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Captive Insurance Risk Alert, Micro-Captive and the IRS

Micro-captive Insurance Companies Beware

Currently, there is a tax provision that allows ‘micro-captive’ insurance companies – created to provide insurance to small companies that create them – to earn premiums tax free.  Ultimately, this was intended to provide more affordable insurance coverage to policyholders.  When the insurance company is well diversified, these have not been an issue. 

Unfortunately, some taxpayers have abused the system to benefit themselves without providing real or realistic insurance policies, or have provided minimal insurance for exorbitant prices.  These cases of concern around micro-captive insurance companies that are set up with fully deductible premiums and no tax payments, and with little to no ability for the IRS to review them, has provided reasons for policy change.  Therefore, under President Biden’s green book, there are several proposed provisions to make those arrangements much more costly for the captive insurance companies.  Here is a summary of the proposed guidelines and impacts:

• Proposal to establish an untaxed income account (UIA) regime. This applies to any captive insurance companies that receive 20% of more of their premiums from any one policyholder or a related group of policy holders. 

• Impact to captive insurance companies: It allows the company not to pay tax on these premiums, and dividends or loans made to the insured parties would be treated as a deemed distribution from the UIA and taxed at a high rate.

• Impact to agribusinesses: Many captives will ensure that no related group of companies will pay more than 20% of total premium income (the threshold that would create a tax payment by the insurance company).  Should the company exceed this and pay taxes however, it will essentially reduce the benefit to farm operations that have created these captives – ultimately, reducing the ability for captives to survive, and leaving a high tax bill on the table for the previous net premiums earned. 

“At this early stage, coupled with recent IRS activity, we’re watching to see what will take shape to stand before Congress. But we fully expect new tax requirements in some form to eliminate the ability of those captives abusing the tax-free provision for small insurance companies,” says Lance Wallach, an expert witness in captive insurance lawsuits whose side has never lost a case.

If you own or participate in a “micro-captive” insurance company, speak to your captive manager about their reinsurance and ceding percentages, and to your captive manager and captive tax return preparer to discuss potential implications of these proposals.

IRS Audits Micro-Captives

IRS Audits Micro-Captives IRS Audits Micro-CaptivesShortly after the Internal Revenue Service once again warned taxpayers to steer clear of unscrupulous promoters selling abusive micro-captives. It is part of the IRS annual Dirty Dozen listing. The IRS Large Business and International (LB&I) Division touted the success of its partnership with the Small Business/Self-Employed Division in carrying out the micro-captive campaign.

The US Tax Court handed the IRS its third straight victory involving a small captive structure in Syzygy v. Commissioner. Six days after the Syzygy opinion was issued, LB&I announced the initiation of a “Captive Services Provider Campaign” aimed at ensuring US multinational companies pay their captives no more than arm’s-length prices.2 The IRS is clearly moving quickly to address tax compliance issues in the captive world.

The IRS has now obtained victories in cases involving both forms of small captives electing tax-exempt status under § 501(c)(15) and captives electing to be taxed only on investment income under § 831(b). With each victory in court, the IRS has succeeded in highlighting problematic program design features and implementation missteps. Going forward, IRS revenue agents and appeals officers will likely look to the deficiencies identified in the case law in resolving captive controversies.

Lance Wallach receives hundreds of calls annually to help people fight the IRS and get their money back from the promoters of these scams. As an expert witness, Lance’s side has never lost a lawsuit. Google Lance Wallach and your advisor, who do you trust?

+1 516-236-8440

Wallachinc@gmail.com

IRS to Settle with some under audit for micro-captive insurance plans

IRS Gathers Information on Taxpayers

IRS Gathers Information on Taxpayers, Micro-captive, IRS Dirty Dozen listSince the time when micro-captive insurance companies were placed on the IRS Dirty Dozen list of tax scams, it has also been identified as a transaction of interest.

The IRS continues to expand its enforcement efforts of what it views as abusive micro-captive insurance arrangements.

The IRS gathers information on taxpayers and institutes a new virtual currency compliance program.

Excerpt from one of their notices; We have information that you have or had at least one account containing virtual currency. Yet may not have properly reported your transactions involving virtual currency, which may include cryptocurrency and/or non-crypto virtual currencies.

A new IRS Notice 6174-A which states that the IRS clearly sees noncompliance on virtual currency transactions as a threat to the tax system.

As if the onslaught of recent losses in Tax Court was not enough, investors in syndicated conservation easements now have more to worry about.

The Senate Finance Committee released a bipartisan report condemning syndicated conservation easements as abusive and therefore encouraging the IRS to take further action to ferret out such abuse.

