IRS adds microcaptives to Dirty Dozen list

The US Internal Revenue Service (IRS) has added microcaptives to its Dirty Dozen list of common scams that it claims that US taxpayers may encounter.

According to the IRS the list reflects its commitment to curbing abusive arrangements through audits, investigations, and litigation. The IRS has devoted substantial resources with more than 500 docketed cases in Tax Court and is conducting numerous income tax examinations of the participants in these arrangements, as well as promoter investigations.

In a statement the IRS said that: “Tax law generally allows businesses to create “captive” insurance companies to insure against risks. The insured business claims deductions for premiums paid for insurance policies. Those amounts are paid, either as insurance premiums or reinsurance premiums, to a “captive” insurance company owned by the insured or related parties and are used to fund losses incurred by the insured business.  Traditional captive insurance typically allows a taxpayer to reduce the total cost of insurance and loss events.

“Insurers that qualify as small insurance companies can elect to be treated as exempt organisations or to exclude limited amounts of annual net premiums from income so that the captive insurer pays tax only on its investment income. In certain “microcaptive” structures, promoters, accountants or wealth planners persuade owners of closely-held entities to participate in schemes that lack many of the attributes of insurance.

“In recent years, the IRS has been successful in litigating these transactions.  In 2017, the U.S. Tax Court disallowed the “wholly unreasonable” premium deductions the taxpayer had claimed under a section 831(b) microcaptive arrangement, concluding that the arrangement was not “insurance” under long established law. (Avrahami v. Commissioner, 149 T.C. No. 7 (2017).)  In 2018, the Tax Court concluded that the transactions in a second microcaptive arrangement were not “insurance”. (Reserve Mechanical Corp. v. Commissioner, T.C. Memo. 2018-86.)

“The IRS in 2016 issued guidance advising that microcaptive insurance transactions have the potential for tax avoidance or evasion. The notice designated transactions that are the same as or substantially similar to transactions described in the notice as “Transactions of Interest.” Notice 2016-66 established reporting requirements for those entering into such transactions on or after Nov. 2, 2006, and created disclosure and list maintenance obligations for material advisors.  Taxpayers who fail to report these arrangements may be subjected to significant penalties.”