Backed by a string of Tax Court victories1, the IRS has stepped up scrutiny of micro-captive insurance devices in recent years, saying such devices are often abusive. The IRS sends warning letters to taxpayers involved in these types of transactions, and a settlement framework is offered to those selected for review.
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 less than $2.2 million in gross premiums received, it is a “micro-captive” and can elect to be taxed only on its income from investment and not on the insurance premiums it receives. The business which is insured by the policies, however, is still able to deduct the full amount of the premiums it pays as an ordinary and necessary business expense under the IRC Sec. 162. These tax benefits make microcaptivity schemes attractive but also prone to abuse.
In 2016, the IRS identified micro-captive transactions as “transactions of interest” due to their potential for tax evasion and evasion.3and the transaction has been on their annual list of “Dirty Dozen” tax scams for several years now.4 The IRS sent letters to taxpayers who engaged in micro-captive transactions, warning them of the audit risk and asking them to respond and indicate whether they continue to participate in the arrangement.5 Those who continue 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 reviews of micro-captive transactions.6 Since 2019, the IRS has offered a settlement program for audited taxpayers for micro-captive transactions, which saw an 80% acceptance rate in its first year.7 When the IRS prohibits deductions for bonuses and other captive-related expenses as part of a review, it also imposes a 40% penalty for an undisclosed transaction that lacks economic substance, rather than the usual penalty of 20% related to accuracy.8
Tax Court Victories for the IRS
The first major Tax Court decision involving micro-captives was Avrahami c. 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 costs. In the years that followed, after the Avrahamis formed a captive insurance company, their companies’ insurance expenses grew to more than $1.1 million annually and included coverage for perils such as terrorism and tax liabilities resulting from an IRS audit. The captive insurance company distributed most of the premiums it received to the Avrahams as 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 big case of captivity, Reserve mechanicsthe Tax Court followed the same reasoning as in Avrahami and again sided with the IRS’ decision denying the deduction for insurance premiums. In this case, the company in question was a manufacturer and distributor of heavy machinery used in underground mining operations. The company said it was concerned about potential liabilities arising from accidental pollution or contamination. He formed a captive insurance company that provided an excess pollution policy, along with several other policies, including tax liability coverage, cyber risk, and more. Their combined annual insurance premiums for 2008 rose to $412,089 from just $38,810 in 2006.
In syzgy, the taxpayer was a family business that manufactured steel tanks, with annual revenues between $54 million and $61 million. After obtaining policies from a captive insurance company, the taxpayer continued to submit all claims arising from the pre-existing liability insurance policies available to it and made no claims under the policies covered by the captive insurance company. Premiums charged for captive policies were up to 4 times more expensive than policies available on the open market, leading the court to conclude that the transaction was not at arm’s length. Eventually, the owner of the insured company decided to leave the captive insurance program because he was unhappy with lower premiums. In an ordinary insurance arrangement this would be very unusual, as one would generally be happy to pay less premium 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 Puglia,9 a case decided in November 2021, the IRS conceded the issue in favor of taxpayers, owners of a private egg farm who sought insurance coverage to mitigate risks such as avian flu, for which coverage insurance was not available on the open market. The taxpayer first applied for insurance with his long-standing commercial insurer, as well as with another insurance company specializing in the agricultural sector, but he was unable to obtain the coverage he was looking for. Eventually, they formed and operated a captive insurance company to obtain coverage for their risks, and several claims were submitted under this policy during the years in question. Upon review, the IRS disallowed premium deductions, just as in previous cases. Before the case reached trial, however, the IRS agreed to concede.
Current settlement framework
As of 2019, the IRS has offered a settlement framework to selected taxpayers for review of their captivity.ten The current version of the settlement program, which began in October 2020, is stricter than the initial program.11
The settlement framework offers taxpayers reduced accuracy penalties of 5%, 10% or 15% (instead of 20% or 40%).12 In exchange, taxpayers must agree to have 100% of premium deductions disallowed for all open tax years, along with all captive-related expenses (eg management fees). The captive insurance company must also be liquidated, otherwise there will be a deemed distribution to the owners for the amount of premiums paid to the captive for all years.
Taxpayers who decline to participate in this settlement program retain all normal rights that accompany an audit, including the right to appeal findings to the IRS Independent Office of Appeals and/or the United States Tax Court.
1Avrahami c. Commissioner, 149 TC No. 7 (2017); Reserve Mechanical Corp. v. Commissioner, TC Memo 2018-86 (2018); Syzygy v. Commissioner, TC Memo 2019-34 (2019).
2Clougherty Packing Co. v. Commissioner, 811 F.2d 1297 (9th Cir. 1987).
5Letter 6336; https://www.irs.gov/forms-pubs/micro-captive-arrangements
9Puglisi, and. Al.c. Commissioner, roll no. 4796-20, 4799-20, 4826-20, 13487-20, 13488-20, 13489-20.
122020 micro-captive insurance resolution conditions.