Lance Wallach has received hundreds of calls in order to help citizens fight the IRS on this subject and help sue the promotors of easement, captive, and cryptocurrency plans.

Your advisor! Who do you trust?

wallachinc@gmail.com

IRS Audits Captive Insurance Again

Taxpayers that have operated micro-captive insurance

Taxpayers that have operated micro-captive insuranceThe IRS announced today that it plans to begin auditing several thousand more taxpayers that have operated section 831(b) or micro-captive insurance companies in the coming months.

The IRS has been aggressively pursing taxpayers operating section 831(b) captives for several years, and it has been successful in its Tax Court litigation.

The IRS’s success in the courtroom has translated to success in audits as it essentially forces taxpayers to either concede or litigate with little opportunity for a resolution somewhere in between.

As part of the announcement, the IRS publicised that nearly 80% of taxpayers offered its settlement initiative (a 90% taxpayer concession) have accepted it.

Lance can and will help!

wallachinc@gmail.com

U.S. Department Of Justice Files Suit

IRS Settles micro-captive insurance audits

micro-captive insurance audits

Anyone who has received an IRS offer to settle a micro-captive insurance audit should immediately consult an experienced tax lawyer to understand the pros and cons of the offer before any deadline expires. micro-captive insurance

IRS to Settle with some under audit for micro-captive insurance plans

 audits The IRS announced its plan to mail settlement offers to a maximum of 200 taxpayers under audit for their participation in micro-captive insurance arrangements which the IRS considers “abusive” and in violation of tax laws. Only those who receive settlement offer letters are eligible for the current initiative. The IRS says that the offer could be offered to others later.

The agency will continue to audit those that reject the offers, subject to tax assessment and available penalties. These taxpayers will not be included in “future settlement initiatives.”

The IRS elected to make the current offers after it was successful in three cases in U.S. Tax Court plans to continue to “vigorously pursue” suspicious micro-captive transactions, which have been on the “Dirty Dozen” list of tax scams since 2014.

What is a micro-captive insurance arrangement?

A business may establish a small micro-captive insurer (or reinsurer) designed to cover certain risks and losses the business may suffer. The insured business normally can deduct insurance premiums as a business expense. Under certain circumstances, the eligible captive insurer can elect to only pay taxes on income from investments and not on income from premium collection.

The structure of these arrangements is subject to abuse of tax benefits when the small insurer is treated as a micro-captive but does not really function as an insurance company. In other words, tax avoidance can happen when the insured business gets deductions for premiums and the captive insurer pays taxes only on investments, but the insurer is more like a sham entity not functioning as a real insurance company would.

In addition, the arrangements may come under IRS scrutiny when the business that pays insurance premiums to the micro-captive insurer turns around and takes loans or other financial benefits from the captive entity. Another red flag can be premiums that are much higher than the market dictates. Sometimes the IRS looks more closely when a third party like an accountant or financial planner makes the arrangements.

Another area of potential IRS interest is when the involved parties fail to report certain related transactions as required by law. Failure to accurately report can bring large financial penalties.

Proceed with caution

The use of micro-captive insurance arrangements is common with many large companies using at least one currently and participation increasing among smaller businesses, reports the Insurance Journal.

According to the IRS, there are about 500 cases in the court system dealing with micro-captive insurance issues. Anyone with this kind of arrangement or considering one should get advice from an attorney to be sure that it is compliant with tax law and for advice about how to report transactions and handle related income tax issues.

Anyone already embroiled in an audit or dispute with the IRS over a captive insurer issue should also seek experienced legal advice. A tax lawyer may be able to negotiate an acceptable arrangement with the agency or have other proposed legal resolutions.

"Group Captives" Insurance Scam

“Group Captives” Insurance Scam

"Group Captives" Insurance ScamJust a few years ago, captive insurance companies were a hot news item in the arcane world of abusive tax shelters.. Group Captives

If you created a cell captive as a property and casualty loss management tool, it’s probably legitimate. If you “bought” an off the shelf captive from a promoter who promised tax savings, there is a good chance you own an abusive tax shelter.

After the initial wave of fraud and audits, many of the bad promoters went away. New reports suggest that captives are again making a comeback. And with the next generation of captives will come the inevitable fraudsters looking to catch a free ride on the resurgent popularity of these products.

The new wave of captive insurance companies are sometimes called cell captive insurance companies or “group captives.” We have also seen them called rent-a-captive, segregated account companies, segregated portfolio companies and incorporated protected cell companies. Whatever they are called, if properly set up they can be completely legal and valuable risk management tool.

