The Internal Revenue Service (IRS) continues to be aggressive in auditing micro captive programmes, according to Bailey Roese, partner, Dentons.
The IRS is said to be extremely stringent in bringing litigation against micro captives, which are small companies taxed under section 831(b) of the US Tax Code. This means that they are taxed on investment but not underwriting income.
During the panel ‘Captive Taxation – Deconstructing the Latest Whirlwind’ at the Vermont Captive Insurance Association (VCIA) 2021 conference, panellists discussed the current landscape of the captive tax world.
The speakers noted that states, such as Washington, are extraordinarily active in the captive tax area currently. By August 2021, there are expected to be decisions in the US Supreme Court case of CIC v IRS, the Reserve Mechanical case (currently on appeal to the Tenth Circuit), and the IRS' suit against the Delaware Department of Insurance.
The panellists explored what the IRS has done to implement its announcement that it will audit thousands of taxpayers, using a dozen new audit teams.
With the deficits being generated by COVID-19, Congress may enact tax legislation. Even the General Accountability Office has written a report on offshore captive insurance companies, delegates agree.
In terms of the impact on the captive market, Roese said there is a need for enhancement of existing programmes, and coordination with the commercial market on areas of innovation and capacity.
The speakers discussed the IRS Audit Initiative from January 2020 (IR-2020-26). The IRS announced that nearly 80 per cent of taxpayers who received settlement programmes offer letters accepted the terms. IRS established 12 new examination teams to open audits for “thousands of taxpayers'' participating in micro captive programs.
A notice was issued which stated that “Potential civil outcomes can include full disallowance of claimed captive insurance deductions, inclusion of income by the captive entity and imposition of all applicable penalties”.
Then on 20 March 2020, the IRS issued Letter 6336. The panellists noted that these letters appeared to be issued to every person who filed a Form 8886, including taxpayers already under audit or with cases pending in tax court.
Roese commented: “Letters from the IRS are always a source of anxiety for taxpayers. The face of the notice did not indicate that it was compulsory to respond but there would be risks and rewards to responding/not responding. The letter caused a lot of questions last year.”
Following this, the IRS issued IR-2020-226 on 1 October 2020. During the panel discussion, it was explained that the IRS advised taxpayers to consult with tax advisers regarding their captive programmes and stated that any future settlement offers would be worse than the prior one.
They also recommended that taxpayers exit their micro captive programmes and affirmed that many taxpayers already reported that they had exited their programmes in response to Letter 6336.
Earlier this year, in April, another notice was introduced (IR 2021-82). Again, the IRS urged participants and micro captives to exit their programmes. The IRS reminded taxpayers that it would ramp up its audits efforts.
Mikhail Raybshteyn, partner, EY, said: “The IRS was warning everyone that they would be aggressive, and aggressive they were. Clients noted that auditing agents lacked experience in the captive space or captive insurance knowledge.”
“Agents have asked, and in some cases insisted, on liquidation of the entity as part of the settlement with the IRS. But this ignores regulatory rules and regulations outside of the IRS’ jurisdiction.”
He explained: “The biggest issues clients have dealt with have been in the asset management space. Due to the multi-tiered partnership structures, some of the funds and master funds may not have known that they had invested into a captive insurance company possibly 15 tiers down in the partnership. This created a lot of administrative chatter and a lot of back and forth that cost clients money and administrative hassle.”
According to Raybshteyn, this was the area where it was most complex to figure out who needs to respond to the letters and who holds ownership.
Roese said: “The IRS continues to be aggressive in auditing these micro captive programmes, and is emboldened by yet another tax court victory, and one that upheld stringent penalties.”
On a positive note, Roese said: “In the tax world we keep on the sunny side of life, and although the IRS usually wins in court cases against micro captives, we believe that a taxpayer victory is still possible. We are seeing a wide variety of micro captives and it is possible for one to challenge the IRS and for the result to come out on the side of the taxpayer.”
Roese and Raybshteyn also stressed that large captives should care about section 831(b) developments.
Raybshteyn highlighted that bad law can be used against large captives, and courts are appearing skeptical of pooling arrangements.
The IRS has now employed a large number of insurance specialists. Raybshteyn affirms: “We see lobbying in letters from congress supporting captives and that can affect how large captives are impacted.”
“There is a feeling that there is going to be an increased focus on audits for larger captives. If everything is properly documented then there should not be an issue," Raybshteyn added.
