Author: Nikolajs Gaikis

If you are a small business owner, someone might have pitched you the idea of a micro-captive insurance company (“MCIC”). They might have told you about tax savings that seem too good to be true. Is that actually the case? Well, the IRS sure thinks so. But, after all, the IRS is just trying to get your hard-earned dollars. Right? Maybe not so fast. . .

This blog will explain why the IRS is likely correct to dissuade you from creating an MCIC for your small business. It will begin with an explanation of what an MCIC is and will be followed by a brief look into a Tax Court case about MCICs. It will conclude with suggested alternatives to MCICs for your small business.

What is an MCIC?

At its core, an MCIC is an insurance company that is entirely owned by its policyholder and also takes advantage of the investment income exemptions in IRC § 831.  However, a wholly owned MCIC that wholly insurers its parent is generally not permitted. Section 831 is beyond the scope of this blog.

Instead, two common corporate structures for MCICs exist. These structures are sometimes confusing, so I’ve made diagrams to help you visualize them.

1. Structure One: Brother-Sister

In a brother-sister structure, an MCIC is entirely owned by a parent company. The parent company also owns other subsidiaries, usually between 8–12. Each company usually accounts for 5–15% of the MCIC’s total underwritten risk. Also, the MCIC insurers only the subsidiaries. Here, the parent company has no business other than to hold ownership interests in its subsidiaries.

2. Structure 2: Unrelated Entities

In an unrelated entity structure, the MCIC is also owned entirely by a parent company. Here, the MCIC insurers the parent company. However, 50% or less of the MCIC’s insurance premiums come from the parent. The MCIC also insurers outside entities. These entities make up 50% or more of the MCIC’s premiums.  

An MCIC presents multiple advantages to the observant businessperson. First, insurance premiums are deductible. A savvy entrepreneur will quickly realize that an MCIC allows them to deduct insurance premiums but keep those premiums within the same corporate family. The MCIC can then invest those premiums and kick up dividends to the parent company. What a deal! 

But every great deal has a catch.

The Tax Court Disapproves of MCICs

Captive insurance companies have long been permissible under the tax law. An MCIC is different because it operates on a much smaller scale, often receiving less than $2.2 million in annual premiums. 

Once the IRS began enforcement against MCICs, the Tax Court came down on them—hard.

In Avrahami v. Commissioner, the Tax Court began tearing down the apparent legitimacy of MCICs. There, the Avrahamis owned a jewelry store and six commercial real estate companies in Phoenix. They also owned an MCIC, Feedback Inc., that insured their seven companies. 

Now, you might notice that the Avrahamis did not own enough companies to use the brother-sister structure, so they merged that structure with the unrelated entities structure.

Feedback also insured an insurance company that sold terrorism insurance to other MCICs. Feedback also paid for terrorism insurance from that company.

Naturally, the Avrahamis were deducting the insurance premiums they paid to Feedback. They also made money off of investing the premiums paid to feedback. The IRS audited them, and the Avrahamis sued the IRS in Tax Court.

The court ultimately struck down the Avrahami’s MCIC arrangement. It turned out that the terrorism insurance company that Feedback insured and received insurance from was not legitimate insurance because money flowed circularly. The court noted that Feedback would pay $360,000 for terrorism insurance and would receive $360,000 for providing terrorism insurance to the company. This circular flow of funds was not insurance. 

Now you will notice, that without the hybrid unrelated entities and brother-sister structure, the Avrahami’s MCIC arrangement does not seem permissible under the tax law. The court thought the exact same thing.

The court reasoned that Feedback only insured risks were in Phoenix. A classic element of insurance is the distribution of risks. The court concluded that with only seven insured risks in the Phoenix area, feedback lacked the risk distribution of an insurance company. Therefore, Feedback was not providing insurance to the Avrahami’s companies.

Ultimately, the Avrahamis owed millions in back taxes and hundreds of thousands in penalties to the IRS.

The Avrahamis are not alone. The Tax Court has unanimously ruled against MCICs seven times. Many of the Tax Court’s other cases also involved insuring bogus risks, like terrorism insurance. All but one case involved a lack of risk distribution.