The IRS issued a bulletin to give guidance on these products including whether premiums can be deductible as insurance costs. The IRS says there must be adequate risk shifting and distribution to be considered “insurance.”

The scam promotions typically offer to shelter a large sum of money by calling it an insurance premium. The premium is usually the same dollar amount as the deduction you seek. The promoter offers “insurance” on a highly improbable risk. Hurricane insurance in Nebraska, anyone? Magically, you get a big deduction and in a few years you are promised the ability to get back your money in the form of a “premium refund” or dividend. Sound familiar? You probably purchased an abusive tax shelter.

If you think that you have one of these products, seek legal help immediately. First, the premiums in bogus captive insurance companies or cell captives are not deductible. That has significant tax implications and likely involves big civil penalties too.

Because the IRS views many of these schemes as abusive tax shelters, there are special penalties that apply. If the IRS finds that your captive insurance resembles an illegal welfare benefit scheme (sometimes called 419 or 412 plans), your plan might be considered a listed transaction subject to penalties of $100,000 or more per year.

Abusive tax shelters can also be criminally prosecuted.

Another danger is that in many of the cell captive frauds, the money is simply not there when you go to cancel the policy and seek a refund of premiums.

It’s not always promoters who sell the bad plans. We know of otherwise honest insurance agents and even accountants who were roped into selling these products. Many promoters lure agents into their scheme by offering legitimate looking “legal” opinion letters and slick marketing materials.

If an agent or accountant sold or recommended the plan, you may still be able to recover your damages if the promoter – and your money – is long gone. (Insurance agents love these plans because they usually pay above average commissions – another red flag.)

Lance can help!

wallachinc@gmail.com

lance wallach

Micro Captive Insurance audit deal from IRS

Micro Captive Insurance audit deal from IRSThe IRS is offering a settlement to up to 200 taxpayers currently under audit for abusive micro-captive insurance transactions following three court wins backing the government’s position. Micro Captive Insurance

A captive insurance company is basically an insurance company created by a company in order to insure itself. Perhaps because it couldn’t find an outside insurer, or because doing so would present a better financial choice. While such companies are generally legal, the IRS issued a notice saying that, in certain cases, transactions with these captive companies count as tax evasion.

In such cases, the insurer is structured that it can qualify as a small insurance company, at which point it can elect to be taxed only on its investment income. This means that the company that owns the insurer can deduct premiums as business expenses. The premiums do not count as income for the insurer. The IRS noted that in such transactions, the insurer lacks many of the attributes of actual insurance. 

The IRS will continue to disallow the tax benefits claimed in these abusive transactions. They will continue to defend its position in court. The IRS has decided, however, to offer to settle some of these cases. The settlement requires a substantial concession of the income tax benefits claimed by the taxpayer, together with appropriate penalties.

Taxpayers who are eligible for the settlement will be notified of the terms by letter from IRS. The initiative is currently limited to taxpayers with at least one open year under examination. Taxpayers that also have unresolved years under the jurisdiction of the IRS Appeals may also be eligible. Those with pending docketed years under Counsel’s jurisdiction are not eligible. The IRS is continuing to assess whether the settlement offer should be expanded to others.

Taxpayers who receive letters under this settlement offer, but opted out will continue to be audited by the IRS under  normal procedures. Potential outcomes may include full disallowance of captive insurance deductions, inclusion of income by the captive and imposition of all applicable penalties.

Although taxpayers that decline to participate will have full appeals rights, the IRS Independent Office of Appeals is aware of this resolution initiative. Given the current state of the law, it is the view of the IRS Independent Office of Appeals that these terms generally reflect the hazards of litigation faced by taxpayers, and taxpayers should not expect to receive better terms in Appeals than those offered under this initiative.

Taxpayers that are offered this private resolution and decline to participate will not be eligible for any potential future settlement initiatives. The IRS also plans to continue to open additional exams in this area as part of ongoing work to combat these abusive transactions.

“The IRS is taking this step in the interests of sound tax administration”, IRS Commissioner Chuck Rettig said. “We encourage taxpayers under exam and their advisors to take a realistic look at their matter and carefully review the settlement offer, which we believe is the best option for them given recent court cases. We will continue to vigorously pursue these and other similar abusive transactions going forward.”

Written by: Lance Wallach, CLU, CHFC, CIMC, Author, National Society of Accountants Speaker of the year and member of the AICPA faculty of teaching professionals.

irs audit captive

IRS is cracking down on micro-captives

IRS is cracking down on micro-captivesAccording to the IRS, nearly 80% of taxpayers who received a time-limited settlement offer elected to accept the settlement terms. The IRS is establishing 12 new examination teams that are expected to open audits to thousands of taxpayers. IRS is cracking down on micro-captives.

