The IRS has been targeting micro-captive insurance companies for the past several years, and included abusive micro-captive arrangements on the agency’s Dirty Dozen list of tax scams again this year. Why is the IRS so intent on pursuing these companies and vigorously litigating against them and those who invest in them? The agency considers many micro-captive insurance companies to be tax avoidance schemes and as such has been employing several tactics against them.
What is Captive Insurance?
A captive insurance company is one that is owned and controlled by those that it insures. Companies of all sizes often will set up captive insurance entities as an alternative to being self-insured. In these arrangements, the captive insurance company is a separate entity with its main purpose being to insure the risks of its owner. At the same time, the owner benefits from the captive insurance company’s underwriting income, which is the difference between premiums collected and claims paid out plus other expenses. Captives are considered established insurance companies and are regulated by state insurance commissioners.
A micro-captive insurer is one that is considered a small insurance company and qualifies under IRS section 831 to only pay taxes on its investment income. In 2021, the premium limit for qualifying as a micro-captive insurer under section 831 is $2.4 million. So, if a captive insurance company receives $2.4 million or less in annual premiums, it can elect section 831(b) and avoid paying taxes on its underwriting income. Because those who control the micro-captive are the same as those who write the premium checks, the IRS is concerned about whether transactions are truly independent and at arm’s length.
IRS Goes After Micro-Captives
Abusive micro-captive insurance arrangements first appeared on the IRS Dirty Dozen in 2014. Then in 2016 the agency issued a notice identifying certain micro-captive transactions as potentially being considered tax avoidance or even evasion. The IRS is particularly concerned when a captive contract has one or more of the following characteristics:
- Coverage involves a largely implausible risk
- Coverage isn’t for a business need or risk of the insured
- Language is vague, ambiguous, or illusive
- The insured has duplicate coverage with a commercial insurer at a lower premium
In 2019, the agency offered a time-limited IRS settlement to taxpayers who were under audit and had participated in potentially abusive micro-captive insurance arrangements. According to the IRS, almost 80% of those who received offers accepted them.
Lack of Economic Substance Penalty
In 2020, the IRS established 12 dedicated examination teams for what it considered to be abusive micro-captive insurance arrangements. If deemed as such, insurance premiums would be considered income and taxpayers subject to interest and penalties. The IRS warned of assessing the lack of economic substance penalty, which is 40% of the amount of underpayment instead of the traditional 20%.
Then in April 2021, the agency urged taxpayers involved in abusive micro-captive insurance arrangements to exit them as soon as possible. The agency cited a number of recent court victories where micro-captives were found to be ineligible for section 831(b) federal tax benefits.
Not all micro-captive arrangements are abusive. Taxpayers should, however, be aware that the IRS is targeting these arrangements and is on the lookout for taxpayers and small businesses with such transactions. If notified by the IRS that it is looking into your micro-captive insurance arrangement, it’s best to contact an attorney for advice before responding or moving forward.
Have Questions? Call the Experienced Tax Attorneys at Wiggam & Geer
If you have received a letter for the IRS offering settlement or have been notified that your return is being audited due to taking the 831(b) election for a micro-captive arrangement, we can help. The experienced attorneys at Wiggam & Geer can evaluate your situation, recommend a course of action, and represent you in discussions and negotiations with the IRS. Contact metro Atlanta’s top tax attorneys by clicking here giving us a call at (404) 537-5030.