What you can do for your business

Well, that didn’t turn out well for the taxpayers, now did it? The good news is, that your business does not have to face the same fate as the other MCICs that failed in Tax Court.

First, protect yourself by not falling victim to attorneys and accountants attempting to sell you the “wonderful” tax benefits of MCIC. It will cost you and your business. In fact, this is a good principle to live by because when a tax promoter tells you something that sounds too good to be true, it probably is.

Second, secure legitimate insurance. Legitimate insurance protects your business from risks and those premiums are actually tax deductible!

Third, if you really want to save some money for a rainy day, that’s great. Do it! Just understand that money your business saves for a potential future claim is not deductible when saved. Rather, your business will likely receive a deduction when the claim is paid out.

Don’t fall for tax tricks that seem too good to be true! Trust your intuition and always talk to a trusted tax advisor before making any tax decisions.

Sources:

IRC § 831

IRC § 162

Avrahami v. Comm’r, 149 T.C. 144 (T.C. 2017).

https://www.irs.gov/newsroom/dirty-dozen-bogus-tax-avoidance-strategies-schemes-with-an-international-element-wrap-up-annual-taxpayer-awareness-campaign

https://www.forbes.com/sites/jayadkisson/2024/01/11/irs-wins-fifth-microcaptive-case-in-keating/?sh=54900eed5148

Patel v. Comm’r, No. 24344-17, 2024 WL 1270772, (T.C. Mar. 26, 2024).

Swift v. Comm’r, No. 13705-16, 2024 WL 37871 (T.C. Feb. 1, 2024).

Image sources:

Diagrams self-created.

https://www.pexels.com/photo/red-stop-sign-39080/

https://www.pexels.com/photo/brown-and-gold-gavel-on-brown-wooden-table-6077189/

https://www.pexels.com/photo/crop-man-getting-dollars-from-wallet-4386433/

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When you own shares in a corporation, profits are the name of the game! Nothing beats a dividends cheque. However, not all “dividends” from a corporation are “dividends” for tax purposes. The type of corporate distribution can have vastly different tax consequences.

A “distribution” refers to any time that a corporation transfers funds, usually profits, from itself to one of its shareholders. Understanding the types and order of distributions is important because proper timing can lower your tax bill. This blog is geared towards corporations owned by a single or small number of shareholders because control of the corporation’s board of directors is required.

This blog first covers several assumptions and explains why they are important. It will then discuss distributions as dividends, return of capital, and distributions in excess of capital. It will conclude with a brief explanation of how and why timing corporate distributions can result in different tax outcomes.

Required Assumptions

To determine the tax consequences of a distribution, the net amount of the distribution, the corporation’s earnings and profits (“E&P”), and the shareholder’s basis in her shares must be known at the time of the distribution. Generally, a shareholder’s basis in her stock is equal to her cost to purchase a share. When a corporation only distributes cash, the distribution’s net amount equals the cash’s value. Calculating a corporation’s E&P is complicated, and warrants its own blog post. Additionally, corporate distributions must be analyzed in the order below. The two assumptions are as follows:

Assumption 1: The corporation only distributes cash.

Distributions of property or property encumbered by debt create complicated tax consequences beyond the scope of this blog. For this blog, what may be considered a dividend, (profits distributed from a corporation to its shareholders) will be referred to as a distribution to avoid confusion with the tax definition of dividend.

Assumption 2: The distribution is to a person.

If a corporation distributes cash to a shareholder that is a corporation or a partnership, many complex rules apply. Some of these include partnership accounting rules and dividends received by a corporation rules. These are beyond the scope of this blog.

Distribution #1: Dividends

When a shareholder receives a tax dividend, the distribution receives the long-term capital gains (“LTCG”) rate, if the shareholder held the stock for longer than one year. The rate is often 15%.

A tax dividend must come out of a corporation’s earnings & profits (“E&P”). Even though calculating E&P is complicated, understanding the types of E&P is simpler. This is important for timing a distribution to result in less tax owed.

