IRS increased enforcement activities related to micro captives
The IRS announced that it is increasing its enforcement activity and number of audit teams around micro-captive insurance arrangements and examining returns that include micro-captive insurance transactions. This increase in enforcement activity comes as a result of several U.S. Tax Court holdings that certain micro-captive are not eligible for Federal tax benefits. As part of its enforcements efforts, the IRS recently released a post-release change to income tax forms outlining the correct procedure to use to amend a tax return to remove the benefits of an ineligible micro-captive insurance transaction. In its effort to increase its enforcement activity in this area, the IRS has been issuing letters to taxpayers who previously claimed a tax benefit from a micro-captive transaction and filed a Form 8886 disclosure.
Micro-captive insurance transactions
In 2016, the IRS designated certain micro-captive transactions as a transaction of interest in Notice 2016-66. Generally, a micro-captive insurance transaction involves a captive insurance company that insures certain risks of its owner or of one or more parties related to its owner. The captive insurance company then elects to have its insurance income exempt from tax under section 831(b). Other income of the captive generally remains subject to tax. In order to have legitimate transactions, the captive must engage in insurance transactions and operate as a legitimate insurance company. The IRS determined that this area had the potential for abuse and was specifically concerned about transactions with the following characteristics:
- Coverage of risks that are implausible or unrelated to the insured’s business
- Duplicative or vaguely described coverage
- Premium amounts determined without an underwriting or actuarial analysis that conforms to insurance industry standards
- Premiums that exceed amounts that unrelated insurers would charge
- Captives that fail to comply with insurance laws or regulations, or lack defined claims administration procedures
- Captives with inadequate capital
- Failure to file claims for insured losses
The IRS has issued letters to taxpayers who have taken a deduction or other tax benefit related to micro-captive insurance on a prior year tax return and have filed a Form 8886 disclosing the tax benefit pursuant to Notice 2016-66. The letters inform the taxpayer that they are being contacted because several recent Tax Court decisions have “confirmed” that certain micro-captive arrangements are not eligible for claimed Federal tax benefits. The letters ask taxpayers whether they are still taking tax benefits from the micro-captive arrangement. If a taxpayer is no longer claiming deductions from the micro-captive arrangement, the taxpayer must send a letter to the IRS stating the last year the taxpayer claimed any tax benefits from the arrangements and the date the taxpayer ceased participating in the micro-captive transaction. The letter must be sent to the IRS by the specified response date and signed with a penalty of perjury statement. The IRS will take into consideration the taxpayer’s response in any subsequent enforcement action.
The letter also provides the procedures by which to amend a return to remove previously claimed benefits. On March 23, 2020, the IRS released the post-release change (see above) noting that taxpayers who have claimed a deduction or other tax benefit on a prior year tax return related to micro-captive insurance may amend their returns to remove these benefits by notating “Microcaptive” at the top of the form.
The IRS has been steadily increasing its compliance and enforcement activities with regard to micro-captive insurance transactions. Taxpayers who claimed a tax benefit and filed a Form 8886 disclosing their participation in such transactions should be prepared to receive a letter from the IRS requesting additional information. Taxpayers who are concerned that the structure of the transaction they engaged in might be questioned by the IRS should contact their tax advisors to discuss possible remedies.