Micro-Captives Retain Their Spot on IRS 2024 Dirty Dozen List

The Internal Revenue Service (IRS) has released its 2024 Dirty Dozen list, and once again, micro-captive insurance arrangements are included on the list.

The IRS said the annual Dirty Dozen list is meant to alert taxpayers, businesses, and tax professionals of potentially abusive tax arrangements, scams, and schemes.

Regarding micro-captive arrangements, an IRS statement said, "Abusive micro-captives involve schemes that lack many of the attributes of legitimate insurance. These structures often include implausible risks, failure to match genuine business needs, and in many cases, unnecessary duplication of the taxpayer's commercial coverages.

The statement continued, "In addition, the 'premiums' paid under these arrangements are often excessive, reflecting non–arm's length pricing."

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.

In 2020, the agency deployed 12 new micro-captive examination teams to substantially increase its examinations of micro-captive insurance transactions, while in April 2021, it warned participants in abusive micro-captive arrangements to exit those arrangements as soon as possible. Days later, the IRS announced that it had formed an office to coordinate the agency's focus on abusive tax avoidance transactions, including abusive micro-captive insurance arrangements.

In January 2022, the IRS Office of Chief Counsel announced it would hire up to 200 additional attorneys to help the agency combat abusive syndicated conservation easements and micro-captive transactions, as well as other abusive schemes.

In April 2023, the IRS and the Treasury Department issued proposed regulations addressing micro-captive insurance transactions that must be reported as either a listed transaction or other transaction of interest. A transaction of interest is a transaction that the IRS believes to have the potential to be tax avoidance or evasive and for which it is monitoring fact patterns.

In the proposed regulations, the IRS went one step further and deemed certain micro-captives as listed transactions.

A listed transaction is a transaction that is the same as or substantially similar to one of the types of transactions that the IRS has determined to be tax avoidance. The IRS provides that participants and material advisors in these transactions are required to disclose each reportable transaction on Form 8886 and are subject to penalties if there is a failure to disclose.

The IRS said in April 2023 that the agency and the Treasury Department intend to finalize the proposed regulations "after due consideration of public comments in 2023."

In June 2023, among others, government entities, captive managers, associations, captives, insureds, owners, and service providers commented on the proposed regulations from the IRS. Many commenters described why captive insurance was important to the insured's business needs and described claims (including COVID claims) that were rejected by the commercial market but covered by more broadly written captive policies.

In its 2024 Dirty Dozen announcement, the IRS said, "Abusive micro-captive transactions continue to be a high-priority enforcement area for the IRS. The agency has prevailed in all micro-captive Tax Court and appellate court cases decided on their merits since 2017."