With quarantine-related IRS offices reopening, and the October filing deadline on the horizon, the IRS is redoubling its focus on section 831(b) captives. On October 1, the Service issued a notice titled “IRS expands enforcement focus on abusive micro-captive insurance schemes; taxpayers urged to consult independent tax advisor before Oct. 15 filing deadline.” Not the punchiest of headlines, but the intent is clear. Commissioner Rettig intends to make good on his promise to focus on allegedly “abusive” micro-captive arrangements. Now the IRS is recommending that captive participants hire independent counsel to review their captive arrangement (preferably before the 10/15 filing deadline). Considering the actions of the IRS over the last twelve months, now may be a good time for captive participants to consult with independent tax counsel on the operation of their captives and potential audit preparedness. Here’s a brief overview.
In September of 2019, after three sizeable Tax Court victories (Avrahami, Syzygy, and Reserve Mechanical), the Service issued a settlement offer to select taxpayers in micro-captive audits. The offer requires taxpayers to hang up their captive operations, and concede to a 90% disallowance in captive insurance premium deductions. In exchange, the Service offers the potential for complete penalty abatement (0-10%), and will abstain from treating the would-be insurance premiums as income to the captive. The terms of the settlement, while not exactly a windfall for taxpayers, is a stark departure from the Service’s general inclination to attack the “Economic Substance” of micro-captive transactions it suspects of abuse. A transaction lacking Economic Substance (as defined in section 7701(o)), is hit with a penalty equal to 40% of additional taxes owed. Moreover, this is a strict liability penalty—the taxpayer gets no relief for relying on advisors or acting in good faith. Although this is a worrisome concept, it is worth noting that the Tax Court has not yet upheld the Economic Substance penalty against a captive participant in a published case.
Since the first tranche of settlement offers, Rettig and others at the Service have indicated they intend to ramp up captive compliance activity. The Service formed twelve new audit groups that will work on captive insurance exams, exclusively, for the next three years. In March of this year, the Service sent Letter 6336: a “soft compliance” letter, requesting that recipients notify the Service if their captive has wrapped up, and otherwise suggests the taxpayer consider voluntarily amending his or her own returns to remove any tax benefit generated by a captive. COVID related office closures put a brief pause on compliance measures, but now the Service seems to be regaining momentum.
The Service has committed a large swath of its dwindling resources to investigating 831(b) captives. Although the IRS concedes that most captives are being operated without ill intent, there is always a risk that well-meaning captive owners and service providers will be lost in the fray. Even the most forthright of captive participants risk being reviewed under the Service’s skeptical eye. This is why taxpayers should consider taking proactive measures to ensure their captive insurance program and underlying reasons for operating a captive are up-to-snuff.
In addition to reviewing the merits of the captive program, competent counsel can help a captive participant prepare for a successful examination. Even in a best-case scenario, an audit involves putting together potentially thousands-of-pages worth of documents including years of bank statements, financial documents, and emails. The Service also likes asking about insurance claims and loss events that occurred a decade ago. Waiting until the IRS asks for all of these materials (typically, all at once, within a 30 day time-frame) means late nights and headaches all-around. A tax adviser who is experienced with IRS examination procedures can help a taxpayer know what to expect, and prepare accordingly.
If you have questions about captive insurance or any other tax matter, please contact Matt Spradling, a Senior Associate with alliantNational’s Houston office, at (713) 548-2213.