Abusive Captive Insurance Falls Off of Dirty Dozen, But Still a Focus of IRS Enforcement Actions
Every year, the IRS publishes a list of 12 tax scams for taxpayers to watch out for. The list has commonly included phishing, theft of tax refunds, automated calls from IRS impersonators, and so on. Recently, the IRS has also targeted abusive captive insurance schemes. Recently, the IRS released their 2020 “Dirty Dozen” tax scam list and although abusive captives appear to have found their way off of the list, they have not fallen off of the radar of the IRS. However, if you have engaged in a captive insurance arrangement or have received correspondence from the IRS regarding your participation in a captive, it is in your best interest to contact an experienced tax attorney today.
The publishing of the Dirty Dozen list provides taxpayers with some visibility into the priorities of the IRS, at least with respect to abusive scams or tax shelters that could hurt both taxpayers and the U.S. tax base. In the past, micro-captive insurance has been included in the Dirty Dozen’s section on abusive tax shelters.
Although micro-captive insurance solutions have been widely marketed to the wealthy, many do not know exactly what the concept of captive insurance is all about. First, it is critical to understand that a captive insurance structure is not per se a tax avoidance mechanism.
The concept of a captive insurance policy is simple. Instead of paying a third party to ensure a particular risk or multiple risks, a business pays a premium to a wholly-owned (or partially-owned) captive insurance company. The insurance premiums paid by the company are tax-deductible, providing an immediate tax benefit. On the captive side, underwriting and investment income are taxed under a special insurance taxation regime.
It is important to note that captive insurance was not created as a tax avoidance mechanism. Captive insurance originally came about when a business had risks that would not be covered under a traditional insurance policy. As time went on, associations of businesses began setting up captive insurance companies for entire industries or associations of companies.
Under section 831(b) of the Internal Revenue Code, small insurance companies are permitted to elect to exclude certain amounts of annual net insurance premiums from their taxable income. In 2020 for instance, an insurance company (other than a life insurance company) with net written premiums under $2.2 million is only taxed on its investment income. Thus, the underwriting income goes untaxed.
This result was clearly intended by Congress in its addition of section 831(b) to the Code. But what was not intended was the flurry of micro-captive tax shelters being sold to individuals and companies without any business justification. In order for premiums to be deductible and for the corresponding underwriting income to be exempt from tax under section 831(b), the arrangement must involve a real insurance policy. The IRS has gone through great lengths to define what an insurance policy is and what it is not.
An insurance policy must involve an insurable risk (like crop failure or terrorism-related supply chain disruptions). Furthermore, the insurance company (the captive) must insure a diverse set of risks. Risk diversification is a complicated topic, but simply said, a captive insurance company cannot be set up to insure one risk from one business and be respected as an insurance arrangement. Lastly, the arrangement must be structured in a way that exhibits the traditional notions of an insurance arrangement (i.e., the form of the transaction is important).
The requirements described above are generally where a micro-captive insurance arrangement fails when they are established only as a tax play and not for a legitimate business purpose. The potential for abuse has led the IRS to become deeply concerned with the dramatic spike in micro-captives. Even though the IRS has removed mention of micro-captives from their Dirty Dozen list this year, their efforts to prevent abuse using micro-captives continues on. Recently, taxpayers who were on the radar of the IRS as having participated in micro-captive insurance arrangements received correspondence from the IRS asking them to confirm whether they have abandoned their micro-captive or not.
As time moves forward, the IRS will likely continue audits of taxpayers with potentially abusive micro-captive insurance structures. If you received a letter from the IRS regarding a micro-captive arrangement or if you are engaged in a micro-captive insurance arrangement, it is in your best interest to meet with an experienced tax defense attorney to anticipate the IRS’ next move and to make any necessary changes before your return is examined and your micro-captive is investigated as a tax evasion strategy.
Regardless of your particular business or estate needs, the professionals at the Tax Law Offices of David W. Klasing are here for you. We are open for business and our team will help ensure that your business is too. Contact the Law Offices of David W. Klasing today to discuss your business with one of our professionals.
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