The IRS has viewed abusive micro-captives as a threat to tax administration for several years. The transaction has appeared on the IRS “Dirty Dozen” list of tax scams since 2014. In 2016, the Department of the Treasury and IRS issued Notice 2016-66 that identified certain micro-captive transactions as having the potential for tax avoidance and evasion.

The settlement offer followed three U.S. Tax Court decisions holding that certain micro-captive arrangements are not eligible for federal tax benefits. The terms of the settlement required substantial concession of the income tax benefits claimed by the taxpayer together with appropriate penalties.

The IRS is establishing 12 new examination teams that will be working to address abusive transactions and open additional exams. Examinations impacting micro-captive insurance transactions of several thousand taxpayers will be opened by these teams in the coming months. Civil outcomes may include disallowance of claimed captive insurance deductions captive entity and imposition of applicable penalties.

The IRS reminds taxpayers and advisors that disclosure of participation in micro-captive insurance transactions is required with the IRS Office of Tax Shelter Analysis under Notice 2016-66. Failure to properly disclose can result in civil penalties

Written by: Lance Wallach, CLU, CHFC, CIMC, National Society of Accountants Speaker of the year and member of the AICPA faculty of teaching professionals.

IRS audit

Understanding The IRS Settlement Initiative Offer For Targeted Captive Insurance Companies

Understanding The IRS Settlement Initiative Offer For Targeted Captive Insurance CompaniesThe so-called tax shelter captive insurance companies are under scrutiny by the IRS. This happens when the promoter dummies up the insurance policies and the risks, in order for the owners of captive insurances are able to artificially generate large tax deductions.

It’s important to understand that the IRS has extended this offer to only 200 taxpayers. Currently at least 2,000 captive arrangements are under audit. There are probably well over 10,000 captive arrangements that may ultimately come under scrutiny by the IRS as well.

The offer will not be extended to captive arrangements and their owners with pending docketed years under IRS Counsel’s jurisdiction.

william coulson

Micro-Captive Audits

Micro-Captive Audits

Key Issues for Micro-Captive  Audits

Micro-Captive Audits

Micro-Captive Audits Shortly after the Internal Revenue Service again warned taxpayers to steer clear of unscrupulous promoters who sell abusive micro-captive insurance which is on the IRS Dirty Dozen list.  It is also targeted by the IRS Large Business and International Division touted the success of its partnership with the Small Business/Self-Employed Division in carrying out the micro-captive campaign, the US Tax Court handed the IRS its third straight victory involving a small captive structure in Syzygy v. Commissioner.

1 Six days after the Syzygy opinion was issued, LB&I announced the initiation of a “Captive Services Provider Campaign” aimed at ensuring US multinational companies pay their captives no more than arm’s-length prices.

2 The IRS is clearly moving quickly to address tax compliance issues in the captive world.

The IRS has now obtained victories in cases involving both forms of small captives under the Internal Revenue Code: captives electing tax-exempt status under § 501(c)(15) and captives electing to be taxed only on investment income under § 831(b). With each victory in court, the IRS has succeeded in highlighting problematic program design features and implementation missteps. Going forward, IRS revenue agents and appeals officers will likely look to the deficiencies identified in the case law in resolving captive controversies.

Program Review

Understanding the current state of the law regarding captives in the US Tax Court is important not only for pending IRS controversies but also for current micro-captive owners as they consider what approach to take going forward. While each case stands on its own, a thorough review of the captive program can help establish an informed basis for decision-making both before and during an audit.

To carry out this review, it is important to understand the key issues that will be addressed during a captive audit. Some of the core substantive issues, involving risk distribution and whether a captive program reflects insurance in the commonly accepted sense, are discussed below.

Super Factor: Arm’s-Length Transaction. One of the most important questions in determining whether a captive can survive IRS scrutiny is a simple one: Do the coverages make economic sense? Whether the coverages are “arm’s-length transactions” is important in determining whether there is real risk distribution, as well as whether the arrangement constitutes “insurance in its commonly accepted sense”.

Key Issues for Micro-Captive  AuditsWhile to date no court has addressed whether this factor might also play a role in resolving whether the arrangement should be set aside under judicial anti-avoidance doctrines, it is certainly possible that the courts could rely on the lack of arm’s-length arrangements as a predicate for applying “substance over form” or the economic substance doctrine.4

Regarding risk distribution, all three of the Tax Court micro-captive cases referenced above involved the employment of a risk pool established by the captive manager in order to enable the captive to insure third-party risk and obtain the requisite risk distribution.

