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The IRS announced (IR-2020-26) on January 31, 2020, that 12 new examination teams are expected to audit more taxpayers in the coming months for participating in micro-captive insurance transactions that the IRS believes to be abusive. Further, the IRS announced that most taxpayers already under audit for participating in these transactions (nearly 80%) have accepted its time-limited settlement offer.

Background

Businesses can create "captive" insurance companies to insure against risks. The insured business claims deductions for premiums paid for insurance policies, and those amounts are paid as premiums to a "captive" insurance company owned by the insured or related parties. A traditional captive insurance company's taxable income is largely computed by reference to its earned premium income attributable to the insured business. A small captive insurance company, i.e., one that meets the standards set forth in IRC Section 831(b)(2) (micro-captives), may elect to pay tax only on its net investment income.

The IRS has long worried that micro-captive insurance transactions could be used for tax avoidance. Accordingly, several years ago, the IRS issued Notice 2016-66, identifying certain transactions with micro-captives as "transactions of interest," and requiring taxpayers participating in such micro-captive insurance transactions on or after November 2, 2006, (and their material advisors) to disclose the transactions as described in Treas. Reg. Section 1.6011-4 (see Tax Alert 2016-1885). More recently, the IRS has won three Tax Court cases challenging micro-captive transactions (See Avrahami v. Commissioner, 149 TC 144 (2017), Syzygy Insurance Co., Inc. v. Commissioner, TC Memo. 2019-246, and Reserve Mechanical Corp. v. Commissioner, TC Memo. 2018-211). In 2019, the IRS offered settlements to certain taxpayers involved in these transactions.

Implications

While the IRS announcement should not preclude taxpayers from exploring risk-financing structures that may be available to them, including using a captive insurance company, taxpayers participating or planning to participate in a micro-captive transaction (and to elect IRC Section 831(b) treatment for the captive) should make sure that all appropriate steps are taken to document the business case for the transaction. The courts have occasionally identified the criteria taxpayers should consider when evaluating whether a planned captive structure, especially a micro-captive structure, is valid and is not being undertaken for tax-avoidance purposes.

Taxpayers considering implementing or continuing a captive insurance arrangement should make sure that:

• All insurance contracts are structured appropriately
• Acceptable actuarial and arm's-length principles are being utilized
• All aspects of the entire arrangement (including claim review and processing) are well documented
• The documentation highlights how the arrangements line up against the four basic pillars for determining the tax qualification of an insurance arrangement: risk shifting, risk distribution, existence of insurable risk, and operating the arrangement under the common notions of insurance

In response to Notice 2016-16, a captive insurance industry consulting firm (CIC Services, LLC) unsuccessfully argued before a divided U.S. Court of Appeals for the Sixth Circuit that the issuance of Notice 2016-16 violated the federal Anti-Injunction Act. In January 2020, CIC Services, Inc., filed a petition for a writ of certiorari with the U.S. Supreme Court.

While we do expect the IRS to continue using available information to ascertain which micro-captive transactions should be examined and disallowed, the announcement of new examination teams focused on micro-captive transactions should not be viewed as a general attack on captive insurance structures. Rather, captive insurance structures are an important risk management tool that may also provide opportunities for tax planning. As the micro-captive matter illustrates, however, there is no substitute for developing a viable business plan; pricing on an arms-length basis; and properly documenting business purpose, underwriting, and compliance with contractual terms.

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