On Sept.16, the IRS announced a settlement offer available to select taxpayers under examination who participated in abusive micro-captive insurance transaction. The settlement offer comes after the IRS won three micro-captive insurance cases in the United States Tax Court. The IRS first made micro-captive insurance a transaction of interest with Notice 2016-66, and required taxpayers to disclose any transactions that met the notice’s definition.
A business may create captive insurance companies to protect against certain risk. Under section 831(b), small insurance companies may elect to pay tax only on investment income, not on premium income. An abusive transaction occurs when the transaction with the captive insurance company lacks the characteristics of an actual insurance company.
In an effort to streamline compliance efforts, avoid repeated litigation and provide finality for taxpayers, the IRS is proactively offering certain taxpayers settlement terms for their micro-captive insurance transactions. The IRS began mailing notices to Taxpayers that qualify for the terms of the settlement. The IRS announcement stated that up to 200 taxpayers qualify for the settlement program. The IRS is assessing whether to expand the offer to other taxpayers. Currently, the settlement offer is limited to taxpayers with at least one open year under exam. Taxpayers with cases under IRS Appeals are eligible for the settlement offer. Taxpayers with cases “docketed with Counsel’s jurisdiction” are not.
The announcement stated that taxpayers should not expect to receive better terms in Appeals than are offered by the settlement offer. The settlement offer also explicitly states that the IRS will not entertain any counteroffers.
Terms of the Settlement
The settlement offer terms involve general terms for accepting the offer and specific financial terms disallowing deductions for premium payments and reduced penalties.
The general terms include items such as the Taxpayer has 30 days to accept the offer, but may request a single 30-day extension. Each partner, member or shareholder of each insured entity or captive entity must agree to participate in the resolution. Taxpayers must execute a closing agreement and pay the full balance of the deficiency before the IRS will accept the closing agreement.
The financial terms for the settlement offer are stringent, and the financial benefits taxpayers obtained with the captive insurance transaction are largely forfeited under the settlement. The terms of the settlement provide as follows:
The IRS will deny 90% of any deductions claimed for captive insurance premiums, but the captive will not be required to recognize taxable income for received premiums.
Any captive related expenses claimed on the insured’s return for formation or maintenance of the captive will be disallowed.
The captive must already be liquidated, will be required to liquidate or will recognize for a deemed qualified dividend and adjust basis for deemed capital contributions.
Accuracy-related penalties are reduced to a rate of 10%. The penalty rate can be further reduced by 5% if either of the following conditions is met (to 0% for both conditions); (1) taxpayers have not previously participated in any other reportable transaction, and (2) the taxpayer relied on advice from an independent tax professional.
If none of the parties to the micro-captive insurance transaction disclosed it, as required with Notice 2016-66, a $5,000 failure to include reportable transaction information with return penalty will apply.
The settlement offer is limited to certain taxpayers who receive notification by letter from the IRS. Taxpayers who opt not to participate in the program will continue to be audited by the IRS, and may face a full disallowance of captive insurance deductions, inclusion of income by the captive and imposition of all applicable penalties. Any taxpayer that receives the notice with the settlement offer should consult with its’ tax advisor to determine the appropriate course of action.