In each case, after analyzing the risk pool as part of its risk distribution analysis, the court held that the participation in the risk pool did not result in adequate risk distribution for the captive. If a taxpayer relies on a risk pool, the IRS will request documentation supporting the risk pool structure.

This will include documentation setting forth the rights and responsibilities of the taxpayer vis-à-vis the others who similarly rely on the pool. Given the responsibilities of the pool participants, the IRS will look for evidence of security mechanisms that would traditionally be required. On top of the blueprint for the pooling mechanism, the IRS will want to review how it worked in reality and how it benefited the insured given the insured’s finances and history.

The courts thus far have reviewed captive policies from an objective viewpoint, considering policy metrics (e.g., total cost of risk and rates on line) before and after the implementation of the captive arrangement. After reviewing the various metrics, a court may consider subjective evidence to determine whether there was a rational justification for any expenditures to cover previously unprotected risks through a review of correspondence, marketing materials, etc.

For example, in Syzygy, the court noted that, generally, it is fair to assume a purchaser of insurance would want the most coverage for the lowest premiums.

After finding that the coverage and associated premium did not make economic sense, the Syzygy court also considered statements made by the taxpayer (which seemed focused on obtaining large tax deductions rather than putting in place a helpful insurance product), which confirmed the court’s conclusion that there was no true distribution of risk.5

Insurance in the Commonly Accepted Sense

Key Issues for Micro-Captive  AuditsIn determining whether program transactions constituted “insurance in the commonly accepted sense,” the courts also looked to whether the captive arrangements constituted arm’s-length transactions. The courts focused on whether the premiums were objectively reasonable. It is probably not much of a stretch for one to conclude that if the captive policies do not make sense, the IRS will conclude that the associated captive premiums were likewise unreasonable and thus, not insurance in the commonly accepted sense.

Likewise, if the insured fails to pursue a claim for which the policy appears to provide coverage, the IRS and the courts may view the arrangement as something other than insurance.

The Syzygy court reached the conclusion that the premiums were unreasonable with only two sentences’ worth of analysis.6 Despite the existence of a claim on the policy by the insured to the captive, adequate capitalization of the captive, and active regulatory oversight, these insurance-like traits were not enough to overcome alleged late-issued policies with ambiguous language and the lack of an arm’s-length transaction.

Thus, as the arm’s-length nature of the arrangement has been considered by the courts when questioning whether the arrangement involved risk distribution as well as whether a captive provided “insurance in the commonly accepted sense,” it is incumbent on the tax advisor to drill deeply into the facts that would bear on whether the arrangement made economic sense.

Opinion Letters

In an effort to avoid penalties, the taxpayer may produce an opinion letter regarding the deductibility of premiums paid into a captive program. Here, the advisor should review the terms of the opinion as well as all other communications, including marketing materials, that might impact the usefulness of the opinion.8 Further, the advisor must be cognizant of the fact that a written tax opinion will not protect a taxpayer from the accuracy penalty imposed with respect to a transaction lacking economic substance, even if the taxpayer relied on that opinion in good faith.9

The captive audit may start as a result of audit of another issue and then blossom into a captive audit or may be initiated solely due to the captive deduction itself. Over the last 2 years, after the § 831(b) micro-captive transaction was designated as a “transaction of interest,” the IRS has obtained a wealth of information from captive owners and captive managers, both from required filings regarding reportable transactions (Forms 8886, Reportable Transaction Disclosure Statement, and 8918, Material Advisor Disclosure Statement) and section 6112 list maintenance request to captive managers.

Information Document Requests

A captive audit will often involve intense questioning via Information Document Requests10 issued to both the captive and the insureds.11 In some cases, the insured taxpayer may handle responding on behalf of the captive as well as the insured party; in other cases, the captive manager or a third party may respond on behalf of the captive. It is critical to understand potential ethical issues, as well as the degree of control the taxpayer has over the captive for purposes of consistency in providing the IRS the information it is entitled to receive under the Internal Revenue Code.

If the requested information is not provided, not only will this likely result in summons enforcement proceedings (assuming the taxpayer can actually provide the information12), but the taxpayer should also be cognizant that any information not provided (perhaps for strategic reasons) may ultimately have to be produced in subsequent litigation challenging the IRS assessment. If critical or important documents are withheld and only surface later in litigation, then the taxpayer’s good faith may be put in question.

