IRS Takes Aim at ‘Abusive Micro-Captive Practices’ with Another Settlement Offer

As the pandemic and rising insurance costs fuel greater interest by large firms in creating captive insurance organizations, the Internal Revenue Service continues to question small captive operations that it has long argued are tax avoidance vehicles and not valid insurance operations.

As it did last fall, the IRS has just issued a round of settlement offers to a group of taxpayers under audit who are involved in what it considers “abusive micro-captives transactions.”

Micro-captives are captives with $2.2 million or less in premium.

The IRS has been warning about these micro-captives for several years and placed them on its annual “Dirty Dozen” list of tax scams. The IRS has consistently disallowed the tax benefits claimed by taxpayers in these micro-captive structures.

The IRS said it its new round of settlement offers contains terms that are stricter than the IRS’s first time-limited initiative last year.

This new announcement occurs after the IRS in January deployed 12 newly-formed micro-captive examination teams to “substantially increase the examinations of abusive micro-captive insurance transactions.”

The IRS is again offering to resolve certain cases by requiring concession of the income tax benefits claimed by the taxpayer together with penalties that can be partly mitigated “if the taxpayer can demonstrate good faith, reasonable reliance on an independent, competent tax advisor and if the taxpayer can demonstrate it did not participate in any other reportable transactions.”

The IRS did not reveal the number of taxpayers or terms of the latest settlements it is offering.

“The IRS maintains a relentless agency-wide commitment to combat abusive transactions,” said IRS Large Business & International Commissioner Douglas O’Donnell. “Our offer terms are only getting stricter; and taxpayers would be well advised to consult with an objective, competent advisor with the aim of getting out now and putting this behind them.”

While some taxpayers have challenged the IRS position in court, none have been successful, according to the IRS. The IRS started sending offers last September to up to 200 taxpayers within the past few days. The agency said there were more than 500 cases in court at that time. The IRS said in January that nearly 80% of the taxpayers accepted its earlier settlement offer it offered last September.

The U.S. Supreme Court next month is scheduled to hear a challenge to the reporting requirement used by the IRS to police micro-captives that includes a $50,000 penalty for noncompliance. CIC Services, a Tennessee business that advises taxpayers on micro-captive transactions, is asking whether taxpayers and their advisers can challenge the reporting requirement without paying the penalty or waiting for the IRS to start enforcement proceeding.

Businesses can create captive insurance companies to insure against risks. Many large companies have at least one captive and captives have also become popular among smaller and midsized firms, including professional services firms. The insured business claims deductions for premiums paid for insurance policies, and those amounts are paid as premiums to a captive insurance company owned by the insured or related parties.

The IRS contends that some advisors have been persuading owners of closely-held entities to participate in captive insurance plans that lack many of the attributes of genuine insurance.

The vehicles are popular because under tax law the owners of a small insurance company can pay up to $1.2 million in tax-deductible premiums. Then, any small property/casualty insurer with annual premiums under $1.2 million may choose to be taxed on its net investment income as opposed to its premium income. The alternative tax provision used by micro-captives is also used by small, mutual and rural insurance companies.

The IRS has long worried that micro-captive insurance transactions could be used for tax avoidance. Several years ago, it began requiring taxpayers participating in such micro-captive insurance transactions on or after November 2, 2006 to disclose the transactions.

In 2017, the U.S. Tax Court disallowed the “wholly unreasonable” premium deductions the taxpayer had claimed under a micro-captive arrangement, concluding that the arrangement was not “insurance” under long established law (Avrahami v. Commissioner, 149 T.C. No. 7 (2017). In 2018, the Tax Court concluded that the transactions in a second micro-captive arrangement were not “insurance.” (Reserve Mechanical Corp. v. Commissioner, T.C. Memo. 2018-86).

No Better Deal

This new IRS settlement initiative is currently limited to taxpayers with at least one open year under exam. Taxpayers who do not receive an offer letter are not eligible for this settlement.

The IRS said that taxpayers who receive offer letters but who opt not to participate will continue to be audited by the IRS under its normal procedures. “Potential outcomes include, but are not limited to, full disallowance of captive insurance deductions, inclusion of income by the captive, withholding tax related to any foreign captives, and imposition of all applicable penalties,” the federal agency warned.

The IRS added that taxpayers should not anticipate receiving better terms in appeals than those offered under this initiative.

In its 2020 captive report, insurance broker Marsh said that that tightening global insurance market conditions throughout 2019 led to higher captive utilization with steep premium volume growth in several coverage lines.

The trend towards greater captive use has continued in the first half of 2020 amid increasingly challenging insurance market conditions and the impact of the global COVID-19 pandemic, Marsh said.