IRS Continues Enforcement Focus on Abusive Micro-Captive Insurance Companies
Since micro-captive insurance companies were placed on the IRS’ “Dirty Dozen” list of tax scams in 2014 and identified as a transaction of interest in 2016, the IRS has continued to expand its enforcement efforts of what it views as abusive micro-captive insurance arrangements.
A micro-captive is a small insurance company that, for 2020, has $2.35 million or less in annual written premiums and meets certain diversification requirements. An insurance company that meets these criteria can elect under Internal Revenue Code Section 831(b) to pay tax only on its net investment income, while the insured business receives a tax deduction for premiums paid to the captive. In abusive micro-captive structures, taxpayers take advantage of these tax benefits even though the arrangement lacks the attributes of genuine insurance. To learn more about captive insurance companies, read our recent BKD Thoughtware® article.
For a micro-captive insurance company to not be considered abusive, the IRS and the courts look at certain factors to determine if the captive has the attributes of genuine insurance for federal tax purposes, including whether:
- The arrangement exhibits risk shifting and risk distribution
- The captive is created for legitimate nontax business reasons
- There’s no circular flow of funds between the captive and insured business
- The insured business faces actual and insurable risk
- The policies are arm’s-length contracts
- The captive charges actuarially determined premiums
- Comparable commercial coverage is more expensive or not available
- The captive is subject to regulatory requirements and adequately capitalized
- The captive pays claims from a separately maintained account
In recent years, the IRS prevailed in a few U.S. Tax Court cases involving captive and micro-captive insurance arrangements, which has given the agency more precedent to attack abusive micro-captive structures.
In Avrahami v. Commissioner of Internal Revenue, a captive insurance company issued seven types of policies to cover the taxpayer’s three jewelry stores, approximately 35 employees, and three commercial real estate properties. The Tax Court found this didn’t constitute enough risk exposures to achieve risk distribution. In addition, the court found the captive wasn’t selling insurance in the commonly accepted sense, so the premiums paid to the micro-captive and deducted by the related insured entities didn’t constitute insurance for federal tax purposes.
In Reserve Mechanical Corp. v. Commissioner of Internal Revenue, the court also found no effective risk distribution due to an insufficient number of risks where the captive issued between 11 and 13 direct written policies for three insureds and received approximately one-third of its premiums from unrelated parties. Also, due to the nature of how the pooling arrangement was established, the court believed this indicated a circular flow of funds and therefore ruled it was not insurance in its commonly accepted sense.
In Syzygy Insurance Co., Inc. v. Commissioner of Internal Revenue, the court ruled that the fronting carriers through which the captive distributed risk weren’t themselves bona fide insurance companies. In addition, the transactions didn’t constitute insurance in its commonly accepted sense when considering, among other things, that although the company was organized as an insurance company and met minimum capitalization requirements, it wasn’t operated as such, the premiums weren’t reasonable, and policies were issued late with conflicting and ambiguous terms.
In 2019, the IRS made a time-limited settlement offer for certain taxpayers under audit that participated in micro-captive insurance transactions being challenged by the IRS. The settlement required concession of a portion of the income tax benefits claimed by the taxpayer and imposed penalties, unless the taxpayer could demonstrate good faith and reasonable reliance on a tax advisor. According to an IRS news release in early 2020, nearly 80 percent of taxpayers who received offer letters agreed to accept the settlement terms. The news release also announced 12 new examination teams to address abusive micro-captive transactions and open exams on several thousand additional taxpayers.
In March and July of 2020, the IRS sent “soft-warning” letters to every taxpayer involved with a micro-captive insurance company disclosed to the IRS (via Form 8886, Reportable Transaction Disclosure Statement). The letters warn that the IRS is substantially increasing its examination activity in this area, which may result in disallowance of micro-captive insurance deductions claimed by the taxpayer, inclusion of income by the captive entity, and imposition of applicable penalties. In addition, if a taxpayer is no longer claiming deductions for premiums paid to a micro-captive, it should notify the IRS of the date it ceased to participate in such an arrangement.
On October 22, 2020, the IRS announced a second settlement initiative for taxpayers under exam where the micro-captive arrangement is being challenged. Qualifying taxpayers will receive a letter from the IRS with the settlement terms, which will be stricter than what the IRS offered in the initial settlement initiative. Taxpayers who decline the offer will continue to be audited by the IRS under its normal procedures and will still have appeal rights; however, the IRS indicated taxpayers shouldn’t anticipate receiving more favorable terms in appeals than what’s being offered under the settlement initiative.
Due to the IRS’ continued and expanded enforcement into abusive micro-captive insurance arrangements, it’s critical to understand the importance of establishing and operating a micro-captive for legitimate risk management purposes and not solely to take advantage of the tax benefits. Taxpayers engaged in micro-captive insurance transactions should consult their tax advisor to evaluate any potential risk exposure and to discuss proper audit documentation, as needed.
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