IRS issues stern warning that abusive microcaptive insurance schemes will be aggressively targeted
TAX ALERT | July 11, 2022
Authored by RSM US LLP
On May 13, 2022, the U.S. Court of Appeals for the 10th Circuit ruled in favor of the IRS in a challenge to an insurance arrangement that a taxpayer entered into with its offshore captive insurance company. Reserve Mechanical Corp. v. Commissioner, No 18-9011 (10th Cir.). The appeals court affirmed an earlier Tax Court decision that denied all insurance expense deductions taken by the taxpayer and held that the premium payments made by the taxpayer to its offshore insurance company were taxable to the insurance company. Following this win, on June 7, 2022, the IRS issued News Release IR-2022-118, reiterating that it will aggressively pursue litigation to assert tax deficiencies and penalties against similarly situated taxpayers who participate in what the IRS considers to be abusive microcaptive insurance arrangements.
Generally, a microcaptive insurance transaction is an insurance agreement between a parent company and an insurer under its control, that is, a “captive” insurance company. An insurance company that qualifies as a small insurance company under section 831(b) receives favorable tax treatment such as taxation only on investment income and not on premiums received. These insurance companies can be exempt from income tax if (1) the gross receipts for the taxable year do not exceed $600,000 and (2) more than 50 percent of such gross receipts consists of premiums. See section 501(c)(15)(A)(i). Captive insurance companies are often used when coverage in conventional insurance markets is unavailable or impractical to obtain. Some advisers, however, are overly focused on the tax advantages. They are promoting arrangements that don’t provide true insurance coverage, which are subject to challenge by the IRS. Taxpayers forming insurance companies with invalid arrangements risk substantial tax deficiencies and penalties if audited by the IRS.
IRS has steadily escalated its pursuit of abusive microcaptive insurance arrangements
The IRS has consistently included microcaptive insurance arrangements on its “Dirty Dozen” list of common tax scams. In 2016, the IRS first published Notice 2016-66 where it identified several characteristics of what it considered to be an improper microcaptive insurance arrangement. These characteristics included coverage that does not match a business need or involves an implausible risk, or coverage that duplicates coverage already provided by an unrelated insurance company.
In 2017, the IRS issued an administrative summons to the Delaware Department of Insurance seeking the filings that two advisory companies made to obtain certificates of authority for their client insurance companies. The IRS alleged that these two advisors were promoting improper microcaptive insurance arrangements that substantially understated the true income tax liability of their clients. When the Delaware Department of Insurance refused to comply with the summons, the United States commenced a lawsuit in federal district court to enforce compliance. The IRS believes that at least 225 taxpayers are involved with these two promoters.
In 2019, after winning several cases in the Tax Court, the IRS sent letters to taxpayers under examination offering a settlement initiative (News Release IR-2019-157). Approximately 80 %of the taxpayers receiving the letter accepted the terms of the settlement initiative. In 2020, the IRS established several new microcaptive examination teams to aid its effort in examining these potentially abusive arrangements, including the taxpayers who did not accept the settlement initiative (News Release IR-2020-26).
The recent Reserve Mechanical Corp. decision constitutes the first appellate decision upholding the circumstances under which microcaptive insurance arrangements are abusive. Examples of these circumstances include: unreasonable premium payments, duplicative insurance coverage and no true distribution of risk. In the news release, the IRS reiterated its intention to “use all available legal options to challenge improper attempts to avoid or evade U.S. income tax.” Abusive microcaptive transactions can result in the loss of deductions, required income inclusion, and for transactions lacking economic substance, the assessment of a strict liability penalty of 40 %
Taxpayers and tax advisors should be on notice of the significant exposure
Taxpayers considering entering a promoted microcaptive insurance transaction are encouraged to speak to a qualified independent advisor. Taxpayers already engaged in a promoted microcaptive insurance arrangement should seek advice from a qualified tax advisor to discuss their options as some settlement opportunities exist for taxpayers that voluntarily come forward to disclose and resolve their participation in the arrangement. Proactive disclosure is particularly important for taxpayers engaged in microcaptive arrangements created or promoted by certain companies that are currently the subject of summons enforcement action.
If you have any questions about IRS operations or have a specific question about IRS procedures, please do not hesitate to contact a member of RSM’s Tax Controversy team.
Call us at (325) 677-6251 or fill out the form below and we'll contact you to discuss your specific situation.
This article was written by Alina Solodchikova, John Cardone, Tiffany Mosely and originally appeared on 2022-07-11.
2022 RSM US LLP. All rights reserved.
The information contained herein is general in nature and based on authorities that are subject to change. RSM US LLP guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. RSM US LLP assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein. This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer.
RSM US Alliance provides its members with access to resources of RSM US LLP. RSM US Alliance member firms are separate and independent businesses and legal entities that are responsible for their own acts and omissions, and each is separate and independent from RSM US LLP. RSM US LLP is the U.S. member firm of RSM International, a global network of independent audit, tax, and consulting firms. Members of RSM US Alliance have access to RSM International resources through RSM US LLP but are not member firms of RSM International. Visit rsmus.com/about us for more information regarding RSM US LLP and RSM International. The RSM logo is used under license by RSM US LLP. RSM US Alliance products and services are proprietary to RSM US LLP.
Condley and Company, LLP is a proud member of the RSM US Alliance, a premier affiliation of independent accounting and consulting firms in the United States. RSM US Alliance provides our firm with access to resources of RSM US LLP, the leading provider of audit, tax and consulting services focused on the middle market. RSM US LLP is a licensed CPA firm and the U.S. member of RSM International, a global network of independent audit, tax and consulting firms with more than 43,000 people in over 120 countries.
Our membership in RSM US Alliance has elevated our capabilities in the marketplace, helping to differentiate our firm from the competition while allowing us to maintain our independence and entrepreneurial culture. We have access to a valuable peer network of like-sized firms as well as a broad range of tools, expertise and technical resources.
For more information on how Condley and Company can assist you, please call (325) 677-6251.