Is your micro-captive insurance arrangement abusive?

The Internal Revenue Service (IRS) recently issued News Release 2021-82 to remind taxpayers that they should exit abusive micro-captive insurance arrangements. The news release follows the March 10, 2021, U.S. Tax Court decision in Caylor Land & Dev. v. Commission, T.C. Memo. 2021-30 (2021) that a micro-captive arrangement failed to qualify as insurance for federal tax purposes. This case represents the fourth time that the Tax Court sided with the IRS and disallowed the section 831(b) status of a micro-captive arrangement. This was, however, the first Tax Court case to assess penalties on a section 831(b) micro-captive case.

By way of background, micro-captives are being used to insure against business risks. The captive insurance company is owned by the insured or a related party. The insured claims deductions for premiums paid to the captive insurance company. In addition, if the captive insurance company meets the requirements of a small insurance company under IRC section 831(b) (micro-captives), they may elect to be taxed only on investment income. As a result, income from premiums of $2.2 million or less is excluded from taxable income.

The IRS has had micro-captive insurance arrangements on its radar for several years. In 2016, the IRS issued Notice 2016-66 and concluded that certain micro-captive insurance company transactions had the potential for tax avoidance or evasion. Specifically, the IRS is concerned when a business utilizes a related micro-captive insurance company, which elects under IRC Section 831(b) to be taxed only on investment income and therefore excludes the payments directly or indirectly received under the contracts from its taxable income. The service contends that the way the contracts are interpreted, administered and applied is inconsistent with arm’s length transactions and sound business practices. Section 2.01 of the Notice identifies the following as a transaction of interest:

1. A, a person, directly or indirectly owns an interest in an entity (or entities) (Insured) conducting a trade or business;
2. A captive insurance company (Captive), an entity directly or indirectly owned by A or Insured enters into contracts (the Contracts) with Insured that Captive and Insured treat as insurance, or reinsures risks that Insured has initially insured with an intermediary, Company C;
3. Captive makes an election under section 831(b) to be taxed only on taxable investment income;
4. A, Insured, or one or more persons related (within the meaning of section 267(b) or 707(b)) to A or Insured directly or indirectly own at least 20% of the voting power or value of the outstanding stock of Captive; and
5. One or both of the following apply:

• The amount of the liabilities incurred by Captive for insured losses and claim administration expenses during the Computation Period (generally defined as the most recent five taxable years of Captive) is less than 70% of the following:
  1. Premiums earned by Captive during the Computation Period, less
  2. Policyholder dividends paid by Captive during the Computation Period; or
• Captive has at any time during the Computation Period directly or indirectly made available as financing or otherwise conveyed or agreed to make available or convey to A, Insured, or a person related (within the meaning of section 267(b) or 707(b)) to A or Insured (collectively, the “Recipient”) in a transaction that did not result in taxable income or gain to Recipient, any portion of the payments under the Contract, such as through a guarantee, a loan or other transfer of Captive’s capital.

In addition to the Service’s recent tax court victory in March, they have had several other decisions come down in their favor. The IRS prevailed in Avrahami v. Commissioner, 149 T.C. 144 (2017), Reserve Mechanical Corp. v. Commissioner, T.C. Memo 2018-86, and Syzygy Insurance Co. v. Commissioner, T.C. Memo 2019-34. All three of these court cases focused on the following questions:

• Does the captive insurance company operate as an insurance company?
• Is the captive organized, operated and regulated as an insurance agency?
• Is the captive adequately capitalized?
• Are the policies issued by the captive valid and binding?
• Are the premiums reasonable and were they determined by arm’s length transactions?
• Is there a history of claims being paid?

The IRS has consistently disallowed the tax benefits claimed by taxpayers in abusive micro-captive structures. Following their string of victories in court, the IRS offered settlements to over 200 taxpayers that were under examination for similar issues.

Additionally, in early 2020, the IRS sent Letter 6336 to certain taxpayers requesting they review their micro-captive insurance filing positions and notify the IRS in writing if they have stopped receiving deductions and other benefits from their micro-captive insurance arrangements.

If you are involved with or have a micro-captive insurance arrangement, please reach out to your Baker Tilly tax contact to review and discuss your situation.

Tax advice, if any, contained in this communication was not intended or written to be used by any taxpayer for the purpose of avoiding penalties, nor should such information be construed as an opinion upon which any person may rely.