Wednesday, December 12, 2012
Beckett G. Cantley (John Marshall (Atlanta)), The Forgotten Taxation Landmine: Application of the Accumulated Earnings Tax to IRC § 831(B) Captive Insurance Companies, 11 Rich. J. Global L. & Bus. 159 (2013):
The owners of a company often can form an IRC § 831(b) captive insurance company (“CIC”) to insure certain risks of the company while retaining insurance management, eliminating underwriting fees, claiming current income tax deductions for insurance premium expense, and controlling the investment portfolio of the CIC. Furthermore, the use of a CIC may defer the realization of ordinary income or even re-characterize ordinary income as capital gain to the common owners of the company and CIC, due to the current qualified dividend tax rate preference. While these tax benefits are substantial, a CIC cannot defer taxation to the parent corporation shareholder indefinitely. A CIC generally must be a Subchapter C corporation to comply with local jurisdictional requirements and thus may be subject to the Accumulated Earnings Tax (“AET”). The AET is a penalty tax designed to prevent corporations from unreasonably retaining after-tax earnings and profits in lieu of paying current dividends to shareholders, where they would be again taxed as ordinary income at applicable shareholder tax rates. If a C corporation is liable for the AET under IRC § 532(a), there will be imposed a tax for each taxable year of fifteen percent (15%) on the corporation’s accumulated taxable income. Accumulated taxable income is reduced by a credit for an accumulation amount sufficient to satisfy reasonable current and future anticipated business needs.
Reasonable current business needs of a CIC generally include (but are not limited to): the amount needed for employee compensation and benefits for the current business cycle; the amount needed for facilities overhead expenses for the current business cycle; and the amount needed to fund the probable claims payable, as determined by actuarial tables. Reasonably anticipated future business needs of a CIC may include (but may not be limited to) planned for expansions of facilities; expansions of workforce; acquisition of stock or assets for diversification or other business needs; redemption of CIC shares; and retiring bona fide business indebtedness of a non-shareholder creditor. The reasonableness of accumulations may be challenged under several scenarios. First, the IRS may claim the CIC had no specific plan outlining how the earnings accumulations are to be utilized. Second, if a CIC claims that accumulations are made in accordance with a plan, but actually has no intent to carry out the plan (as shown through a lack of substantial steps to further the plan), the accumulations may be deemed unreasonable. Third, if a CIC actually makes expenditures in furtherance of a plan for accumulation in fixed assets but does not use those fixed assets for business purposes, the fixed assets may be deemed liquid assets subject to the AET, since such liquid investments are considered available to satisfy the capital needs of the CIC. Lastly, if accumulated earnings are received in liquid form but converted to non-liquid form, the accumulation may be deemed to be objectively unreasonable, made for tax avoidance purposes, and thus deemed liquid assets subject to the AET.
This article discusses (i) the requirements, benefits, and tax attributes of an IRC § 831(b) CIC; (ii) an overview of the AET and the reasonable needs test which must be met to avoid the AET; and (iii) the potential future application of the AET to an IRC § 831(b) CIC and the negative results that could arise if the IRS chooses to do so. Given that the IRS has yet to announce any policy about applying the AET to combat the growth of this popular tax arrangement, this article seeks to analyze how the IRS may prospectively make use of this tool and how CIC owners and mangers should conduct themselves to not run afoul of the IRS.