A captive insurance company is one that is created by a business as protection against certain risks. And, Section 831(b) of the Internal Revenue Code allows certain small insurance companies the option of paying tax on only their investment income. There are other tax advantages to captives, as well.
It’s perfectly legal and quite common for companies to set up a captive insurer, as long as it actually provides insurance. The company that owns the captive can take a tax deduction on up to $1.2 million in premiums each year. Then, Section 831(b) allows the captive to choose to be taxed on its investment income rather than on those premiums, as long as it receives no more than $1.2 million in premiums annually.
Some companies, however, have been trying to take advantage of the rules by creating tiny captive insurance companies — micro-captives — purely in an effort to reduce their tax burden.
The IRS calls many of these micro-captives illegitimate, as they lack crucial attributes of genuine insurance. For example, in many cases the primary purpose of these micro-captives is to affect taxation rather than to provide insurance. Many micro-captives pay no claims.
In 2015, the IRS named micro-captives as its top abusive tax scheme. And, the agency has consistently disallowed the tax benefits claimed by companies that have created micro-captives that don’t meet the basic legal definition of insurance. A number of taxpayers have challenged the IRS’s position in court, but so far none has been successful.
Watch for a settlement offer in the mail
If you are currently under audit for micro-captive insurance transactions, you may soon receive a notice of an IRS settlement offer. There are about 500 of these cases in court and the IRS said this week that it had mailed notices to around 200 taxpayers. (If a settlement letter is not sent to you, you are probably not eligible.)
What is the offer? According to the IRS, it will require “substantial concession of the income tax benefits claimed by the taxpayer together with appropriate penalties unless the taxpayer can demonstrate good faith, reasonable reliance.”
In other words, they are willing to settle the matter as long as you substantially repay whatever tax benefits you received through the use of micro-captives. And, if you can’t show that you acted in good faith and reasonable reliance on an IRS rule, you will also be expected to pay an appropriate penalty.
Therefore, the terms of the settlement depend in some part on your specific situation. If you receive a settlement letter from the IRS, we strongly recommend having a tax attorney evaluate your position and negotiate the final resolution with the IRS.
