The Internal Revenue Service (IRS) has urged participants in ‘abusive micro captive insurance arrangements’ to exit these transactions as soon as possible.
The IRS has stepped up examinations of these arrangements and has recently won another micro captive case involving Caylor Land & Development.
In the court case on 10 March, Judge Holmes found that the micro captive involved did not provide insurance because it failed to distribute risk and didn’t act as an insurer commonly would.
Speaking on the court case, the IRS states that this case “confirmed the IRS’s determinations that certain micro captive arrangements were not eligible for the claimed federal tax benefits”.
The IRS highlights that taxpayers who engage in ‘abusive micro captive transactions’ are encouraged to consult an independent tax advisor prior to filing their 2020 tax returns.
The IRS says: “Taxpayers should consider exiting the transaction and not reporting deductions associated with abusive micro captive insurance transactions.”
The IRS has targeted micro captives for years, but in more recent times they have ramped up their efforts to do so, including them on its ‘Dirty Dozen’ list of tax scams since 2014, along with other actions.
In 2016, the Department of Treasury and IRS issued Notice 2016-66, which formally labelled micro captives as ‘transactions of interest’. The IRS advised that these transactions have the potential for tax avoidance or evasion.
Under section 831(b) of the US tax code, captive insurers that qualify as small insurance companies can elect to exclude limited amounts of annual net premiums from income, so that the captive pays tax only on its investment income.
In 2020, the IRS deployed 12 newly formed micro captive examination teams to substantially increase the examinations of ongoing abusive micro captive insurance transactions.
The IRS points out that it will disallow tax benefits from transactions that are determined to be abusive and may also require domestic captives to include premium payments in income and assert a withholding liability on foreign captives.
The IRS will continue to assert penalties, as appropriate, including the strict liability penalty that applies to transactions that lack economic substance.
In March and July 2020, the IRS issued letters to taxpayers who participated in a Notice 2016-66 transaction alerting them that IRS enforcement activity in this area will be expanding significantly and providing them with the opportunity to tell the IRS if they've discontinued their participation in this transaction before the IRS initiates examinations.
Early responses indicate that a significant number of taxpayers who participated in these transactions have exited the transaction.
In October 2020, the IRS offered a new second time-limited settlement initiative for certain taxpayers under audit who participated in ‘abusive’ micro captive insurance transactions.
Commenting on the advice, IRS Commissioner Chuck Rettig says: “In multiple cases before the courts, judges have held that these ‘fanciful’ and ‘unreasonable’ arrangements don’t add up to insurance in the commonly accepted sense.”
“I strongly urge participants in these arrangements to get independent legal advice separate from those who helped steer them into these abusive arrangements,” he adds.
