Thousands of taxpayers around the country have received letters within the past month indicating that they are (or have been) involved in micro-captive insurance arrangements and that the IRS is targeting such activity. This article focuses on what captive insurance is all about and what the recent micro-captive letter from the IRS means for you if you have or continue to utilize a micro-captive insurance company in your company’s structure. Captive insurance arrangements are relatively complicated from a planning and compliance standpoint and any questions relating to them should be taken up with an experienced tax defense attorney.
Note: As long as a taxpayer that has, (or merely appears too) willfully committed tax crimes (potentially including the improper use of a captive insurance company) self-reports the tax fraud (including a pattern of non-filed returns) through a domestic or offshore voluntary disclosure before the IRS has started an audit or criminal tax investigation/prosecution, the taxpayer can ordinarily be successfully brought back into tax compliance and receive a nearly guaranteed pass on criminal tax prosecution and simultaneously often receive a break on the civil penalties that would otherwise apply. A letter from the IRS concerning your captive insurance company involvement does not necessarily prevent you from entering into a voluntary disclosure.
It is imperative that you hire an experienced and reputable criminal tax defense attorney to take you through the voluntary disclosure process. Only an Attorney has the Attorney-Client Privilege and Work Product Privileges that will prevent the very professional that you hire from being potentially being forced to become a witness against you, especially where they prepared the returns that need to be amended, or advised you to utilize a captive insurance company in the first place (even if an Attorney under the crime-fraud exception), in a subsequent criminal tax audit, investigation or prosecution.
Moreover, only an Attorney can enter you into a voluntary disclosure without engaging in the unauthorized practice of law (a crime in itself). Only an Attorney trained in Criminal Tax Defense fully understands the risks and rewards involved in voluntary disclosures and how to protect you if you do not qualify for voluntary disclosure.
As uniquely qualified and extensively experienced Criminal Tax Defense Tax Attorneys, Kovel CPAs and EAs, our firm provides a one-stop-shop to efficiently achieve the optimal and predictable results that simultaneously protect your liberty and your net worth. See our Testimonials to see what our clients have to say about us!
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What is Captive Insurance?
Every business faces risk. Whether you are a seller of shoes or a farmer who grows and harvests corn, you face uncertainty. In today’s insurance landscape, most any risk can be insured. Traditionally, a business contracts with a 3rd-party insurance company and pays a periodic premium in exchange for risk coverage. The insurance premium is generally deductible for tax purposes.
A captive insurance arrangement involves the business setting up its own insurance company and insuring at their own risk. Premium payments are still made to the insurance company and are tax-deductible, but the insurance company is controlled by the business, allowing business owners to effectively retain the premiums that it paid.
Why Are Captive Insurance Arrangements Advantageous for Tax Purposes?
In addition to having access to paid-in premiums that are left over from any claims that are paid, micro-captives are only subject to tax on their net investment income under section 831(b), rather than their net income, providing the potential for significant tax savings.
A micro-captive that qualifies for section 831(b) treatment must have written premiums that do not exceed $2.2 million (adjusted for inflation annually) and must also meet risk diversification requirements that were put into place to ensure that a micro-captive is not acting as an insurance company for only one company. As a general rule, one policyholder cannot make up more than 20 percent of the written policies of the captive, with related corporations generally being grouped together and considered one policyholder. The rules are slightly more relaxed for insured individuals.
Why is the IRS Targeting Captive Insurance Arrangements?
The IRS has grown concerned that some taxpayers may be forming micro-captives in an attempt to shelter up to $2.2 million of income from tax without having met the diversification requirements contained in the statute. Essentially, they are concerned that some taxpayers are making tax-deductible payments to an entity claiming to be an insurance company but does not function like one, insuring only risks of one policyholder. Then, on the other end of the transaction, the captive only pays tax on net investment income, providing a substantial tax benefit. Micro-captives are even explicitly listed by the IRS as part of the annual IRS Dirty Dozen tax schemes.
What Does the Letter Say?
The letter, sent to who appears to be every taxpayer that has previously reported their micro-captive on Form 8886 (the “Reportable Transaction Disclosure Statement”), informs the recipient that they have taken the benefit of a micro-captive in the past and that the IRS has had recent victories against micro-captive abuse. If the taxpayer has ceased taking the benefits of a micro-captive arrangement, the IRS encourages them to complete a “Penalties of Perjury” statement that includes the years in which micro-captive benefits were claimed and the date the taxpayer ceased utilizing a micro-captive arrangement.
The message to those who continue to utilize a micro-captive arrangement reads more threatening. It indicates that the IRS has stepped up enforcement in the area of micro-captives and that it has deployed specialized teams to assist field agents in their examinations of taxpayers’ returns. Lastly, it urges taxpayers to seek advice from an independent tax advisor before continuing the use of micro-captive arrangements.
What Should Micro-Captive Taxpayers Do?
The letter certainly has a call-to-action for its recipient, regardless of whether the taxpayer is using micro-captives currently or has discontinued the practice. Regardless of whether you continue to use a micro-captive arrangement or not, you should contact an experienced civil and criminal tax defense attorney to discuss your particular situation and the potential risks to your net worth and even potentially, your risk of criminal tax prosecution followed by incarceration.
Returning the IRS letter indicating that you have ceased the use of a micro-captive arrangement, along with the Penalties of Perjury statement, can be used against you in future legal proceedings and may even amount to a criminal admission. For those who continue to use micro-captives, it is critical to ensure that your arrangement meets the legal requirements imposed by section 831(b) and the relevant regulations and case law. Willful ignorance of the requirements of a micro-captive insurance arrangement cannot be used as a defense if the IRS deems your captive structure to be out of compliance. In either case, taxpayers should contact an experienced tax defense attorney to discuss the next steps and options on how to respond to the letter or whether a response is appropriate, at all.
Contact an Experienced Tax Attorney Today
The tax and accounting professionals at the Tax Law Offices of David W. Klasing have extensive experience representing a diverse group of taxpayers. From individuals to middle-market businesses and beyond, our team of zealous advocates will assist in the development of a strategy to help you reach your specific goals and objectives. Whether you are under a tax examination or are in need of tax planning advice, contact the Tax Law Offices of David W. Klasing today, online or by phone at (800) 681-1295, for a reduced-rate consultation.
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