IRS Urges Participants in ‘Abusive’ Micro-Captives to Get Out Now

Internal Revenue Service officials are again urging participants in “abusive” micro-captive insurance arrangements to exit these transactions as soon as possible.

The IRS considers that many micro-captive arrangements are not really about insurance. The IRS has stepped up examinations of these arrangements in recent years. In 2020, the agency deployed 12 micro-captive examination teams to substantially increase the examinations of ongoing abusive micro-captive insurance transactions.

Adding to its argument, the IRS has just won another case in U.S. Tax Court that such arrangements are not eligible for the tax benefits claimed because they are not real insurance arrangements.

On March 10, 2021, the U.S. Tax Court held in Caylor Land & Development v. Commissioner, T.C. Memo. 2021-30 (2021), that yet another micro-captive arrangement failed to qualify as insurance for federal tax purposes. In this case, an Arizona construction company’s deduction of $1.2 million for what it said were insurance premiums paid to its captive insurer was improper because the entity being paid failed to distribute risk and was not selling insurance in the commonly accepted sense.

This decision follows several earlier Tax Court decisions that also confirmed the IRS’s determinations that certain micro-captive arrangements were not eligible for the claimed federal tax benefits. In Caylor, the Tax Court also sustained the IRS’s determination of accuracy-related penalties and rejected the taxpayer’s claim of reliance on tax advice.

“In multiple cases before the courts, judges have held that these ‘fanciful’ and ‘unreasonable’ arrangements don’t add up to insurance in the commonly accepted sense,” said IRS Commissioner Chuck Rettig. “I strongly urge participants in these arrangements to get independent legal advice separate from those who helped steer them into these abusive arrangements.”

The IRS says it will disallow tax benefits from transactions that are determined to be abusive and may also require domestic captives to include premium payments in income and assert a withholding liability on foreign captives. The IRS said it will continue to assert penalties including the strict liability penalty that applies to transactions that lack economic substance.

Under a micro-captive arrangement, the net premium paid by a taxpayer cannot exceed $2.2 million (prior to 2017 the cap was $1.2 million) and the captive is taxed only on taxable investment income.

In its Notice 2016-66, the IRS advised that micro-captive insurance transactions have the potential for tax avoidance or evasion.

While some taxpayers have challenged the IRS position in court, none have been successful, according to the IRS. The IRS started sending offers in 2019. The agency said there were more than 500 cases in court at that time. The IRS said in January, 2020 that nearly 80% of the taxpayers accepted its earlier settlement offer made in September 2019,

In March and July 2020, IRS again issued letters alerting taxpayers who participated in a Notice 2016-66 transaction of ramped up IRS enforcement activity and providing them with the opportunity to tell the IRS if they’ve discontinued their participation in this transaction before the IRS initiates examinations.

The IRS said responses indicate that a “significant number” of taxpayers who participated in these transactions have exited them but did not give numbers.