Current E&P reflects the corporation’s E&P for the current taxable year. Current E&P is distributed to shareholders on a proportional basis. Current E&P is reduced before accumulated E&P. Calculating a shareholder’s allotted current E&P is simple:

(Shareholder’s Allotted Current E&P) = (amount of shareholder’s distribution) *[(corporations total current E&P) ÷ (total distributions to shareholders)]

The exact value of a shareholder’s allotted current E&P is effectively unknown until the very end of a taxable year because of E&P allocation and calculation rules.

Next, accumulated E&P is analyzed. Accumulated E&P reflects the corporation’s amassed but undistributed E&P from previous taxable years. Distributions reduce accumulated E&P only after current E&P is exhausted. Accumulated E&P is depleted by the value of the shareholder’s distribution on a first-come-first-served basis. Hypothetically, one shareholder could receive all of the corporation’s accumulated E&P, but the others receive none.

Distribution #2: Return of Capital

If the corporation has insufficient E&P to cover the shareholder’s distribution, then the distribution is treated as a return of the shareholder’s capital. A shareholder’s capital is equal to the basis in her shares in the corporation.

A shareholder’s basis in her shares generally equals the share’s purchase price. However, this could be reduced if the shareholder previously received a return of capital distribution. All return of capital distributions are tax free.

This step has two possible conclusions. First, if the shareholder’s basis exceeds the remaining distribution, then the analysis stops. If the shareholder’s distribution exceeds her basis, then the analysis continues to step 3.

Distribution #3: In excess of basis

This step is the simplest so far. The balance of the shareholder’s remaining distribution receives LTCG treatment, if the shareholder held the stock for longer than one year.

Why Understanding Corporate Distributions Matters

You might be asking yourself “Why does it matter?” After all, dividends and distributions in excess of basis both receive LTCG treatment, and return of capital distributions are tax free.

Here’s the rub. If you have excess of basis distributions, you will have less basis in your stock because your capital has been returned. Therefore, when you sell your shares in your business, you will pay more in tax.

Alternatively, you might have some personal long-term capital losses (“LTCL”) that can offset your LTCG. Personal LTCLs could be from the sale of stock or LTCLs from another business, like a partnership. If your personal LTCL exceeds your dividend, you will eat into your basis even though you had the LTCL to offset your LTCG.

Here, the solution is simple. If you wait until the following taxable year to pay out a tax dividend with sufficient E&P, then your remaining personal LTCL will carry over to that year to offset the LTCG. It is important to confirm that your LTCL is eligible for carryover. In this situation, your LTCGs have been offset by your personal LTCLs and your basis in your stock remains intact.

Closing Thoughts

Understanding corporate distribution rules empowers shareholders to time their corporate distributions to result in the least taxable impact for herself and other shareholders. Properly timed corporate distributions can save shareholders large amounts of tax. However, understanding the whole picture of both the corporation’s and the shareholder’s personal taxes is required to properly time corporate distributions. It is always a good idea to seek the advice of a tax professional before undertaking a complicated tax plan. Good luck and happy distributions!

Sources

I.R.C. § 301

www.leoberwick.com/leo-berwicks-math-lesson-of-the-day-calculating-earnings-and-profits/

www.irs.gov/taxtopics/tc409

www.irs.gov/newsroom/new-limits-on-partners-shares-of-partnership-losses-frequently-asked-questions

https://pixabay.com/photos/dollar-flying-concept-business-2891817/

https://pixabay.com/photos/school-a-book-knowledge-study-1661731/

https://pixabay.com/photos/entrepreneur-idea-competence-vision-1340649/

https://pixabay.com/photos/ledger-accounting-business-money-1428230/

https://pixabay.com/photos/money-grow-interest-save-invest-1604921/

By: Nikolajs Gaikis

Employees working for promising start-ups love stock compensation because a massive payday may be around the corner! Businesses should be aware of the consequences of compensating employees with property. The exciting part is that any business can pay their employees with property!

In this blog, you’ll learn about the tax consequences of compensating employees with property, what deductions are and how to take advantage of them with property compensation, and the pros and cons of compensating employees with property.

Property Compensation for the Employee

Entrepreneurs should understand how employees are taxed under the Internal Revenue Code § 83 when they receive property for their services because the employee’s tax consequences impact your business.