Ancillary Proceedings

Key Issues for Micro-Captive  AuditsSimultaneous with a tax audit, the advisor must be aware of and address numerous ancillary proceedings, such as issues related to state taxing authorities, civil proceedings involving service providers in particularly weak programs, as well as the exit of a small captive program.13

For example, the taxpayer may be interested in civil remedies, joining a class action, or seeking relief in arbitration.14 Consequently, the advisor will need to carefully review and monitor the flow of information, as it is being requested in different settings, utilized for different purposes, but ultimately for the benefit of the taxpayer client.

As an example, a failure to review and monitor communications may lead to tax counsel making statements to the IRS in a tax audit that are wildly inconsistent with statements made by plaintiff’s counsel in pursuing a claim against a service provider. In sum, a captive tax audit may become an incredibly complex process that involves managing numerous moving parts.

captive insurance audits

Captive Insurance and the IRS

The IRS continues to heavily scrutinize captive insurance arrangements. Certain captive insurance types have consistently appeared on the IRS Dirty Dozen list.

Micro-captives in particular have been identified as potential vehicles for illegal tax shelters and the IRS is more than happy to crack down on them.

If the IRS believes that a captive insurance company is claiming deductions for non-insurance activities they will litigate immediately.

This include companies which are claiming unreasonable premium deductions.

If the Captive company can’t prove that they are distributing risk, shifting risk, or whether transactions involve insurance risk then that captive is an IRS target.


wallachinc@gmail.com

IRS audits micro-captives

IRS Audits Captive Insurance Again

IRS Audits Captive Insurance AgainCaptive Insurance, Shortly after the Internal Revenue Service (IRS) again warned taxpayers to “steer clear” of unscrupulous promoters selling abusive micro-captives as part of its annual “Dirty Dozen” listing and the IRS Large Business and International (LB&I) Division touted the success of its partnership with the Small Business/Self-Employed Division in carrying out the micro-captive “campaign,” the US Tax Court handed the IRS its third straight victory involving a small captive structure in Syzygy v. Commissioner.

Six days after the Syzygy opinion was issued, LB&I announced the initiation of a “Captive Services Provider Campaign” aimed at ensuring US multinational companies pay their captives no more than arm’s-length prices. The IRS is clearly moving quickly to address tax compliance issues in the captive world.

The IRS has now obtained victories in cases involving both forms of small captives under the Internal Revenue Code: captives electing tax-exempt status under § 501(c)(15) and captives electing to be taxed only on investment income under § 831(b). With each victory in court, the IRS has succeeded in highlighting problematic program design features and implementation missteps. Going forward, IRS revenue agents and appeals officers will likely look to the deficiencies identified in the case law in resolving captive controversies.

Program Review

Understanding the current state of the law regarding captives in the US Tax Court is important not only for pending IRS controversies but also for current micro-captive owners as they consider what approach to take going forward. While each case stands on its own, a thorough review of the captive program can help establish an informed basis for decision-making both before and during an audit.

To carry out this review, it is important to understand the key issues that will be addressed during a captive audit. Some of the core substantive issues, involving risk distribution and whether a captive program reflects insurance in the commonly accepted sense, are discussed below.

Super Factor: Arm’s-Length Transaction. One of the most important questions in determining whether a captive can survive IRS scrutiny is a simple one: Do the coverages make economic sense? Whether the coverages are “arm’s-length transactions” is important in determining whether there is real risk distribution, as well as whether the arrangement constitutes “insurance in its commonly accepted sense”.

While to date no court has addressed whether this factor might also play a role in resolving whether the arrangement should be set aside under judicial anti-avoidance doctrines, it is certainly possible that the courts could rely on the lack of arm’s-length arrangements as a predicate for applying “substance over form” or the economic substance doctrine.

Risk Distribution

Regarding risk distribution, all three of the Tax Court micro-captive cases referenced above involved the employment of a risk pool established by the captive manager to enable the captive to insure third-party risk and (hopefully) obtain the requisite risk distribution. In each case, after analyzing the risk pool as part of its risk distribution analysis, the court held that the participation in the risk pool did not result in adequate risk distribution for the captive.

If a taxpayer relies on a risk pool, the IRS will request documentation supporting the risk pool structure. This will include documentation setting forth the rights and responsibilities of the taxpayer vis-à-vis the others who similarly rely on the pool. Given the responsibilities of the pool participants, the IRS will look for evidence of security mechanisms that would traditionally be required.

On top of the blueprint for the pooling mechanism, the IRS will want to review how it worked in reality and how it benefited the insured given the insured’s finances and history.

The courts thus far have reviewed captive policies from an objective viewpoint, considering policy metrics (e.g., total cost of risk and rates on line) before and after the implementation of the captive arrangement. After reviewing the various metrics, a court may consider subjective evidence to determine whether there was a rational justification for any expenditures to cover previously unprotected risks through a review of correspondence, marketing materials, etc.

