Micro captives have been named on the Internal Revenue Service (IRS) ‘Dirty Dozen’ list of tax scams for the fourth consecutive year.
The annually produced list outlines the tax scams that the IRS will be targeting over the coming year.
Under section 831(b) of the 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.
Named as a type of “abusive tax shelter”, the IRS suggested some micro captives may be used by promoters, accountants or wealth planners to persuade owners of closely-held entities to participate in schemes that lack many of the attributes of genuine insurance.
The micro-captives’ coverages may insure implausible risks or duplicate commercial coverages with premiums that are significantly higher than those for comparable commercial coverage.
According to the IRS, their policies may be ambiguous and deceptive and fail to meet regulatory standards, while their claims processes may be insufficient or completely absent, and insureds may fail to file claims that are allegedly covered under the captive insurance.
The IRS added: “Micro captives may invest in illiquid or speculative assets or loans or otherwise transfer capital to or for the benefit of the insured, the captive’s owners or other related persons or entities.”
“Captives may also be formed to advance intergenerational wealth transfer objectives and avoid estate and gift taxes. Promoters, reinsurers and captive insurance managers may share common ownership interests that result in conflicts of interest.”
The much-anticipated decision to name micro captives on the list for a fourth year follows the verdict of the Avrahami v. Commissioner US Tax Court case in August 2017.
The court found the micro-captive arrangement did not involve sufficient risk shifting, risk distribution, and insurance risk, or meet the commonly accepted notions of insurance and was therefore not ‘insurance’ under long-established decisional law principles.
Additionally, the court disallowed premium deductions claimed by the taxpayer through the section 831(b) micro-captive arrangement.
In November 2016, the IRS released Notice 2016-66 in which they labeled micro captives as ‘transactions of interest’ which have the potential for tax avoidance or evasion.
Micro-captive’s have also caught the attention of the US Congress who, in the Protecting Americans from Tax Hikes Act, effective 1 January 2017, established stringent diversification and reporting requirements for captives.