R.S concedes would take decades to resolve. The fight is winnable. What it requires is for the captive industry and those who benefit from it to become both more aware and more proactive.