The IRS has been auditing small captive insurance programs claiming that they are usually not legitimate. IRS officials have urged participants in these abusive micro-captive insurance plans to exit as soon as possible. The irs has increased audits and has won many cases in tax court. Recently, twelve newly formed IRS micro-captive examination teams were constructed to substantially increase audits.
Don’t get audited. Contact Lance Wallach and his team of experts for more information. 516-236-8440 or wallachinc@gmail.com
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.
Tax practitioners should be cognizant of the Internal Revenue Service (“IRS”) increasing and focused activity related to micro-captive insurance companies (hereinafter referred to as Captive Insurances. Captive Insurance Risk Alert
Additional scrutiny and skepticism may increase the professional liability risk of a CPA firm. CPA firms with clients who have established, or are considering establishing, a Captive should pay special attention to this Risk Alert.
Since 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.
Taxpayers engaged in micro-captive insurance arrangements (and re-insurance arrangements) have started receiving correspondence directly from the Large Business and International (LB&I) division of the IRS. The correspondence asks taxpayers to certify whether they have terminated their participation in the arrangement and, if so, to disclose the last tax year they claimed a tax benefit from the arrangement.
For taxpayers still engaged in micro-captive insurance arrangements as a means to self-insure against business risk, the IRS letter may be an occasion to review the captive insurance arrangement.
Background
In Notice 2016-66, the IRS described micro-captive insurance arrangements as “transactions of interest.” Although many taxpayers engage in captive insurance arrangements to legitimately self-insure against business risk, the IRS expressed concern that some arrangements may result in tax abuse. The notice requires taxpayers participating in such arrangements to disclose the transaction on Form 8886—Reportable Transaction Disclosure Statement—and file the form with their current tax return and with the Office of Tax Shelter Analysis.
The notice provided examples of abusive micro-captive insurance arrangements. The IRS describes the potential abusive transaction as one that starts with a taxpayer who deducts premiums paid to a micro-captive insurance company, with the insurance company electing (under section 831(b)) to be taxed only on its investment income (premium income is not directly taxed). The mismatching of the deductible insurance premiums and the insurance company’s election not to be taxed on premium income may lead to potential abuse. This abuse may exist where the micro-captive insurance company insures against implausible risks, the micro-captive insurance company is used as an investment vehicle for its owners, or where there are loans between the micro-captive and related parties.
Notice 2016-66 lists a number of factors used to determine whether a micro-captive arrangement is an abusive tax structure. However, captive insurance arrangements are also widely used to legitimately self-insure against business risk, and micro-captive insurance companies (defined as having annual premiums of less than $2,200,000) are used by many taxpayers in the middle market. The notice recognizes this fact and specifically states:
However, the Treasury Department and the IRS lack sufficient information to identify which § 831(b) arrangements should be identified specifically as a tax avoidance transaction and may lack sufficient information to define the characteristics that distinguish the tax avoidance transactions from other § 831(b) related-party transactions.
IRS correspondence
Last year, the IRS successfully litigated several cases where the micro-captive insurance arrangement was clearly tax abusive. Based on these cases, the IRS sent out the above-mentioned letters to those taxpayers who had previously filed a Form 8886. The letter instructs taxpayers who are no longer claiming deductions or other tax benefits for any of the captive transactions described in Notice 2016-66 to notify the IRS. The notification must be signed under penalty of perjury, and include the date the taxpayer ended participation in the micro-captive arrangement, and the last tax year the taxpayer claimed any tax benefit from the arrangement.
Noticeably confusing in the IRS letter is whether taxpayers still engaged in micro-captive insurance arrangements need to respond at all to the IRS letter. Many taxpayers have established micro-captive insurance companies to insure against legitimate business risk; the captive insurance company manages reserves and pays claims that come due. Under the terms of the IRS letter, these taxpayers may not need to specifically respond to the IRS.
Client discussion
The IRS correspondence received by taxpayers has caused confusion as to how to respond and whether a taxpayer’s micro-captive insurance arrangement will be respected. Taxpayers still engaged in a micro-captive insurance arrangement should consider whether and how to respond to the IRS. Based on concerns raised in IRS Notice 2016-66, questions to determine if the captive insurance arrangement is acceptable may include the following:
Does the micro-captive insurance coverage match a business need or risk to the insured?
Does the coverage duplicate other insurance coverage already in place?
Are premium payments calculated to cover risk based on an analysis consistent with industry standards?
Are premium payments consistent with premiums required under commercially available insurance contracts?
Is there documentation of insurance coverage?
Has the captive insurance company registered as an insurance company with the applicable government agency?
If the captive insurance company is an offshore entity, has it elected under section 953(d) to be taxed as a U.S. insurance company?
Does the captive insurance company have procedures for the handling of claims?
Does the captive insurance company have adequate reserves to cover claims?
Does the captive insurance company have assets that significantly exceed the necessary reserves?
Does the captive insurance company invest in illiquid or speculative assets?
Does the captive insurance company provide loans to related parties?
Although no one factor is dispositive of a bona fide captive insurance arrangement, these questions should be considered by taxpayers to gain an understanding of the micro-captive insurance arrangement and to evaluate their own arrangements. In addition, there is a real concern that the IRS may begin examining taxpayers who are still engaged in micro-captive insurance transactions.
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