For the employee to determine their tax bill, they must determine the fair market value (“FMV”) of their property compensation. FMV is the price that a motivated buyer and seller would exchange property for on the market. Also, the FMV must reflect any permanent restrictions on it, like a requirement to sell all the property at once.

The most common form of property compensation is stock. Determining the FMV of your company can be incredibly challenging. This topic warrants its own blog post. Thus, this blog will only focus on the tax benefits of property compensation.

Next, employees’ property compensation is taxed when it is substantially vested. Substantially vested means whenever the employee can freely transfer the property and the property is not forfeitable. In other words, if an employee quits and can keep the property, the property is substantially vested because it is forfeitable. If no restriction ever existed, then the employee’s property is substantially vested upon receiving it.

However, employees can elect to pay tax on their property compensation within 30 days of receiving it. Here, they will not pay tax when the property is substantially vested. Instead, the employee pays tax immediately. We’ll call this “the election.” The employee must use the property’s FMV at the time of the election.

Section 83 for the Employer

Let’s get to the fun part where your business saves money! We can skip whether your business has income from an employee’s labor because businesses have no income when receiving services from an employee.

Generally, businesses receive deductions for the costs of compensating employees. Business deductions lower your taxable income. However, paying employees with property could result in two different deduction amounts and times to take that sweet deduction.

If you pay the employee with non-forfeitable property, it is deductible in the year you compensated your employee. Furthermore, the amount of the deduction will be the FMV of the property in the year you paid your employee. Easy!

Paying employees with forfeitable property is more complicated. Here, the employee’s tax choices dictate when your business gets a deduction. If the employee waits until the property is non-forfeitable, your business receives a deduction in the year the property is non-forfeitable. Also, the amount of the deduction is the FMV of the property in the year when the property is non-forfeitable.

If your employee opts for the election, then your business receives its deduction in the year the employee took the election. This will always be within 30 days of compensating your employee with property. Your business deduction will be equal to the FMV at the time of election.

Previously Purchased Property

If your business purchased property and then compensated an employee with that property, your business must determine whether it made a gain or loss on the purchase of that property. You must report that gain or loss to the Internal Revenue Service. Determining a gain or loss is easy.

The magic equation is as follows:

Amount Realized

—                    Basis                 

Gain or Loss

The amount realized is the sale price. Here, the amount realized is the FMV of your employee’s services, which always equals the FMV of their property compensation. Remember, the FMV of the property might change depending on whether the employee had the election option and took it. Next, your business’s basis is your cost of buying the property, which includes expenditures like closing costs. Abracadabra! You have determined your gain or loss.

If you have a gain, you must report that as income on your taxes. If you have a loss, your business likely qualifies for a loss deduction. This IRS capital gains and losses guide explains this process well.

The Pros and Cons of Property Compensation

If your business is strapped for cash, compensating employees with property could save you cash, especially if you have the property on hand, like stock. Also, if you compensate your employees with stock, they have a stake in your business and will work as if it was their own. Finally, employees may work harder and stay around longer. In fact, with the FTC’s proposed ban of non-competes, substantial vesting may play a role in keeping employees around because they’ll want to keep their property compensation.

A disadvantage of property compensation is that the tax details are more complicated than cash compensation. Also, a major disadvantage, specifically for stock, is losing equity in your company to your employees. This limits your equity in the business or equity that you could use to raise investor capital. Finally, the employee’s election decision determines when your business receives its deduction, if their compensation is forfeitable. If your business really needs that deduction for the current tax year, you should compensate your employees with non-forfeitable property.

The Takeaway for Entrepreneurs

Paying employees with property is an awesome way for them to have a stake in your company. They’ll work harder and stay around longer. It’s also great for ambitious start-ups that are strapped for cash but extremely promising. As with any tax concerns, consulting a professional is always a good idea. Have fun with it, and good luck!

Sources

IRC § 83

IRC § 1001

IRC § 1011

IRC § 1012

https://www.irs.gov/taxtopics/tc703

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https://www.pexels.com/search/employee%20salary/

https://www.pexels.com/photo/tax-documents-on-black-table-6863259/

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