The Internal Revenue Service (IRS) has concluded its annual "Dirty Dozen" list of tax scams for 2018, placing "abusive" microcaptives on there for the fourth consecutive year.
The Dirty Dozen is a list of tax scams that taxpayers may encounter, particular during the tax-filing season.
A microcaptive is the name given to smaller captives that makes the 831(b) election under the tax code, which allows the company to exclude limited amounts of annual net premiums from income so that the captive pay tax only on its investment income.
These structures have been targeted as a potential tax shelter that can be "peddled by promoters and others to avoid taxes", the IRS said.
The IRS suggested that coverages provided by microcaptives may insure implausible risks, fail to match genuine business needs, or duplicate the taxpayer’s commercial coverages.
"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. Policies may contain vague, ambiguous or deceptive terms and otherwise fail to meet industry or regulatory standards. Claims’ administrative processes may be insufficient or altogether absent. Insureds may fail to file claims that are seemingly covered by the captive insurance," the IRS said in a statement.
"Micro-captives may invest in illiquid or speculative assets or loans 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 share common ownership interests that result in conflicts of interest."
In the first major case involving microcaptives, Avrahami v Commissioner, the US Tax Court disallowed premium deductions the taxpayer had claimed under a section 831(b) microcaptive arrangement, concluding that the arrangement was not “insurance” under long established decisional law principles.
In order to qualify as insurance under those principles, an arrangement must involve risk shifting, risk distribution and insurance risk, and must also meet commonly accepted notions of insurance.
Judge Mark Holmes concluded that the taxpayer’s arrangement failed to distribute risk and that the taxpayer’s captive was not a bona fide insurance company.
The court pointed to a number of facts that it found problematic, including circular flows of funds, grossly excessive premiums, non-arm’s length contracts, and an ultra-low probability of claims being paid.
Furthermore, the arrangement was not considered insurance in the commonly accepted sense, due in part to haphazard organisation and operation, the captive’s investments in illiquid assets, unclear policies, and inflated premiums.
The Avrahami case is often addressed by industry experts who have highlighted the need to seek proper guidance on how to manage this type of structure.
831(b)s are still considered an attractive option for smaller companies looking to retain their own risk, as long as they are set up the 'right way'.
IRS, Captive Insurance, Tax Shelters, Microcaptives, North America