How the IRS Distinguishes Legitimate Micro-Captive Transactions and Works to Wipe out Abuse
In June 2021, the IRS published its annual list of the “Dirty Dozen” tax scams. Once again, abusive micro-captive tax structures were included on the list. The transactions first appeared on the IRS’s Dirty Dozen in 2014 and remain a priority enforcement issue. But not all captives are abusive. If properly structured, micro-captives can be a beneficial risk-financing tool for companies.
By definition, captive insurance is a form of self-insurance in which a taxpayer creates an insurance company to provide coverage in exchange for a tax-deductible premium. Captives that elect to be taxed under Section 831(b) of the Internal Revenue Code (the “Code”), micro-captives are taxed only on their investment income and not on premiums received or underwriting income.
In evaluating the legitimacy of a micro-captive, the IRS looks to four non-exclusive criteria to determine whether a company’s policy constitutes “insurance” within the meaning of the Code:
- risk shifting;
- risk distribution;
- insurance risk; and
- whether the arrangement looks like commonly accepted notions of insurance.
According to IRS Notice 2016-66, captive transactions targeted by the IRS have one or more of the following characteristics relating to payments, claims procedures and capital structure:
- the amounts of the insured's payments under the contract are designed to provide the insured with a deduction under Code Sec. 162 of a particular amount;
- the payments are determined without an underwriting or actuarial analysis that conforms to insurance industry standards;
- the payments are not made consistently with the schedule in the contract;
- the payments are agreed to by the insured and the captive without comparing the amounts of the payments to payments that would be made under alternative insurance arrangements providing the same or similar coverage;
- the payments significantly exceed the premium prevailing for coverage offered by unrelated, commercial insurance companies for risks with similar loss profiles; or
- if the insured includes multiple entities, the allocation of amounts paid to the captive among the insured entities does not reflect the actuarial or economic measure of the risk of each entity.
Claims Procedures and Captive Management
- the captive fails to comply with some or all of the laws or regulations applicable to insurance companies in the jurisdiction in which the captive is chartered, the jurisdiction(s) in which the captive is subject to regulation because of the nature of its business, or both;
- the captive does not issue policies or binders in a timely manner consistent with industry standards;
- the captive does not have defined claims administration procedures that are consistent with insurance industry standards; or
- the insured does not file claims for each loss event covered by the contract.
- the captive does not have capital adequate to assume the risks that the contract transfers from the insured;
- the captive invests its capital in illiquid or speculative assets usually not held by insurance companies; or
- the captive loans or otherwise transfers its capital to the insured, entities affiliated with the insured or persons related to the insured.
IRS Enforcement Actions
The IRS has never been better positioned to eradicate abusive captive transactions. IRS enforcement tools include the following:
- Warning letters. In March and July 2020, the IRS issued 6,336 letters to taxpayers who participated in a Notice 2016-66 transaction alerting them that IRS enforcement actions in this area will be expanding considerably and allowing them to tell the IRS if they've abandoned their participation in these transactions before the IRS initiates examinations.
- Tax examinations. In 2017, the IRS’s Large Business and International (LB&I) Division announced its examination campaign to address micro-captive insurance transactions. In January 2020, the IRS announced that it is establishing 12 new examination teams to assist in the audits of abusive micro-captives.
- Classification of micro-captives as transaction of interest. In Notice 2016-66, the IRS classified certain micro-captives as “transactions of interest,” requiring taxpayers to disclose their participation in such arrangements to the IRS Office of Tax Shelter Analysis or face penalties under IRC § 6707(a), IRC § 6707A and IRC § 6708(a). The validity of Notice 2016-66 was thrown into question by the case of CIC Services, LLC v. Internal Revenue Service et. al. remanded to District Court by the United States Supreme Court on May 17, 2021.
- Settlement offers. In September 2019, the IRS sent settlement offers to approximately 200 taxpayers involved in micro-captive insurance audits. The settlement requires substantial concession of the income tax benefits claimed by the taxpayer together with appropriate penalties. Nearly 80 percent of taxpayers who received offer letters elected to accept the settlement terms.
- Criminal referrals. At a conference for the American Institute of CPAs in November 2019, the Commissioner of the IRS Small Business/Self-Employed Division said the IRS is looking into making referrals of some 831(b) captive insurance cases to its criminal investigations office.
- Consequences. For taxpayers that participate in abusive micro-captive activities, the consequences can include full disallowance of claimed insurance deductions, inclusion of income by the captive entity and the imposition of civil penalties. In some extreme cases, a taxpayer may even be subject to criminal sanctions.
Taxpayers involved in these abusive transactions should immediately consult with an independent tax advisor to discuss their best available options.
Marcus Dyer, CPA, Esq., is the team leader of tax controversy at Withum. He is a member of the NJCPA Federal Taxation Interest Group.