IRS Warns Participants To Exit Abusive Micro-Captive Arrangements

The Internal Revenue Service (IRS) is urging participants in abusive micro-captive arrangements to exit those arrangements as soon as possible.

In a statement, the IRS said it has increased examinations of micro-captive arrangements and noted that it recently won another US Tax Court case that determined that the arrangement in question wasn't eligible for the benefits the small captive’s owners claimed.

The IRS statement cited the March 10 ruling in Caylor Land & Dev v. Commissioner, T.C. Memo. 2021-30 (2021) in which the Tax Court found the micro-captive arrangement failed to qualify as insurance for federal tax purposes.

"This decision follows several earlier Tax Court decisions that also confirmed the IRS's determinations that certain micro-captive arrangements were not eligible for the claimed federal tax benefits," the IRS statement said. "In Caylor, the Tax Court also sustained the IRS's determination of accuracy-related penalties and rejected the taxpayer’s claim of reliance on tax advice."

The IRS encouraged taxpayers engaged in abusive micro-captive transactions to consult independent tax advisors before filing their 2020 tax returns and suggested that taxpayers consider exiting the transactions and not reporting deductions associated with the arrangements.

"In multiple cases before the courts, judges have held that these 'fanciful' and 'unreasonable' arrangements don't add up to insurance in the commonly accepted sense," IRS Commissioner Chuck Rettig said in the IRS statement. "I strongly urge participants in these arrangements to get independent legal advice separate from those who helped steer them into these abusive arrangements."

So-called micro-captives, small captive insurance companies that elect to be taxed under section 831(b) of the Internal Revenue Code, which allows small insurance companies to be taxed only on their investment income, have been the target of IRS scrutiny in recent years. Until 2020, micro-captives had been included for several years on the IRS's annual "Dirty Dozen" list of potentially abusive transactions.

The IRS has won several tax cases against such small captive insurance companies, though many in the industry, including some domicile organizations, have suggested the federal tax agency has gone overboard in its scrutiny.

In its latest statement, the IRS noted that in the past several years, it has intensified its efforts to combat abusive micro-captive insurance arrangements. In 2020 the agency deployed 12 new micro-captive examination teams to substantially increase its examinations of micro-captive insurance transactions.

"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 on foreign captives," the IRS statement said. "The IRS will continue to assert penalties, as appropriate, including the strict liability penalty that applies to transactions that lack economic substance."