Taxpayers generally strive to legally minimize their tax burden while staying within the contours of the U.S. Tax Code. Taxpayers may pursue an array of tax strategies in pursuit of this goal. While there are many approaches that will lead to the legal minimization or avoidance of taxes, there are also approaches that will constitute illegal tax fraud or tax evasion.
Unfortunately, at least some “asset protection” or “tax minimization” firms will advise taxpayers to engage in financial transactions and practices that are improper and likely to lead to a tax audit or other enforcement action. One area where financial advisors commonly cross the line from legal tax avoidance to illegal tax evasion concerns entities known as “captives” and “micro-captives.”
If you are concerned about a tax strategy that may have included improper practices regarding captives or mico-captives, the Tax Attorneys, CPAs and EAs of The Tax Law Offices of David W. Klasing may be able to assist. We approach all matters strategically and work to mitigate the potential consequences of tax mistakes. We can discuss whether domestic voluntary disclosure is the right option to fix your tax mistakes. To schedule a confidential, reduced rate consultation please call 800-681-1295 today.
What Are Captives and Micro-Captives?
A micro-captive is a type of captive entity where annual premiums are less than $1.2 million. As suggested in the foregoing, this means that captives and micro-captives are typically a type of insurance company entity organized under Internal Revenue Code § 831(b). Under § 831(b), a captive must meet the following standards:
- The captive must have adequate risk-shifting, be operated like a bona fide insurance company, and have adequate capitalization.
- The entity must make a proper tax election under section 953(d) of the Tax Code.
- To qualify as a micro captive, the gross premium income for a tax year must be less than $1.2 million.
When a taxpayer utilizes a micro-captive, he or she can reap certain tax benefits because the entity’s premium income is not subject to tax. The entity pays tax only on investment income.
While the tax benefits are clear, there is significant room for mistakes and errors. For one, some tax minimization firms will recommend for taxpayers to reduce their taxes by emphasizing the mathematical $1.2 million threshold and deemphasizing or omitting other important requirements. Setting up a “paper” captive or micro-captive that exists only to leverage the tax benefit, will attract the attention of the IRS and will often lead to an audit or other tax enforcement action.
IRS Is Focusing on the Abuse of Captives and Micro-Captives
Recently, a representative from the IRS indicated that the agency is looking into taxpayer use of captives and micro-captives as illegal tax shelters. Alexis MacIvor, insurance branch chief in the IRS’s Office of Associate Chief Counsel stated that the organization is in the process of cataloging and analyzing transaction data to determine the level of abuse involving captives. He states that the organization is keeping its options open and, “At the end, we may remove the transaction as a transaction of interest. We may make captive’s a listed transaction. We may do a combination of a listing notice and a transaction of interest.”
While the representative took a diplomatic approach to the issue, in light of the IRS’s past recent actions, it is far more likely that captives will face additional scrutiny in the upcoming months and years.
In 2016, the IRS seemed to acknowledge that an issue existed regarding taxpayer use of captives when it released Notice 2016-66. This notice made micro-captives reportable transactions. This IRS action came on the heels of micro-captives being featured in the IRS’s “Dirty Dozen” tax scams list for the last several years.
The IRS has already indicated that the Office of Tax Shelter Analysis is reviewing and analyzing the thousands of reports from micro-captives the agency has already received. Initial reviews are concentrated on ensuring that forms are accurate and complete. The IRS has already put taxpayers on notice that incomplete or inaccurate forms may be forwarded to the Large Business and International Division examination team. This team will determine whether penalties are appropriate for incomplete disclosures. In any case, it is clear that the IRS is paying attention to this commonly abused tax shelter.
Work with our Tax Attorneys in Los Angeles and Irvine
If you have tax concerns regarding the use of certain tax minimization tactics including the use of micro-captives the Attorneys, CPAs, EAs, and tax professionals of the Tax Law Offices of David W. Klasing may be able to help. To schedule a confidential reduced rate consultation and explore whether Domestic Voluntary Disclosure is right for you, please call 800-681-1295 or schedule online today.
