IRS Targets Micro-Captive Insurance Companies

Published: Mar 7, 2022
Topics: Tax
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Backed by a string of Tax Court victories¹, the IRS has stepped up examinations of micro-captive insurance arrangements in recent years, claiming that such arrangements are often abusive. The IRS is sending warning letters to taxpayers who are involved in these types of transactions, and a settlement framework is being offered for those who are selected for examination.

What Are Micro-Captives?

A “captive insurer” is an insurance company organized for the purpose of insuring the liabilities of its owners (or related entities)². Under IRC Sec. 831(b), if the captive insurance company has $2.45 million of gross premiums received, it is a “micro-captive” that can elect to be taxed only on its investment income and not on the insurance premiums it receives. The company that is insured by the policies, however, is still able to deduct the full amount of premiums it pays as an ordinary and necessary business expense under IRC Sec. 162. These tax benefits make micro-captive arrangements attractive but also ripe for abuse.

IRS Response

In 2016, the IRS identified micro-captive transactions as “transactions of interest” due to their potential for tax avoidance and evasion³, and the transaction has appeared on their annual “Dirty Dozen” tax scams list for several years now.⁴ The IRS has been sending letters to taxpayers who have engaged in micro-captive transactions, warning them of the risk of audit and asking them to respond and indicate whether they are continuing to participate in the arrangement.⁵ Those who are continuing to engage in the captive arrangement have a significant risk of being audited by one of the twelve dedicated teams the IRS has deployed to conduct examinations of micro-captive transactions.⁶ Since 2019, the IRS has been offering a settlement program for taxpayers who are under audit for micro-captive transactions, which had an 80% acceptance rate during its first year.⁷ When the IRS disallows deductions for premiums and other captive-related expenses as part of an examination, they are also assessing a 40% penalty for a nondisclosed transaction that lacks economic substance, rather than the usual 20% accuracy-related penalty.⁸

Tax Court Victories for IRS

The first major Tax Court decision involving micro-captives was Avrahami v. Commissioner. The taxpayers owned several jewelry stores and commercial real estate companies in Arizona. In 2006, all of these entities deducted a combined total of approximately $150,000 in insurance expenses. In the years that followed, after the Avrahamis formed a captive insurance company, the insurance expense for their companies increased to more than $1.1 million each year and included coverage for risks such as terrorism and tax liabilities resulting from an IRS audit. The captive insurance company distributed most of the premiums it received to the Avrahamis in the form of loans. The Tax Court ultimately sided with the IRS, determining that the amounts paid to the captive insurance companies were not legitimate insurance premiums.

In the next major captive case, Reserve Mechanical, the Tax Court followed the same line of reasoning as in Avrahami and again sided with the IRS’s determination disallowing the deduction for the insurance premiums. In that case, the company in question was a manufacturer and distributor of heavy machinery used in underground mining operations. The company claimed that it was concerned about potential liabilities stemming from pollution or accidental contamination. It formed a captive insurance company that provided an excess pollution policy, as well as several other policies including tax liability coverage, cyber risk, and more. Their combined annual insurance premiums for 2008 rose to $412,089, up from just $38,810 in 2006.

In Syzgy, the taxpayer was a family business that manufactured steel tanks, with annual revenues between $54-61 million. After obtaining policies from a captive insurance company, the taxpayer continued submitting any claims that arose under the pre-existing third-party insurance policies it had, and did not submit any claims under the policies covered by the captive insurance company. The premiums being charged for the captive policies were as much as 4x more expensive than policies available on the open market, causing the court to conclude that the transaction was not conducted at arms-length. Ultimately, the owner of the insured company decided to leave the captive insurance program because he was displeased with a decrease in the premiums. In an ordinary insurance arrangement, this would be highly unusual, as one would typically be pleased to pay less in premiums for the same insurance policy.

Not All Micro-Captives Are Abusive

Despite the unsuccessful cases discussed above, captive insurance companies can exist for legitimate purposes. In Puglisi,⁹ a case decided in November 2021, the IRS conceded the issue in favor of the taxpayers, the owners of a privately held egg farm that sought insurance coverage to mitigate against risks such as avian flu, for which insurance coverage was unavailable on the open market. The taxpayer first sought the insurance from its longstanding commercial insurance provider, as well as from another insurance firm that specialized in the agricultural industry, but it could not obtain the coverage that it sought. Eventually, they formed and managed a captive insurance company to obtain coverage for their risks, and several claims were submitted under that policy during the years in question. During the examination, the IRS disallowed the premium deductions, just as in the previous cases. Prior to the case reaching trial, however, the IRS agreed to concede.

Current Settlement Framework

Since 2019, the IRS has been offering a settlement framework for taxpayers who are selected for examination of their captive arrangement.¹⁰ The current iteration of the settlement program, which started in October 2020, is stricter than the initial program.¹¹

The settlement framework offers the taxpayers reduced accuracy-related penalties of 5%, 10%, or 15% (rather than 20% or 40%).¹² In exchange, the taxpayers must agree to have 100% of the premium deductions disallowed for all open tax years, as well as any captive-related expenses (e.g., management fees). The captive insurance company must also be liquidated, or else there will be a deemed distribution to the owners for the amount of premiums paid to the captive during all years.
Taxpayers who decline to participate in this settlement program retain all the normal rights that come with an audit, including the right to appeal the findings to the IRS Independent Office of Appeals and/or the United States Tax Court.

¹Avrahami v. Commissioner, 149 TC No. 7 (2017); Reserve Mechanical Corp. v. Commissioner, T.C. Memo 2018-86 (2018); Syzygy v. Commissioner, T.C. Memo 2019-34 (2019).
²Clougherty Packing Co. v. Commissioner, 811 F.2d 1297 (9th Cir. 1987).
³Notice 2016-66.
⁴https://www.irs.gov/newsroom/irs-wraps-up-its-2021-dirty-dozen-scams-list-with-warning-about-promoted-abusive-arrangements
⁵Letter 6336; https://www.irs.gov/forms-pubs/micro-captive-arrangements
⁶https://www.irs.gov/newsroom/irs-takes-next-step-on-abusive-micro-captive-transactions-nearly-80-percent-accept-settlement-12-new-audit-teams-established
⁷https://www.irs.gov/newsroom/irs-takes-next-step-on-abusive-micro-captive-transactions-nearly-80-percent-accept-settlement-12-new-audit-teams-established
⁸https://www.forbes.com/sites/jayadkisson/2020/02/04/the-irs-strikes-a-rich-seam-of-tax-and-penalty-gold-in-risk-pooled-831b-captives-and-is-sending-in-more-miners/?sh=648c140439a8
⁹Puglisi, et. al. v. Commissioner, Docket No. 4796-20, 4799-20, 4826-20, 13487-20, 13488-20, 13489-20.
¹⁰https://www.irs.gov/newsroom/irs-offers-new-stricter-settlement-for-micro-captive-insurance-schemes-offer-letters-being-mailed-to-groups-under-audit
¹¹Id.
¹²2020 Micro-Captive Insurance Resolution Terms.