IRS to step up examinations of potentially abusive micro-captive insurance schemes

The IRS made a large investment in personnel to accelerate investigation of potential abuses of micro-captive insurance transactions. 

Since 2014, the IRS has put micro-captive insurance arrangements under a microscope to uncover taxpayers and taxpaying entities that may be abusing associated tax benefits. We provided an article in 2019 about IRS settlement offers made to up to 200 taxpayers then under audit for potentially violating federal tax laws involving micro-captives. Here we will share information about new agency actions involving micro-captive insurance transactions.

Background: The problem with micro-captive insurance transactions

A micro-captive insurer is a small insurance company (with less than $2.2 million in yearly premiums) set up by a small- or medium-sized business to self-insure for losses not covered by other, standard policies. Tax law allows the business to deduct payments of insurance premiums as business expenses, while the micro-captive entity may be able to pay taxes on gain from investments only and not from premiums collected.

This arrangement can be abused when the micro-captive insurer is only a shell or sham entity used for the tax benefits but not for legitimate insurance and business purposes. Unusual financial entwinement between the two entities can be a sign that something is off, as can inflated premiums that allow higher deductions. The arrangement is also subject to strict transactional reporting requirements and when the parties fail to report, they may be subject to significant IRS financial penalties.

The agency has been consistently aggressive in examinations of these arrangements as well as stern in its public warnings against suspicious micro-captive insurance schemes. Should a taxpayer be found to have violated tax law in this regard, they could be subject to delinquent tax assessment, interest charges and monetary penalties.

IRS developments

The IRS announced on Oct. 1, 2020, that it has formed 12 new micro-captive enforcement teams to substantially step up the number of audits in this area. The agency also said that it has uncovered and is actively countering recent variations of abusive micro-captive insurance transactions, including some in Puerto Rico and otherwise offshore.

Then, on Oct. 22, 2020, the agency issued a news release about an anticipated second wave of settlement offers (with expiration dates) for selected taxpayers currently under audit for participation in micro-captive arrangements or with their cases at the IRS Independent Office of Appeals level. The IRS will send settlement offers out that will not be as generous as those made last year. Micro-captive disputes before the U.S. Tax Court are not eligible. Only parties who receive settlement offers will be eligible, so approaching the agency about these offers will likely be unsuccessful, although perhaps other negotiated resolutions could still come to fruition.

The offered settlement would require the taxpayer to pay taxes that were reduced by wrongfully taken tax benefits plus associated penalties. The IRS could reduce the penalties if the taxpayer can show “good faith, reasonable reliance on an independent, competent tax advisor” and that the taxpayer did not fail to report any other taxable transactions.

More broadly, the IRS is advising taxpayers involved in such arrangements to consult with a professional and “seriously consider exiting the transaction and not claiming deductions associated with abusive micro-captive insurance transactions.”

Take immediate action

Because of the IRS’ aggressive approach to these arrangements, any taxpaying entity involved in one should seek legal advice promptly to understand whether any adjustments need to be made for full compliance with the law. Or, it may be worth discussing with an experienced tax attorney whether to continue with the arrangement or explore other options.

If a taxpayer under audit or at the appeals level for a micro-captive insurance scheme receives a settlement offer, they should immediately get legal guidance to understand the pros and cons of accepting the terms. The IRS reportedly has included expiration dates with these offers, so time is of the essence.