On May 13, 2022, the U.S. Court of Appeals for the 10th Circuit ruled in favor of the IRS in a challenge to an insurance arrangement that a taxpayer entered into with its offshore captive insurance company. Reserve Mechanical Corp. v. Commissioner, No 18-9011 (10th Cir.). The appeals court affirmed an earlier Tax Court decision that denied all insurance expense deductions taken by the taxpayer and held that the premium payments made by the taxpayer to its offshore insurance company were taxable to the insurance company. Following this win, on June 7, 2022, the IRS issued News Release IR-2022-118, reiterating that it will aggressively pursue litigation to assert tax deficiencies and penalties against similarly situated taxpayers who participate in what the IRS considers to be abusive microcaptive insurance arrangements.
Generally, a microcaptive insurance transaction is an insurance agreement between a parent company and an insurer under its control, that is, a “captive” insurance company. An insurance company that qualifies as a small insurance company under section 831(b) receives favorable tax treatment such as taxation only on investment income and not on premiums received. These insurance companies can be exempt from income tax if (1) the gross receipts for the taxable year do not exceed $600,000 and (2) more than 50 percent of such gross receipts consists of premiums. See section 501(c)(15)(A)(i). Captive insurance companies are often used when coverage in conventional insurance markets is unavailable or impractical to obtain. Some advisers, however, are overly focused on the tax advantages. They are promoting arrangements that don’t provide true insurance coverage, which are subject to challenge by the IRS. Taxpayers forming insurance companies with invalid arrangements risk substantial tax deficiencies and penalties if audited by the IRS.
IRS has steadily escalated its pursuit of abusive microcaptive insurance arrangements
The IRS has consistently included microcaptive insurance arrangements on its “Dirty Dozen” list of common tax scams. In 2016, the IRS first published Notice 2016-66 where it identified several characteristics of what it considered to be an improper microcaptive insurance arrangement. These characteristics included coverage that does not match a business need or involves an implausible risk, or coverage that duplicates coverage already provided by an unrelated insurance company.
In 2017, the IRS issued an administrative summons to the Delaware Department of Insurance seeking the filings that two advisory companies made to obtain certificates of authority for their client insurance companies. The IRS alleged that these two advisors were promoting improper microcaptive insurance arrangements that substantially understated the true income tax liability of their clients. When the Delaware Department of Insurance refused to comply with the summons, the United States commenced a lawsuit in federal district court to enforce compliance. The IRS believes that at least 225 taxpayers are involved with these two promoters.
In 2019, after winning several cases in the Tax Court, the IRS sent letters to taxpayers under examination offering a settlement initiative (News Release IR-2019-157). Approximately 80 %of the taxpayers receiving the letter accepted the terms of the settlement initiative. In 2020, the IRS established several new microcaptive examination teams to aid its effort in examining these potentially abusive arrangements, including the taxpayers who did not accept the settlement initiative (News Release IR-2020-26).
The recent Reserve Mechanical Corp. decision constitutes the first appellate decision upholding the circumstances under which microcaptive insurance arrangements are abusive. Examples of these circumstances include: unreasonable premium payments, duplicative insurance coverage and no true distribution of risk. In the news release, the IRS reiterated its intention to “use all available legal options to challenge improper attempts to avoid or evade U.S. income tax.” Abusive microcaptive transactions can result in the loss of deductions, required income inclusion, and for transactions lacking economic substance, the assessment of a strict liability penalty of 40 %
Taxpayers and tax advisors should be on notice of the significant exposure
Taxpayers considering entering a promoted microcaptive insurance transaction are encouraged to speak to a qualified independent advisor. Taxpayers already engaged in a promoted microcaptive insurance arrangement should seek advice from a qualified tax advisor to discuss their options as some settlement opportunities exist for taxpayers that voluntarily come forward to disclose and resolve their participation in the arrangement. Proactive disclosure is particularly important for taxpayers engaged in microcaptive arrangements created or promoted by certain companies that are currently the subject of summons enforcement action.
If you have any questions about IRS operations or have a specific question about IRS procedures, please do not hesitate to contact a member of RSM’s Tax Controversy team.