For example, in Syzygy, the court noted that, generally, it is fair to assume a purchaser of insurance would want the most coverage for the lowest premiums. After finding that the coverage and associated premium did not make economic sense, the Syzygy court also considered statements made by the taxpayer (which seemed focused on obtaining large tax deductions rather than putting in place a helpful insurance product), which confirmed the court’s conclusion that there was no true distribution of risk.

Insurance in the Commonly Accepted Sense. In determining whether program transactions constituted “insurance in the commonly accepted sense”, the courts also looked to whether the captive arrangements constituted arm’s-length transactions.

Here, the courts focused on whether the premiums were objectively reasonable. It is probably not much of a stretch for one to conclude that if the captive policies do not make sense (e.g., are duplicative of commercial policies maintained by the taxpayer or that contain coverage that is arguably illusory), the IRS will conclude that the associated captive premiums were likewise unreasonable and thus, not insurance in the commonly accepted sense.

Likewise, if the insured fails to pursue a claim for which the policy appears to provide coverage, the IRS and the courts may view the arrangement as something other than insurance. The Syzygy court reached the conclusion that the premiums were unreasonable with only two sentences’ worth of analysis.6 Despite the existence of a claim on the policy by the insured to the captive, adequate capitalization of the captive, and active regulatory oversight, these insurance-like traits were not enough to overcome alleged late-issued policies with ambiguous language and the lack of an arm’s-length transaction.

Thus, as the arm’s-length nature of the arrangement has been considered by the courts when questioning whether the arrangement involved risk distribution as well as whether a captive provided “insurance in the commonly accepted sense,” it is incumbent on the tax advisor to drill deeply into the facts that would bear on whether the arrangement made economic sense.

Opinion Letters

In an effort to avoid penalties, the taxpayer may produce an opinion letter regarding the deductibility of premiums paid into a captive program. Here, the advisor should review the terms of the opinion as well as all other communications, including marketing materials, that might impact the usefulness of the opinion.

Further, the advisor must be cognizant of the fact that a written tax opinion will not protect a taxpayer from the accuracy penalty imposed with respect to a transaction lacking economic substance, even if the taxpayer relied on that opinion in good faith

Federal Tax Audit

The captive audit may start as a result of audit of another issue and then blossom into a captive audit or may be initiated solely due to the captive deduction itself. Over the last 2 years, after the § 831(b) micro-captive transaction was designated as a “transaction of interest,” the IRS has obtained a wealth of information from captive owners and captive managers, both from required filings regarding reportable transactions (Forms 8886, Reportable Transaction Disclosure Statement, and 8918, Material Advisor Disclosure Statement) and section 6112 list maintenance request to captive managers.

Information Document Requests

A captive audit will often involve intense questioning via Information Document Requests issued to both the captive and the insureds. In some cases, the insured taxpayer may handle responding on behalf of the captive as well as the insured party; in other cases, the captive manager or a third party may respond on behalf of the captive.

Here, it is critical to understand potential ethical issues, as well as the degree of control the taxpayer has over the captive for purposes of consistency in providing the IRS the information it is entitled to receive under the Internal Revenue Code.

If the requested information is not provided, not only will this likely result in summons enforcement proceedings (assuming the taxpayer can actually provide the information), but the taxpayer should also be cognizant that any information not provided (perhaps for strategic reasons) may ultimately have to be produced in subsequent litigation challenging the IRS assessment.

If critical or important documents are withheld and only surface later in litigation, then the taxpayer’s good faith may be put in question.

Ancillary Proceedings

Simultaneous with a tax audit, the advisor must be aware of and address numerous ancillary proceedings, such as issues related to state taxing authorities, civil proceedings involving service providers in particularly weak programs, as well as the exit of a small captive program.

For example, the taxpayer may be interested in civil remedies, joining a class action, or seeking relief in arbitration. Consequently, the advisor will need to carefully review and monitor the flow of information, as it is being requested in different settings, utilized for different purposes, but ultimately for the benefit of the taxpayer client.

As an example, a failure to review and monitor communications may lead to tax counsel making statements to the IRS in a tax audit that are wildly inconsistent with statements made by plaintiff’s counsel in pursuing a claim against a service provider. In sum, a captive tax audit may become an incredibly complex process that involves managing numerous moving parts.

irs audits captives

Captive Insurance Audit Settlements

Captive Insurance Audit SettlementsThe Internal Revenue Service announced that the mailing of a time-limited settlement offer for certain taxpayers under audit who participated in abusive micro-captive insurance transactions. Captive Insurance Audit

Taxpayers eligible for this offer will be notified by letter with the applicable terms. Taxpayers who do not receive such a letter are not eligible for this resolution.

