IRS Names Microcaptives as Top Abusive Tax Scheme

April 15, 2015

The IRS is growing increasingly uncomfortable that an increasing number of smaller companies and professional firms have been doing what larger companies do — creating their own or joining a captive insurer.

The IRS believes some of these smaller companies are creating these so-called “microcaptives” in order to lower their taxable incomes and not to insure against risks.

The New York Times recently reported on the types of captives the IRS is targeting, where the owners claim they are formed to insure against highly unlikely or costly specific risks but in reality they rarely pay out any claims, including one set up by a dentist to insure against a terrorist attack in his dental office.

Originally, captives were created to provide coverage that was hard to find in traditional insurance markets but they have expanded well beyond that to provide almost all types of insurance. Many of the largest companies have at least one captive today and experts say they are gaining popularity among smaller and midsized firms, including professional services firms.

The vehicles are popular because under tax law the owners of a small insurance company can pay up to $1.2 million in tax-deductible premiums. Then, under Section 831(b) of the tax code, any small property/casualty insurer with annual premiums under $1.2 million may choose to be taxed on its net investment income as opposed to its premium income.

The 831(b) alternative tax provision used by microcaptives is also used by small, mutual and often rural insurance companies.

In February, the IRS placed captive insurance on its “Dirty Dozen” list of abusive tax scams. The IRS also has challenged the tax status of several microcaptives.

The IRS suspicions over captives is not new. It did not officially recognize them as legitimate tax structures until 2002. In 2008, it proposed and then dropped a bid to alter how captives are taxed after lawmakers from Vermont and other states complained. It has also questioned payment of what it believes are excessive premiums into captives by some owners.

Now the IRS is targeting small captives and what is says are “unscrupulous promoters” who persuade closely held entities to create captives onshore or offshore. They draft organizational documents and prepare initial filings to state insurance regulators and the IRS. Then, according to the IRS, the promoters assist with “creating and ‘selling’ to the entities often times poorly drafted ‘insurance’ binders and policies to cover ordinary business risks or esoteric, implausible risks for exorbitant ‘premiums,’ while maintaining their economical commercial coverage with traditional insurers.”

According to the IRS, the annual premiums paid each year into the captive often equals the amount of deductions business entities need to reduce income for the year; or, for a wealthy entity, total premiums amount to $1.2 million annually to take full advantage of the 831(b) code provision.

That’s not the only red flag for the IRS. “Underwriting and actuarial substantiation for the insurance premiums paid are either missing or insufficient. The promoters manage the entities’ captive insurance companies year after year for hefty fees, assisting taxpayers unsophisticated in insurance to continue the charade,” the IRS says.

Most Fortune 500 companies have captives today. According to Captive Experts, an Arizona firm that specializes in creating captives for closely-held businesses, there are as many as 7,000 captives today versus only about 500 back in the 1980s when they started to catch on. Captive insurance growth today is being fueled by smaller companies and professional firms using the 831(b) provision, the firm says.

While Bermuda, Barbados and the Cayman Islands used to be the domiciles of choice for captives, most captives today are formed in the U.S. under state insurance laws. In the 1970s, Colorado, Tennessee and Vermont passed the first state laws permitting captives to form. Today 38 states allow captives and many of them actively market their states to attract new captives.

Vermont has licensed more than 1,000 captives with $30 billion in premiums, with hospitals and doctors’ groups among the most active recently. North Carolina, which passed a captive law in late 2013, licensed nine captives within its first year.

While the IRS would like to reign in microcaptives, recent Congressional activity meant to assist small mutual insurers could have the opposite effect and make microcaptives more attractive.

The Senate Finance Committee, led by Sen. Charles Grassley, R-Iowa, in February approved a bipartisan measure on the 831(b) alternative tax for small insurers. Currently small property/casualty insurers with less than $1.2 million in premiums may elect to be taxed on their net investment income as opposed to their premium income. The committee bill would raise that threshold to $2.2 million in premiums and index it to inflation in future years.

An earlier committee proposal that died would have done the opposite by limiting the percentage of its premium that a small insurer could have from a single policyholder to 20 percent in order to be eligible for the alternative tax.

A similar bill to the Senate measure to update the 30-year old 831(b) provision has just been introduced in the House by Reps. Erik Paulsen, R-Minn., and Ron Kind, D-Wis. According to the National Association of Mutual Insurance Companies (NAMIC), which supports raising the threshold, more than 600 small mutual insurers would be affected by the change.

In announcing his agency’s 2015 “Dirty Dozen” tax scams, IRS Commissioner John Koskinen said the IRS is “committed to stopping complex tax avoidance schemes and the people who create and sell them,” and warned “everyone to watch out for people peddling tax shelters that sound too good to be true.”

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