In September, the IRS announced it would mail time-limited settlement offers to certain taxpayers under audit who had participated in abusive microcaptive insurance transactions (IRS News Release IR-2019-157). Only taxpayers who receive an offer by mail are eligible.
A captive insurance arrangement is one in which an insurance company insures only the risks of companies related to it. Captive insurers designated "micro" are generally those intended to qualify as eligible to make a Sec. 831(b) election, by which certain small insurance companies may be taxed only on their investment income. But as part of that eligibility (or for a company to be subject to taxation more generally as an insurance company), taxpayers must be able to show the insurer is in fact a bona fide insurance company within the meaning of Secs. 831(c) and 816(a). Case law guidance requires consideration of all the facts and circumstances in making this determination, and courts have applied four criteria: (1) The arrangement involves insurance risk; (2) the arrangement shifts risk of loss to the insurer; (3) the insurer distributes risk among policyholders; and (4) the arrangement meets commonly accepted notions of insurance.
Examples of insurance risk include workers' compensation, property and casualty loss, general liability, and other acceptable commercial risk relevant to the industry of the insured. Risk distribution occurs when an insurer pools a large enough collection of unrelated risks (i.e., risks that are generally unaffected by the same event or circumstance) (see Rent-A-Center, Inc., 142 T.C. 1, 24 (2014)). The analysis focuses on both the number of independent risk exposures and the number of related entities that are insured (see Avrahami, 149 T.C. 144 (2017)). In looking into whether risk shifted from an insured to a captive, the court will apply the step-transaction, substance-over-form, and economic substance doctrines. The analysis focuses on whether the insured or the captive bears the economic risks relevant to the insurance policy.
IRS COURT VICTORIES
To determine whether an arrangement constitutes insurance in the commonly accepted sense, courts have looked at the following facts: (1) whether the company was organized, operated, and regulated as an insurance company; (2) whether it was adequately capitalized; (3) whether the policies were valid and binding; (4) whether premiums were reasonable and the result of arm's-length transactions; and (5) whether claims were paid. None of these factors are mutually exclusive.
The IRS has won the following Tax Court cases in recent years involving captive and microcaptive insurance transactions: In Avrahami, the individual petitioners took large loans from their captive after it had accumulated a surplus. The Tax Court found there was no risk distribution when the captive insured only seven types of direct policies covering exposures for four related entities. A portion of the loans were considered distributions, and the Sec. 831(b) election of the captive was invalidated, resulting in the disallowance of deductions for paid insurance premiums (see also "Tax Matters: Microcaptive Premium Deductions Disallowed," JofA, Nov. 2017).
In Reserve Mechanical Corp., T.C. Memo. 2018-86, a captive was formed to provide additional coverage that the petitioner's third-party insurers would not cover. The Tax Court found there was no risk distribution because the policies were "cookie-cutter" and not necessarily appropriate for the petitioner's business. The policies indicated on their face that they were copyrighted material of a company that managed and administered the microcaptive through a "turnkey" operation and did not meet the needs of each of the insureds; rather, all the entities in the group had the same policy with the same premium, regardless of their size or risk. The court also found that the premiums were not actuarially calculated and were a one-size-fits- all rate for all of the insured entities (see also "Tax Matters: Tax Court Again Denies Microcaptive Insurance Arrangement," JofA, Sept. 2018).
In Syzygy Insurance Co., T.C. Memo. 2019-34, the Tax Court held that the petitioner's captive was organized and regulated as an insurance company and met the state's minimum-capitalization requirements; however, the captive charged unreasonable premiums and issued policies late and with conflicting and ambiguous terms. For the claims that were filed, no due diligence was done to determine whether they were covered under the policy. The court held that the captive's Sec. 831(b) election was invalid, and the insurance deductions were disallowed (see also "Tax Matters: Tax Court Denies Microcaptive Insurance Arrangement," JofA, July 2019).
Following these wins, the IRS decided to offer settlements to taxpayers that have participated in certain microcaptive transactions and are currently under exam. The IRS has stated that it will require the taxpayer to make a substantial concession of the tax benefits, with the appropriate penalties.
Among its terms, the settlement disallows 90% of any deductions claimed for captive insurance premiums for all open tax years. The remaining 10% would be allowed. Any captive-related expenses claimed on the insured's returns, such as fees paid to captive managers for formation or maintenance of a captive, would be disallowed. The captive would not be required to recognize taxable income for received premiums. In addition, the captive must liquidate if it has not already done so, or recognize income for a deemed qualified dividend and adjust its basis for deemed capital contributions.
Under the settlement, the accuracy-related penalty applies at a reduced rate of 10%. This rate can be lowered to 5% if the taxpayer has not previously participated in any other reportable transaction and signs a declaration to that effect or obtains a declaration from an independent tax professional stating the taxpayer relied on that professional's advice. The penalty will be reduced to zero if the taxpayer supplies a reportable transaction declaration and an independent tax professional's declaration.
The taxpayer must pay the full balance of the deficiency and any applicable penalties and interest. Taxpayers in addition must file gift tax returns and pay gift tax, absorb credit, or both for any transfer of value to the shareholders of the captive.
Taxpayers that decline an offered settlement will not be eligible for any potential future microcaptive settlement initiatives. Those taxpayers will continue to be audited under normal procedures and may be subject to full disallowance of the captive insurance tax benefits and the imposition of all applicable penalties.
Editor's note: A version of this column was first published as "Tax Practice & Procedures: IRS Offers Time-Limited Settlement on Microcaptive Insurance Issues" in The Tax Adviser, Jan. 2020.
Mark Heroux, J.D., is a partner with the National Tax Services Group at Baker Tilly Virchow Krause LLP in Chicago and is a member of the AICPA Tax Practice & Procedures Committee.
To comment on this article or to suggest an idea for another article, contact Paul Bonner, a JofA senior editor, at Paul.Bonner@aicpa-cima.com.