It’s no secret that the IRS has been spending a lot of time and resources examining micro-captives and their transactions. Since 2014, transactions involving micro-captives have appeared on the IRS “Dirty Dozen” list of tax scams. Anyone with an entity utilizing a micro-captive insurance structure has probably already been audited, and if they haven’t, you can bet it’s coming. Forming a captive insurance entity is a legitimate tax structure, if done correctly; however, connections to certain known “bad actors” when structuring micro-captive insurance companies will likely create ongoing IRS problems.
Just the potential of an IRS examination has intimidated some clients to end their insurance arrangement, regardless of the legitimacy. Recently, the IRS confirmed that 80% of taxpayers under audit for a micro-captive have settled with the IRS. This has only fueled the position of the IRS. They have now announced that 12 new IRS audit teams have been established to continue the examination campaign. These new audit teams are comprised of both the Large Business & International and Small Business/Self-Employed divisions.
It is now believed the IRS will turn their focus to those taxpayers who have filed a Form 8886 but were not part of the original audits, which focused heavily on a few captive management promoters. Recently, a few other captive management companies have become the focus of promoter examinations, and as a result, their micro-captive clients may start seeing audit notices. Regardless of how well they were structured, the companies could become subject to examination simply because the micro-captive promoter fell under IRS scrutiny.
As part of this process the IRS has now sent out Form letter 6336 warning taxpayers of recent court rulings and potential IRS examinations. These letters are sent to everyone who filed a form 8886 in previous years. It requires a response if the captive is no longer in operation and urges others to speak to an independent advisor to ensure their captive meets federal requirements discussed below. It is important to obtain advice from an independent advisor to ensure the captive is operating appropriately and to understand the potential audit risk.
Establishing the Captive
The grey areas of the regulations and the resulting potential tax benefits are what attracts taxpayers to the micro-captive structure. Those same tax benefits create IRS scrutiny.
First and foremost, to establish a valid captive insurance arrangement, there needs to be insurable risk, risk shifting and risk distribution (Rev. Rul. 2002-91) and it must be considered insurance in the commonly accepted sense. These are the central examination issues, and the IRS has developed positions based on these issues that attack some of the most common micro-captive structures.
The IRS defines insurable risk as that which involves the notion of “fortuity:” a chance event that is not certain to happen. Arrangements designed to manage risks that are almost certain to occur (business risk), or that are not the result of fortuitous events, do not fit this IRS definition of insurance. The fortuity principle is central to the notion of what constitutes insurance. The insurer should not be asked to provide coverage for a loss that is reasonably certain or expected to occur within the policy period. It is explained that, for an event to be fortuitous, it must not be certain to happen.
The more important issue to address is why a certain type of insurance was selected.
- Perhaps the business has a long history of dealing with losses from a particular issue or the company experienced a large exposure once in the past.
- Perhaps the company was unable to obtain insurance coverage, or it was prohibitively expensive.
Regardless, the risk to be insured should arise from the business’ risk issues, not picked from a menu of available risks provided by a captive management company. In other words, business and risk advisors should be consulted when determining the risk exposures before talking to anyone about a captive.
Risk Shifting and Risk Distribution
Risk shifting and risk distribution are evaluated when determining the captive structure and how it will operate. Valid insurance shifts the insured’s risk of a potential loss to a third party. However, funds set aside as reserves against contingent losses, even if paid to an insurance company, will be considered purely non-deductible and considered “self-insurance.”
Risk Distribution (from Rev. Rul. 2002-91) requires pooling of premiums such that the insured is not, in
significant part, paying for its own risk as discussed in the case of Humana, Inc. v. Commissioner. Under Rev. Rul. 2002-89, risk distribution exists where more than 50% of a captive’s premiums are received from unrelated parties, and more than 50% of a captive’s risks assumed are from unrelated parties. Distributing risk allows the insurer to reduce the possibility that a single costly claim will exceed the amount taken in as premiums. By assuming numerous, relatively small independent risks that occur randomly over time, the insurer smooths out potential losses to more closely match its receipt of premiums.
There are two theories in which taxpayers with single owner captives have been successful in sharing risk: “brother-sister” (siblings) and enough “third-party,” “outside” or “unrelated” business (strangers). The IRS lost two important cases when it challenged the deductibility of premiums. Sears, Roebuck & Co. v. Commissioner and Harper Group and Includible Subsidiaries v. Commissioner. The IRS has however been successful in attacking arrangements which borrow risk from a pooling arrangement mixed with other third party captives who take back a quota share (percentage) of the pooled risk.
Important facts in Rev. Rul. 2002-89 include proper pricing, which verifies price was a correct proxy for volume of risk because premiums were set according to industry formulas and standards. Then too, proper conduct was analyzed to confirm all actions by the parties involved were consistent with standards applicable to an insurance arrangement between unrelated parties.
