by Mike Godfrey, Tax-News.com Washington
20 September 2019
On September 16, 2019, the United States Internal Revenue Service (IRS) announced the mailing of a time-limited settlement offer for certain taxpayers under audit who participated in abusive micro-captive insurance transactions.
The IRS confirmed that taxpayers eligible for this offer will be notified by letter with the applicable terms. However, taxpayers who do not receive such a letter are not eligible for this resolution.
The US tax code generally allows businesses to create captive insurance companies to protect against certain risks. Traditional captive insurance, established by an insurance company owned by the insured or parties related to the insured, typically allows a taxpayer to reduce insurance costs. The insured business claims deductions for premiums paid.
Micro-captive insurers (with annual written premiums of less than USD2.3m) can also elect to pay tax only on their investment income, and can thereby exclude the payments they directly or indirectly receive under the insurance contracts from their taxable income.
However, the IRS has long been concerned about abusive micro-captives. In Notice 2016-66, issued on November 1, 2016, the agency warned that the use of micro-captive transactions have “a potential for tax avoidance or evasion,” as it believes they may be established more to avoid federal income tax than for their stated aim of providing additional insurance for clients.
The agency’s concern is that, in abusive micro-captive structures, owners of closely held entities are persuaded to participate in schemes that lack many of the attributes of genuine insurance. For example, the coverage taken may insure implausible risks, fail to match genuine business needs, or duplicate the taxpayer’s commercial coverage. Premium amounts may be unsupported by underwriting or actuarial analysis, may be geared to a desired deduction amount, or may be significantly higher than premiums for comparable commercial coverage.
In addition, captives may invest in illiquid or speculative assets, or loan or otherwise transfer capital to or for the benefit of the insured, the captive’s owners, or other related persons or entities. Captives may also be formed to advance inter-generational wealth transfer objectives and avoid estate and gift taxes. Promoters, reinsurers, and captive insurance managers may also share common ownership interests that result in conflicts of interest.
Notice 2016-66 designated certain micro-captive insurance transactions as “Transactions of Interest.” It established reporting requirements for those entering into such transactions on or after November 2, 2006, and created disclosure obligations for material advisors.
However, the IRS has decided to provide certain micro-captives with a settlement offer after it won three cases against abusive schemes in the US Tax Court.
The settlement requires substantial concession of the income tax benefits claimed by the taxpayer together with appropriate penalties (unless the taxpayer can demonstrate good faith, reasonable reliance). Taxpayers eligible for the settlement will be notified of the terms by letter from IRS. The initiative is currently limited to taxpayers with at least one open year under exam. Taxpayers who also have unresolved years under the jurisdiction of the IRS Appeals may also be eligible, but those with pending docketed years under Counsel’s jurisdiction are ineligible. The IRS is continuing to assess whether the settlement offer should be expanded to others.
Taxpayers who receive letters under this settlement offer, but who opt not to participate, will continue to be audited by the IRS under its normal procedures. Potential outcomes may include full disallowance of captive insurance deductions, inclusion of income by the captive, and imposition of all applicable penalties, the IRS said.
Taxpayers who are offered this private resolution and decline to participate will not be eligible for any potential future settlement initiatives, the agency said. The IRS also plans to continue to open additional exams in this area as part of ongoing work to combat these abusive transactions.