IRS efforts to crack down on micro-captive insurance schemes continue after some wins in the U.S. Tax Court. The IRS also recently made a limited settlement offer to some taxpayers who participated in abusive micro-captive insurance transactions and were already under audit. The IRS has been concerned with abusive micro-captives for several years and has consistently disallowed tax benefits claimed by taxpayers in abusive micro-captive arrangement.
IRS Settlement Offers for Captive Insurers
The IRS recently sent time-limited settlement offers to approximately 200 taxpayers who participated in abusive micro-captive insurance transactions. The offer is limited to taxpayers currently under audit or jurisdiction with IRS Appeals. The settlement terms of the offer require substantial concessions of the income tax benefits claimed by the taxpayers together with appropriate penalties (unless the taxpayer can demonstrate good faith, reasonable reliance).
Captive insurance is a form of insurance where a business establishes and operates an insurance company to insure its interest. A captive insurance company may allow the business to improve its risk management or obtain coverage that it might not be able to find commercially. Like other insurance companies, a captive insurance company’s taxable income is generally its gross income, including premiums received from the insured business.
A small insurance company, however, may elect to exclude premiums received from gross income and only be taxed on its investment income. A small insurer is an insurance company that receives $2.3 million or less of premiums in 2019 ($2.35 million or less for 2020).
Some businesses have combined the benefits of captive insurers and small insurance companies to form micro-captive insurance companies. The hope is that the micro-captive insurance company can avoid tax on the insurance premiums paid by its owner.
Potential Abuse of Micro-Captives
The IRS has viewed the use of micro-captive insurance skeptically as having the potential for abuse. Beginning in November 2016, it designated certain micro-captive insurance transactions between related parties as transactions of interest. Taxpayers that engage in these transactions may by subject to additional disclosure and reporting obligations, and liable for some special penalties.
The IRS worries that a micro-captive arrangement does not provide any actual insurance, and the micro-captive insurer will pay few, if any, claims. Instead the micro-captive scheme is used merely for tax avoidance.
Without a true insurance component, a micro-captive arrangement effectively allows the insured business to shelter income. The insured deducts its premiums paid, but the micro-captive does not have to include those premiums in its gross income. The micro-captive might even lend its surplus back to the insured if licensed in a jurisdiction with limited rules on reserve requirements and related-party transactions.
Is Micro-Captive Insurance Really Insurance?
The Code does not define “insurance.” However, court cases have found that actual insurance involves:
- whether the arrangement involves the existence of insurance risk;
- risk shifting and risk distribution; and
- whether the arrangement was for insurance in its commonly accepted sense.
Diversification Requirements for Micro-Captives
Beginning after 2016, a micro-captive insurer cannot elect to exclude premiums from gross income unless it satisfies one of two diversification requirements under Code Sec. 831(b):
- No more than 20 percent of the company’s premiums are attributable to one policyholder in a tax year (the “risk diversification test”).
- No person who is a specified holder owns a direct or indirect interest in the insurance company that exceeds more than a de minimis percentage of the percentage of interest in the insured(s).
Micro-Captive Insurance Can be a Risky Business
The IRS won several cases against micro-captive insurance companies before the diversifications were added. The Tax Court found that there was no valid insurance arrangement. Thus, the premiums paid by the insured could not be deducted and the micro-captive election to exclude premiums from gross income was invalid.
In the cases, the court focused on the only on the questions of risk distribution and whether the arrangement was insurance in the commonly accepted sense.
- In B. Avrahami, the Tax Court found that the company did not have enough independent risk exposures, let alone a sufficient number to achieve risk distribution through affiliated entities. Also, it policies issued were unclear, contradictory, and charged unreasonable premiums.
- Similarly in Syzygy Insurance Co. Inc., the court found that the micro-captives did not qualify as a bona fide insurance company. The insurer’s premiums were not actuarially determined, its contracts were not at arm’s length, and the flow funds in the arrangement was suspiciously like a circular flow of funds.
- In Reverse Mechanical Corp. the court found that a captive insurer was not an insurance company lacked risk distribution because it had only insured three entities and had an insufficient number of risk exposures. The arrangement also involved the circular flow of fund and premiums were not determined at arm’s length.
By John Buchanan, J.D., LL.M