We’ve previously discussed the issue of microcaptive insurance companies, such as the IRS’s successful attack on such an arrangement in the case of Avrahami, et al v. Commissioner, 149 TC No. 17.[1]  The IRS has continued to go after taxpayers who had entered into such arrangements, with Tax Notes Today Federal reporting on September 17, 2019 that 500 cases involving this matter were pending before the Tax Court and even more were in process in Exam and Appeals.[2]  Such structures were identified as listed transactions in Notice 2016-66.[3]

The IRS has now decided to offer a settlement option to up to 200 taxpayers with such issues outstanding, per a press release issued by the agency.[4]  The release notes that:

Taxpayers eligible for this offer will be notified by letter with the applicable terms. Taxpayers who do not receive such a letter are not eligible for this resolution.[5]

The IRS notes the broad classes from which the 200 will and will not be drawn:

The initiative is currently limited to taxpayers with at least one open year under exam. Taxpayers who also have unresolved years under the jurisdiction of the IRS Appeals may also be eligible, but those with pending docketed years under Counsel’s jurisdiction are not eligible.[6]

The notice points out the IRS’s successes in challenging this strategy:

Following wins in three recent U.S. Tax Court cases, the IRS has decided to offer settlements to taxpayers currently under exam. In recent days, the IRS started sending notices to up to 200 taxpayers.

Tax law generally allows businesses to create “captive” insurance companies to protect against certain risks. Under section 831(b) of the Internal Revenue Code, certain small insurance companies can choose to pay tax only on their investment income. In abusive “micro-captive” structures, promoters, accountants or wealth planners persuade owners of closely held entities to participate in schemes that lack many of the attributes of genuine insurance.

The IRS has consistently disallowed the tax benefits claimed by taxpayers in abusive micro-captive structures. Although some taxpayers have challenged the IRS position in court, none have been successful.  To the contrary, the Tax Court has now sustained the IRS’ disallowance of the claimed tax benefits in three different cases.[7]

The news release also contains a warning that taxpayers who decline the invitation to accept the settlement offer should not expect a better result in Appeals:

Although taxpayers who decline to participate will have full Appeals rights, the IRS Independent Office of Appeals is aware of this resolution initiative. Given the current state of the law, it is the view of the IRS Independent Office of Appeals that these terms generally reflect the hazards of litigation faced by taxpayers, and taxpayers should not expect to receive better terms in Appeals than those offered under this initiative.[8]

The news release also warns that those who are offered the settlement agreement but decline to enter it will not be eligible for later settlement agreements.

The Tax Analysts article cited earlier on the issue notes that the worst case result for a taxpayer who loses on this issue at the end of the day is a denial of all deductions for payments made to the captive insurance carrier and recognition of the premiums as income. [9] 

The article quotes Stephen T. Miller, a former acting IRS commissioner and now with Alliantgroup, LP, regarding what taxpayers are currently being offered in Appeals—full disallowance of the deduction of any premiums, but being will to take a less severe line on taxability of the premiums to the captive and potentially even on the return of the funds from the captive to the owners.  Mr. Miller suggested that it is likely the program has been designed to offer terms similar to those being given in Appeals to those who agree to participate.[10]

Taxpayers who receive the letter will need to make a decision on whether to take the IRS up on the offer (the exact terms of which are far from clear in the press released) or to continue to press their case, hoping for a more favorable outcome. 

[1] See “No Deduction Allowed for Premiums Paid to Related Entity in Microcaptive Structure,” Current Federal Tax Developments website, August 22, 2017, https://www.currentfederaltaxdevelopments.com/blog/2017/8/22/no-deduction-allowed-for-premiums-paid-to-related-entity-in-microcaptive-structure

[2] Emily Foster, “IRS Initiates Settlement Offer for Select Microcaptive Insurers,” Tax Notes Today Federal, September 17, 2019, https://www.taxnotes.com/tax-notes-today-federal/insurance/irs-initiates-settlement-offer-select-microcaptive-insurers/2019/09/17/29y9z (subscription required), retrieved September 17, 2019

[3] https://www.irs.gov/pub/irs-drop/n-16-66.pdf, retrieved September 17, 2019

[4] IR 2019-157, “IRS offers settlement for micro-captive insurance schemes; letters being mailed to groups under audit,” IRS website, https://www.irs.gov/newsroom/irs-offers-settlement-for-micro-captive-insurance-schemes-letters-being-mailed-to-groups-under-audit, September 16, 2019, retrieved September 17, 2019

[5] Ibid

[6] Ibid

[7] Ibid

[8] Ibid

[9] Foster, Tax Notes Today

[10] Ibid