Recent micro-captive cases won by the IRS (Syzygy Ins. Co. v. Commissioner, Reserve Mech. Corp. v. Commissioner and Avrahami v. Commissioner) have raised issues questioning why the captive was created in the first place. The IRS considers these big wins in a string of cases they have litigated. However, regardless of the difficult facts in these cases, no penalties were sustained, making the cases largely losses by the IRS. For the most part, they have made the quota pool arrangements used for many of these captives a continuing target for the IRS. And, despite not winning penalties in these cases, the IRS is still pushing for 40% penalties under the codified economic substance doctrine (IRC § 7701(o)).
In making this economic substance determination, the courts analyze two key factors:
- Objective: Did the questioned transaction have reasonable potential to produce nontax economic benefit for the taxpayer?
- Subjective: Did the taxpayer have a nontax business purpose?
The IRS hopes this analysis highlights the intent of the taxpayers and allows them to win penalties.
In a micro-captive case, premiums paid will be heavily analyzed, and someone must be able to explain why premiums paid are much higher than comparable commercial insurance offerings. Of course, there are many kinds of captives, and the ones addressed in recent Tax Court cases were deemed to be formed not for insurance purposes, but rather to stash inflated premiums at deferred and slightly lower tax rates. Recent tax law changes to tax rates make it less substantial, which makes it more useful as an insurance cost savings vehicle than a potential tax savings vehicle.
Maintaining the Captive
Once you have passed the hurdles of establishing a need for a captive, it takes significant time and cost to maintain the validity of the structure. It is also important to determine which tax forms to file, whether domestic or foreign, and properly file and document all records. Most commonly, Form 1120-PC will be filed with an IRC 953(d) election to treat a foreign domiciled corporation as a U.S. taxpayer. Additionally, most elect to take advantage of IRC 831(b) if premium income is below 2.3 million, as it will not be taxed, thereby potentially limiting the captive to a single tax on dividends.
A controlled foreign corporation will file a Form 5471. Having foreign bank accounts will also add to the complex procedural requirements, as the IRS is scrutinizing and requiring strict compliance related to these types of accounts. In addition, a Report of Foreign Bank and Financial Accounts under the Bank Secrecy Act, FinCEN Form 114, must be filed.
IRC 831(b) captive insurance is considered a Listed Transaction, requiring Form 8886, Reportable Transaction Disclosure Statement, to be prepared each year. Any taxpayer, including an individual, trust, estate, partnership, S corporation or other corporation, that participates in a reportable transaction and is required to file a federal tax return or information return must also file Form 8886 disclosing the transaction. The filing requirement applies whether or not another party, related or otherwise, has filed a disclosure for that transaction.
A taxpayer must attach a Form 8886 disclosure statement to each tax return reflecting participation in the reportable transaction and must also send a copy of the Form 8886 to the Office of Tax Shelter Analysis (OTSA). See Treasury Regulation § 1.6011-4(e)(1) and Form 8886 instructions.
IRS Exam of the Captive
After establishing a captive and maintaining the captive from year to year, the inevitable IRS examination of the captive will most likely follow. During an examination, you can expect a face-to-face interview with the IRS, lengthy and in-depth document requests and a final settlement offer. Until the IRS started offering a settlement procedure, each taxpayer was treated differently, and many were treated unfairly. Some micro-captives were pushed into a courtroom by IRS agents and attorneys with little regard to the facts differentiating one micro-captive from another. Apparently, the IRS finally realized they weren’t making good penalty cases and were otherwise spending time and resources on what typically amounts to around a 14% tax rate differential for all their efforts.
The limited settlement offer position developed by the IRS followed three U.S. Tax Court decisions confirming that certain micro-captive arrangements are not eligible for federal tax benefits. The worst of which, Syzygy Ins. Co. v. Commissioner, denied a deduction for premiums paid, taxed the premiums paid at the captive and taxed the dividends paid by the captive. The terms of the settlement required a 90% concession of the income tax benefits claimed by the taxpayer, together with appropriate and potentially reduced penalties. It is antici.pated that these will be the same settlement terms offered to taxpayers who fall under new examinations in the coming months.
Settlement by taxpayers on the micro-captive issue is not necessarily the result of believing their transaction was abusive as determined by the IRS, but it results more from the fact that fighting the IRS can be costly. Expert witness fees alone for captive cases can exceed $100,000. But the unseen cos—sometimes doing the greatest damage—is that the time required to fight these cases can be very emotionally draining.
Captive Insurance Arrangements Must be Made Carefully
Once all the above factors have been considered and it is determined that a captive insurance arrangement is still a valuable risk mitigation solution, it is important that proper regulations and procedures are followed according to IRS guidelines.