Micro-Captive Insurance Companies Feel Pressure with Recent IRS Settlement Offers and Court Victories

The IRS announced Tuesday that it is sending time-limited settlement offers to certain taxpayers under audit with micro-captive insurance transactions.  Eligible taxpayers will be notified of this offer by a letter containing the applicable terms. 

A micro-captive is a small captive insurance company that may be taxed under Internal Revenue Code § 831(b). The code section provides that captives qualifying to be taxed as a U.S. insurance company pay tax only on their investment income if written premium income is at or below $2.3M in 2019 ($2.2M in 2018). These structures are often used to provide coverage where insurance is unavailable or unreasonably priced. The risk management benefits of captives along with their tax and estate planning advantages are attractive for taxpayers with insurable risk. However, these tax-advantageous structures have come under scrutiny by the IRS in recent years and are often listed among the agency’s “dirty dozen” tax scams. Since 2016, microcaptives have been required to file additional tax forms, disclosing specific arrangements and providing additional information regarding transactions.

In legal claims involving microcaptive insurance companies, the IRS recently won its last three U.S. Tax Court cases, leading some to speculate about the potential of a large-scale settlement. According to a recent IRS news release, there are more than 500 micro-captive cases sitting at the Tax Court. Many practitioners believe it’s unrealistic for the Tax Court to individually try each case.

The IRS, capitalizing on its recent momentum, is now offering settlements to taxpayers currently under exam. The service has already sent notices to up to 200 taxpayers and has offered to resolve cases on applicable terms set out in the letters. The settlement offers are currently limited to taxpayers with at least one open year under exam.  Additional taxpayers may be eligible for a settlement in certain situations.

The settlement terms generally require substantial concessions of the income tax benefits claimed by the taxpayer. In some cases, the lost benefit is nearly the entire amount; penalties generally will apply. Taxpayers who receive letters and do not participate in the settlement will remain under IRS audit and face potential loss of full captive insurance deductions, inclusion of income by the captive, and applicable tax penalties.  However, taxpayers retain full appeals rights.  The IRS has emphasized that taxpayers who receive offers and decline to participate will not be eligible for future settlement programs.

The IRS plans to continue to open additional examinations in this area as a part of its initiative to combat these transactions. Taxpayers with micro-captives should consult with their tax advisor and specialists in the micro-captive area, and evaluate the likelihood of their position. If you are a taxpayer with a micro-captive or considering setting up a micro-captive, please contact your SD tax advisor.

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Material discussed is meant for informational purposes only, and it is not to be construed as investment, tax, or legal advice. Please note that individual situations can vary. Therefore, this information should be relied upon when coordinated with individual professional advice.

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