US GAO Recommends Improvements in IRS Micro-Captive Audit Process

The US Government Accountability Office (GAO) has recommended that the Internal Revenue Service (IRS) clarify guidance on offshore micro-captive insurance audits and establish a formal review system for investigations.

In a recently released statement describing the findings of a GAO study into how the IRS conducts its enforcement of offshore insurance compliance issues, the GAO said that offshore insurance arrangements, including micro-captives, can be used to improperly claim tax benefits.

"We found that IRS could improve how it reviews its audits and investigations of such arrangements," the GAO statement said. "For example, IRS managers have little guidance for when an audit should have a managerial review. IRS also could improve how it records and analyzes its quality reviews of investigations."

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, the IRS announced that it was looking to hire up to 200 additional tax attorneys to focus on abusive tax schemes, including abusive micro-captive arrangements.

In its statement, the GAO noted that micro-captives have regularly been included in the IRS's "Dirty Dozen" tax schemes list.

The GAO review found that the IRS uses two approaches to ensure that micro-captive insurance audits are conducted properly.

• · Managerial reviews: Various types of written reviews, including in-process case reviews and workload reviews, among others, performed by the managers overseeing the audit
• · Quality reviews: Reviews conducted by independent reviewers outside of the audit work-stream to ensure that all processes meet the IRS's standards

IRS officials have said that its current oversight practices are sufficient to ensure that micro-captive audits are conducted accurately, the GAO statement said. "However, IRS's application of its review approaches could be enhanced," the GAO said.

The GAO noted that the IRS also investigates whether promoters of micro-captive schemes violate tax law. "IRS's oversight of promoter investigations has no systematic method that would enable IRS to evaluate the effectiveness of its micro-captive promoter investigation program," the GAO said.

For example, the IRS's Small Business and Self Employed Division lacks a systematic method to identify micro-captive promoter investigations for quality review, the GAO said. From fiscal years 2016 through 2020, the IRS's Large Business and International Division did not apply quality reviews to any micro-captive insurance promoter investigations.

"Conducting formal reviews more systematically would better assure the quality of IRS's promoter investigations on micro-captive arrangements," the GAO said.