The Internal Revenue Service is warning against the use of so-called “micro-captive transactions” and similar transactions as potentially abusive.

In such transactions, taxpayers try to reduce their aggregate taxable income using insurance contracts and captive insurance companies. Each entity that the parties treat as an insured entity under the contracts claims deductions for insurance premiums. The related company that is treated as a captive insurance company elects under Section 831(b) of the Tax Code to be taxed only on investment income and therefore excludes the payments it directly or indirectly received under the contracts from its taxable income. The IRS said the manner in which the contracts are interpreted, administered and applied is inconsistent with arm’s length transactions and sound business practices.

In Notice 2016-66, the Treasury Department and the IRS said they believe such transactions have a potential for tax avoidance or evasion. However, they admitted they lack sufficient information to identify which Section 831(b) arrangements should be identified specifically as tax avoidance transactions and they may lack enough information to define the characteristics that distinguish the tax avoidance transactions from other Section 831(b) related-party transactions.

The notice identifies the transaction and substantially similar transactions as transactions of interest for purposes of the Income Tax Regulations and the Tax Code. The notice also alerts people who are involved in such transactions about the responsibilities and potential penalties they could face from their involvement with such transactions.

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