With New Proposal Regulation, IRS Reaffirms Commitment to Crack Down on Micro-Captives

The IRS recently issued a proposed regulation holding taxpayers and practitioners responsible for reporting micro-captive insurance transactions that could lead to tax avoidance or evasion, or face potential penalties. The proposed regulation is the culmination of a lawsuit against the IRS that has been winding its way through federal courts for nearly seven years.

In 2016, the IRS originally issued Notice 2016-66 notifying taxpayers and practitioners of the reporting requirement, but a lawsuit by CIC Services, a company in Knoxville, Tennessee, that helps small and midsized business owners set up captive insurance companies, challenged the IRS’s authority to take such action by the notice process without public comment.

At issue is the IRS’s position that certain micro-captive transactions be identified as “transactions of interest,” which could potentially lead to tax avoidance or evasion, or “listed transactions,” which are abusive tax transactions that have the potential for tax avoidance or evasion.

In the wake of court rulings reaching all the way to the U.S. Supreme Court that upheld the CIC Services procedural claim, the IRS on April 10, 2023 issued the proposed regulation, Announcement 2023-11, setting in motion the rulemaking and public comment process that could lead to implementation. The move signals that the IRS is committed to holding taxpayers and practitioners responsible for reporting potentially abusive practices by micro-captives.

The effects of these proposed regulations will fall on material advisors and participants in  listed transactions and transactions of interest. Material advisors and participants will be required to file disclosures with the IRS and will be subject to penalties for failure to disclose, if the proposed regulations are implemented.

Businesses are generally allowed by tax law to create captive insurance companies to protect themselves against insurance risks, particularly when they cannot find affordable insurance in the marketplace to cover unique risks. Moreover, a key driving feature of the micro-captive qualification is that certain small non-life insurance companies, under current law, can choose to be taxed only on their investment income under Section 831(b) of the Internal Revenue Code.

In abusive micro-captive arrangements, however, owners of closely held entities participate in schemes that lack many of the attributes of authentic insurance. Captive insurance entities have long been included on the IRS’s annual “dirty dozen” list of common tax scams.

What to do now?

Taxpayers who are involved with micro-captive insurance programs should prepare for the new regulation by discussing with their advisors any practices or transactions that may not pass the IRS’s sniff test.

Taxpayers also should be skeptical of any promises they receive from promoters about tax benefits related to micro-captive programs. If it sounds too good to be true, it likely is. Talk to us first.

The IRS is watching

The IRS in January 2020 announced the formation of 12 new examination teams to audit taxpayers that participated in abusive micro-captive insurance transactions. Those audits have resulted in a settlement offer for certain taxpayers that denies the tax deductibility of certain payments to a micro-captive, while eliminating the ability of the micro-captive to include such payments in its taxable income.

It’s fair to anticipate that the IRS, with a recently proposed infusion of enforcement funding, will step up its scrutiny of captive insurance arrangements even more.

We’re here to help

Captive insurance arrangements have many advantages when structured properly, including tax benefits and the legitimate risk management for which they are designed. Businesses that create captive insurance arrangements can engage in certain best practices that help establish transparency, including:

• Develop a business plan for the insurance entity
• Keep pricing of premiums on an arms-length basis
• Clearly document the business purpose of the insurance entity, as well as underwriting and compliance with contractual terms

Business owners who want to enter captive insurance arrangements must be sure to work with trusted advisors who have expertise in this sophisticated marketplace.