Armed with three precedent-setting wins, IRS has its sights set on micro-captives

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Over the last few years, captive insurance has become the tax shelter du jour for accountants and wealth planners looking to find ways to help their small business owner clients reduce their tax exposures. Now the IRS is cracking down on the scheme. The agency just sent settlement offers to upwards of 200 taxpayers that participated in these tax structures and said it plans to go after organizers of these structures with penalties that could amount to hundreds of thousands — even millions — of dollars.

Captive insurance is nothing new. The first captive policy in America was formed in 1953, and companies of every type have used these types of policies to provide supplemental coverage that was hard to find in traditional insurance markets. More recently, that construct has been stretched to include so-called micro-captives, which are small insurance company structures that pay tax only on their net investment income. And that’s where things started to get messy.

By definition, a micro-captive is a small insurance company that makes less than $2.3 million in premium income and pays tax only on its net investment income. Thus, small business owners who set up their own micro-captive insurance companies to cover risks associated with their business are able to claim a tax deduction for the premiums they pay to the micro-captive insurer — which they also own. On top of that, any funds remaining after any claims are paid are eventually returned to the insured as a dividend or liquidating distribution, both of which are potentially taxed at preferential capital gains rates.

That’s all fine and good if the micro-captive insurer is being set up to cover a real risk and pay out based on legitimate claims. But it becomes a problem if those micro-captive arrangements lack the attributes of genuine insurance or, worse, pay out claims based on falsified valuations.

Joining the 'Dirty Dozen'

The IRS has long voiced skepticism about micro-captives and even placed them on its “Dirty Dozen” list of tax scams starting in 2014. That skepticism has hardly been universal, though. In fact, Congress has historically supported micro-captive structures — especially for rural taxpayers who are unable to obtain property insurance through traditional means.

It was Congress that opened Pandora’s box by enacting Section 831(b) of the Internal Revenue Code, which permits insurance companies (other than life insurance companies) with net premiums under a certain amount to elect to be taxed only on their net investment income without taxing their premium income.

According to the IRS, though, many of these arrangements are not insurance policies at all; they’re merely schemes aimed at avoiding taxes. In a 2016 notice, the IRS designated certain micro-captive insurance transactions between related parties as “transactions of interest,” and required taxpayers to disclose information about micro-captive arrangements. As a result, filers must provide sufficient details regarding the structure of their transactions with a micro-captive, the identity of all participants, and when and how they became aware of the transaction.

In 2017, the IRS’s Large Business & International division adopted a new audit strategy that focused on specific issues or “campaigns” — one of which addressed micro-captive insurance transactions. According to guidance the IRS issued at the time, the campaign was to be conducted through issue-based examinations and will involve standardized information document requests that ask more than 30 detailed questions about the transaction.

Emboldened by Avrahami

The IRS gained some serious momentum on this issue following a major Tax Court victory in 2017.

In 2008, an Arizona couple, the Avrahamis — who owned various shopping centers and jewelry stores in the Phoenix area — decided to form the Feedback Insurance Company. For the 2009 tax year, entities owned by the Avrahamis paid Feedback $730,000 in premiums for direct coverage. In addition, Feedback participated in a risk pool through an entity known as Pan American Reinsurance Company Ltd., with $360,000 paid to Pan American for terrorism insurance. The latter raised some eyebrows considering the low likelihood of a terrorist incident in suburban Arizona.

Similarly, for the 2010 tax year, Feedback was paid $810,000 in premiums for direct coverage, and Pan American received $360,000 for terrorism insurance. What’s more, each of the entities owned by the Avrahamis continued to buy insurance from third-party commercial carriers and made no change to its coverage under those policies after contracting with Feedback.

During this time, no claims were filed against Feedback under any of its policies, and as a result, the entity accumulated significant cash. Eventually, the funds were transferred to Mrs. Avrahami and an entity owned by her three children. The entity used the money to purchase 27 acres of land in Snowflake, Arizona. According to Feedback’s tax returns, the funds were classified as mortgage and real estate loans.

The IRS contended that the Avrahamis’ insurance premium deductions should be denied in full, claiming that the arrangements with Feedback and Pan American didn’t constitute insurance under federal tax law. Ultimately, the Tax Court agreed the premiums were not deductible as ordinary and necessary business expenses.

Risky business

Armed with that huge win and two subsequent victories (against Reserve Mechanical Corp. and Syzygy Insurance Co. Inc., respectively), the IRS now has an inroad to collect a significant amount of missing revenue. Still, advisors actively promote micro-captives, which makes it crucial for tax practitioners to learn to identify the characteristics of bona fide insurance.

In order for clients to legally and responsibly reap the benefits of Section 831(b), tax professionals will need to walk their clients through the extensive paces and prepare them for the increased scrutiny they will face. Some may still want to set up a micro-captive, but it is imperative that they do so with their eyes wide open to the risk involved.

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