Abusive micro-captives have been a concern to the IRS for several years. The transactions have appeared on the IRS “Dirty Dozen” list of tax scams since 2014. In 2016, the Department of Treasury and IRS issued Notice 2016-66 (PDF). Some  identified certain micro-captive transactions as having the potential for tax avoidance and evasion.

Following wins in three recent U.S. Tax Court cases, the IRS has decided to offer settlements to taxpayers currently under exam. In recent days, the IRS started sending notices to up to 200 taxpayers.

Captive Insurance Audit SettlementsTax law generally allows businesses to create “captive” insurance companies to protect against certain risks. Under section 831(b) of the Internal Revenue Code, certain small insurance companies can choose to pay tax only on their investment income. In abusive “micro-captive” structures, promoters, accountants or wealth planners persuade owners of closely held entities to participate in schemes that lack many of the attributes of genuine insurance.

IRS has consistently disallowed the tax benefits claimed by taxpayers in abusive micro-captive structures. Although some taxpayers have challenged the IRS position in court, none have been successful. To the contrary, the Tax Court has now sustained the IRS’ disallowance of the claimed tax benefits in three different cases.

The IRS will continue to disallow the tax benefits claimed in these abusive transactions and will continue to defend its position in court. The IRS has decided, however, to offer to resolve certain of these cases on the terms outlined below.

“Now the IRS is taking this step in the interests of sound tax administration,” IRS Commissioner Chuck Rettig said. “We encourage taxpayers under exam and their advisors to take a realistic look at their matter and carefully review the settlement offer, which we believe is the best option for them given recent court cases. We will continue to vigorously pursue these and other similar abusive transactions going forward.”

The settlement brings finality to taxpayers with respect to the micro-captive insurance issues. The settlement requires substantial concession of the income tax benefits claimed by the taxpayer together with appropriate penalties (unless the taxpayer can demonstrate good faith, reasonable reliance). Taxpayers eligible for the settlement will be notified of the terms by letter from IRS.

Captive Insurance Audit SettlementsThe initiative is currently limited to taxpayers with at least one open year under exam. Taxpayers who also have unresolved years under the jurisdiction of the IRS Appeals may also be eligible, but those with pending docketed years under Counsel’s jurisdiction are not eligible. The IRS is continuing to assess whether the settlement offer should be expanded to others.

Taxpayers who receive letters under this settlement offer, but who opt not to participate, will continue to be audited by the IRS under its normal procedures. Potential outcomes may include full disallowance of captive insurance deductions, inclusion of income by the captive, and imposition of all applicable penalties.

Although taxpayers who decline to participate will have full Appeals rights, the IRS Independent Office of Appeals is aware of this resolution initiative. Given the current state of the law, it is the view of the IRS Independent Office of Appeals that these terms generally reflect the hazards of litigation faced by taxpayers, and taxpayers should not expect to receive better terms in Appeals than those offered under this initiative.

Taxpayers who are offered this private resolution and decline to participate will not be eligible for any potential future settlement initiatives. The IRS also plans to continue to open additional exams in this area as part of ongoing work to combat these abusive transactions. 

irs audits captives

abusive micro-captive transactions

abusive micro-captive transactions
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For the third consecutive year, the IRS places abusive micro-captive insurance tax shelters on its list of “Dirty Dozen” tax scams. IRS takes next step on abusive micro-captive transactions; nearly 80 percent accept settlement, 12 new audit teams established


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captive

Abusive tax shelters, trusts and conservation easements

Abusive tax shelters, trusts and conservation easements
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The IRS today warned taxpayers to steer clear of abusive tax avoidance schemes and the unscrupulous individuals who promote them. Abusive tax shelters

Abusive tax shelters, trusts and conservation easements make IRS’ “Dirty Dozen” list of tax scams to avoid.

help with irs audits

IRS Audits Focus on Captive Insurance Plans

IRS Attacks Business Owners that participate in a 419 plan, 412i plan, Section 79 or a Captive Insurance. Under Section 6707A  

lance wallach, IRS Audits Focus on Captive Insurance Plans

By Lance Wallach

Taxpayers who previously adopted any of the following plans, 419, 412i, captive insurance or Section 79 are in trouble.

In recent years, the IRS has identified many of these plans as abusive devices to funnel tax deductible dollars to shareholders and classified these arrangements as listed transactions.