In September, the IRS announced that they would mail time-limited settlement offers to certain taxpayers under audit who had participated in abusive micro captive insurance transactions (IRS News Release IR-2019-157). Only Eligible taxpayers are notified through mail.
Captive insurance management is one in which an insurance company insuring only the risk of its related companies. Captive insurers labeled “micro” are those who are anticipated to qualify as eligible to make a Sec. 831(b) election, by which small insurance companies may be taxed upon their investment income. But to qualify for that eligibility, taxpayer must be able to show insurer is bona fide company within the meaning of Secs. 831(c) and 816(a). As per case law guidance it’s necessary to consider all the facts and circumstances to determine that, and courts have applied following four criteria:
- Arrangement involves insurance risks.
- The arrangement transferred risk of loss to insurer.
- Risk is distributed among policyholders by insurer.
- Arrangement generally meets the commonly accepted ideas of insurance.
Examples of insurance risk includes workers’ compensation, property and casualty loss, general liability, and other acceptable commercial risk relevant to the industry of the insured. Risk distribution occurs when the insurance company has a large group of unrelated risks (i.e., risks that are generally unaffected by the same event or circumstance) (see Rent-A-Center, Inc., 142 T.C. 1, 24 (2014)). The analysis focuses on both the independent risk exposures and the number of related entities insured (see Avrahami, 149 T.C. 144 (2017)). In finding whether risk transferred from insured to captive the court will apply step-transaction, substance-over-form and economic substance doctrines. The analysis make sure that insured or captive withstand economic risks relevant to insurance policy.
IRS COURT VICTORIES
In order to find that if an arrangement constitutes insurance in the commonly accepted sense, courts have looked at the following facts:
- Whether that company was organized, operated and regulated as an insurance company.
- Whether company has adequate capital.
- Whether the policies were valid and binding.
- Whether premiums were reasonable and the result of arm’s-length transactions.
- Whether claims were paid or not.
None of these factors are mutually exclusive.
In recent years the IRS has won following tax court cases involving captive and micro captive insurance transactions. In Avrahami, the individual applicant took large loans from their captive after it had secured a surplus. The Tax Court found there was no distribution of risk when the captive insured only seven types of direct policies covering exposures for four related entities. A portion of the loans were considered distributions, and the Sec. 831(b) election of the captive was invalidated, resulting in the disallowance of deductions for paid insurance premiums (see also “Tax Matters: Microcaptive Premium Deductions Disallowed,” JofA, Nov. 2017).
In Reserve Mechanical Corp., T.C. Memo. 2018-86, a captive was formed to provide additional coverage that the applicant’s third-party insurers would not cover. The tax court found that the risks were not distributed because the policies were “cookie-cutter” and did not necessarily suit the applicants’ business. The policies indicated on their face that they were copyrighted material of a company that managed and administered the microcaptive through a “turnkey” operation and did not meet the needs of each of the insureds rather, all the entities in the group had the same policy with the same premium, regardless of their size or risk. The court also found that the premiums were not correctly calculated and were a one-size-fits- for all of the insured entities “Tax Matters: Tax Court Again Denies Microcaptive Insurance Arrangement,” JofA, Sept. 2018).
In Syzygy Insurance Co., T.C. Memo. 2019-34, the Tax Court found that the applicant’s captive met the minimum criteria of capitalization requirements and was organized and regulated as an insurance company, however, the captive charged unreasonable premiums and issued policies late and with conflicting and ambiguous terms. For the claims that were filed, no due diligence was done to ascertain whether they were covered under the policy. The court found that the captive’s Sec. 831(b) election was invalid, and the insurance deductions were not allowed (see also “Tax Matters: Tax Court Denies Microcaptive Insurance Arrangement,” JofA, July 2019).
Following these victories, the IRS decided to offer settlements to taxpayers who have participated in certain microcaptive transactions and are currently being inspected. The IRS has said that this would require taxpayers to make significant concessions in tax benefits with appropriate penalties.
Under the terms, the settlement does not allow for the 90% deductions claimed for insurance premiums for all open tax years. The remaining 10% will be allowed. Expenses related to captive on the insured’s return, such as fees paid to captive managers for formation or maintenance of a captive, would not be allowed. Captives will not be required to identify taxable income for the premium received. In addition, the captive must liquidate if it has not already done so, or recognize income for a deemed qualified dividend and adjust its basis for deemed capital contributions.
Under the settlement, the accuracy-related penalty applies at a reduced rate of 10%. This rate can be reduced to 5% if the taxpayer has not previously participated in any other notifiable transaction and signs a declaration to that effect or obtains a declaration from an independent tax professional stating the taxpayer relied on that professional’s advice. The penalty will be reduced to zero if the taxpayer furnished a reportable transaction declaration and an independent tax professional’s declaration.
Taxpayers must pay the full balance of deficiency and any applicable fines and interest. In addition, taxpayers must submit gift tax returns and pay gift tax, absorb credit, or both to transfer any value to the shareholders of the captives.
Taxpayers rejecting the offered settlement will not be eligible for any future micropactive settlement initiatives. Such taxpayers will continue to be audited under the normal procedure and may be subject to complete rejection of captive insurance tax benefits and all applicable penalties.