The Internal Revenue Service’s (IRS) continued focus on ‘abusive’ micro captives, and its most recent statement “is a combination of past talking points that are meant to scare business owners utilising captives into exiting their captive structures, regardless of whether they are doing the right thing or not”, according to Ryan Work, vice president of government relations, Self-Insurance Institute of America (SIIA).
In its most recent statement, the IRS said taxpayers should not assume they will be able to settle any transactions with the IRS or chief counsel on terms more favourable than the previously announced settlement offers.
The service also highlighted that any potential future settlement initiative that it considers will require additional concessions by the taxpayer.
Work explained that even after a number of congressional concerns around its timing and tactics, the IRS decided to flaunt the fact that it is “embarking on even more purposefully onerous and unnecessary requirements”, despite the ongoing COVID-19 pandemic.
“The fact is that the IRS remains in group-think mode, whereby it refuses to spend time understanding what appropriate structures look like, instead falsely jumping to the conclusion that all captives are bad captives”, Work said.
In March and July this year, 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 it if they’ve discontinued their participation in this transaction before the IRS initiates examinations.
However, the issued letters were not received well by the industry, with various captive insurance associations sharing concerns about the timing of the letter during the ongoing COVID-19 pandemic.
The associations, among others in the industry, requested the IRS withdraw the letter and suspend its audit activities of micro captives until the COVID-19 crisis is over and the economy is on the road to recovery.
Although the IRS did not suspend the letters, it did move the deadline from 4 May to 4 June 2020.
Work suggested that the IRS is better served utilising its resources more effectively so that US businesses using a legitimate section of the tax code can continue to do so under a national emergency and beyond, mitigating risks that are now more prevalent than ever.
While the IRS should go after truly abusive structures, Work noted that American business owners utilising legitimate captive structures, and managing those structures appropriately, “should not be scared into submission because the IRS is on a witch hunt, spreading its net far and wide until it stumbles upon what it’s looking for”.
Associations continue to support appropriate IRS actions to curb abusive practices, however, Richard Smith, president of the Vermont Captive Insurance Association, stated that it “objects to the unnecessary regulatory burdens being imposed on taxpayers”.
Smith affirmed: “These taxpayers are being forced to comply with the Notice 2016-66 regardless of whether their captive insurance arrangement contained any of the characteristics of concern identified by the IRS.”
Elsewhere, Peter Kranz, executive managing director, captive practice leader at Beecher Carlson, said there is “a lot to unpack with respect to the IRS’ enforcement actions around captives”.
A key issue is whether the IRS has the right to compel transaction disclosures. Although the bad structures need to be “cleaned up”, Kranz suggested the IRS be less aggressive in its actions.
While there are a lot of people promulgating bad information and advice, there are also a large number of people giving strong, solid advice about captive structures which have nothing to do with making specific tax elections.
Kranz added: “With the IRS as aggressive as it is on the micro captive front, I wish they would just come out publicly and acknowledge that the majority of the captive industry is well run and captives are a valuable risk financing and management tool which has been dramatically highlighted by the firming, or hardening, insurance market and the COVID-19 pandemic.”
The IRS suggested taxpayers “should seriously consider” exiting the transaction and not claiming deductions associated with micro captive transactions.
For those taxpayers that do not exit the transaction and continue taking deductions, the IRS said it will disallow tax benefits from transactions that it determines to be “abusive”.
The IRS noted that it may also require domestic captives to include premium payments in income and assert a withholding liability related to foreign captives.
Penalties will also be enforced as appropriate, including the strict liability penalty that applies to transactions that lack economic substance, according to the service.
The IRS also stated that it will “continue to litigate these abusive transactions in tax court”.
Why now?
Having recently won three tax court cases in a row, the IRS knows that it is presently at its point of maximum leverage over the industry, according to Sean King, principal, CIC Services.
King said: “Hundreds of tax court cases are still pending, and the IRS knows that it will lose many of them. As it does, its leverage to extort settlements will be diminished.”
“This explains the urgency and frequency of the IRS’s pronouncements. The service wants to force as many settlements as quickly as it can before adverse precedent is set by the tax court, and it knows that its time to do that is limited”, he added.
Although Ben Whitehouse, senior counsel at Butler Snow, said it’s good advice for captive owners to seek independent advice about their tax positions, he highlighted that the IRS seems more inclined to try and scare all captive insurance participants out of the marketplace regardless of merit.
King reaffirmed this point and suggested the IRS’ threat is “strategic rather than real”.
He explained: “Demanding stricter settlements simply incentives even more taxpayers to take the IRS to court rather than to settle. And that’s the very last thing the service wants.”