Captive No More! IRS Offers to Settle Lawsuits over Questionable Micro-Captive Insurance Arrangements

Nearly 200 taxpayers being audited for abusive micro-captive insurance arrangements – a practice that since 2014 has made the agency’s “Dirty Dozen” list of tax scams – may be able to breathe a sigh of relief after being offered a settlement by the IRS.

By issuing a detailed notice of what constitutes an abusive micro-captive insurance arrangement, the IRS also provided clarity to taxpayers seeking to qualify for a popular tax benefit.

In a micro-captive arrangement, a person directly or indirectly owns an interest in a business and at the same time directly or indirectly owns a “captive entity” that provides insurance for the business. The insured business entity pays the captive entity under a contract and deducts the insurance premium payments as business expenses. The captive entity treats these payments as insurance premiums and elects to be taxed on its taxable investment income instead of its premium income. In these transactions, the captive entity often offers coverage only to the insured business and persons related to or affiliated with the insured business.

These arrangements have been met with skepticism, however, and the IRS has often not allowed micro-captive insurance structures to qualify to be taxed only on investment income if they lack certain attributes of a genuine insurance company. The IRS has listed abusive micro-captive insurance transactions on its “Dirty Dozen” list of tax scams since 2014 and identified certain micro-captive transactions as having the potential for tax avoidance and evasion.

The IRS has noted, however, that related parties may use captive insurance companies for risk management purposes, but may not use these arrangements simply to avoid taxes. The IRS pointed out that in improper arrangements, the “manner in which the contracts are interpreted, administered, and applied is inconsistent with arm’s length transactions and sound business practices.”

For more information about the settlement and the specific characteristics of abusive micro-captive insurance arrangements, contact a Weaver professional.