In an early October announcement, the IRS outlined their focus on micro-captives. The statement noted that the “IRS expands enforcement focus on abusive micro-captive insurance schemes; taxpayers urged to consult independent tax advisor before October 15 filing deadline.”
There has been a significant increase in IRS exam activity in the recent two months, with indications that the IRS will continue to drastically increase these examinations without discrimination by type or pooling arrangement. However, as noted in previous announcements, this typically does not relate to F&I type captives, but captives ensuring enterprise risk in an 831(b) arrangement.
The IRS had indicated it is no longer providing settlement offers to those engaged in micro-captive insurance arrangements as part of examination resolutions. They have apparently reversed this position for some taxpayers and have indicated they will be sending settlement letters under a new settlement procedure. The terms are far less generous than previous settlements. This includes a minimum 5% penalty on taxes required under the terms provided, and only if the taxpayer can demonstrate they received affirmative advice independent of the captive management company.
Go behind the scenes of captive insurance.
IRS Warns Taxpayers to Exit Captive Insurance Transactions
As previously noted, the IRS has warned taxpayers numerous times to consider exiting these transactions and consult with an independent tax advisor on next steps. The IRS previously issued letter 6336 to those taxpayers identified in having the reportable transaction listed on their return. The letter asks the taxpayer to state whether the captive is discontinued or the last year of deductions taken, or invites them to file a corrected amended return.
“For those taxpayers that do not exit the transaction and continue taking such deductions, the IRS will disallow tax benefits from transactions that are determined to be abusive and may also require domestic captives to include premium payments in income and assert a withholding liability related to foreign captives. The IRS will also assert penalties, as appropriate, including the strict liability penalty that applies to transactions that lack economic substance under sections 7701(o) and 6662(i) (40%). The IRS Office of Chief Counsel will continue to litigate these abusive transactions in Tax Court.”
Enforcement Action to Be Taken
Enforcement action and exams including captive promoter projects and exams based on IRS letters 6336 are in full force, and it can be extremely costly to respond to document requests. And now, with a limited settlement option to fall back on, it’s more important than ever to evaluate your captive arrangement. Of course, the validity of the micro-captive arrangements is still hotly contested in the courts, and it may take several years before an objective opinion determines which captives are properly formed and run. Many taxpayers will be examined and pressured to take the settlement.
However, if you want to mitigate the potential 5% to 40% penalty, there is still an opportunity to amend your return and protect against this result. Additionally, amending to remove the deduction for premiums paid will allow you to follow up with a protective claim to take those deductions if later court rulings find in favor of your type of captive/pooling arrangement. You still will need to pay the tax on the premiums, but you would not be subject to penalties. This must be done before you receive an audit notice.
Take part in the 2020 Micro-Captive Resolution.
The Threat of IRS Examination
Just the potential of an IRS examination has intimidated many taxpayers to end their insurance arrangement regardless of the legitimacy. Recently, the IRS has confirmed that 80% of taxpayers under audit for their micro-captive have settled with the IRS. This has only fueled the position of the IRS, and it has now announced that 12 new IRS audit teams have been established. These audit teams are comprised of both Large Business & International and Small Business/Self-employed divisions.
As previously mentioned, the IRS has issued limited settlement procedures to a few taxpayers currently in exam. The settlement would require surrendering 100% of the premium and expense deductions taken with a 5-15% penalty depending on whether the taxpayer relied on advice of a competent professional. The captive would be liquidated with taxes paid on the liquidation and a potential penalty as well. We are hoping for more clarification from the IRS. We have had conflicting statements about the liquidation treatment of the premium payments subject to the settlement, but in previous settlements those were treated as capital contributions.
Let’s make sense of captive insurance arrangements and the necessary compliance.
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