Captive Insurance Arrangements Face IRS Scrutiny

Editor: Michael D. Koppel, CPA/PFS/CITP, MSA, MBA

Special Industries

Tax practitioners are seeing a rise in IRS audits directed at companies using captive insurance arrangements (captives). While big businesses have long used captives as a way to manage risk, IRS efforts appear to be directed at smaller companies that rely on Sec. 831(b) (small captives with premiums of $1.2 million or less for the tax year qualify for special tax treatment).

For a captive insurance arrangement to qualify as legitimate, the taxpayer must demonstrate that the premiums charged are appropriate and that the need for insurance is real. Companies that create captives to shelter taxable income can expect an audit and hefty penalties. Years ago, the captives industry was marred by widespread fraud. The resurgence of cell captives, which involve a parent company setting up separate cell insurance subsidiaries whose assets are kept separate from each other, has again attracted the IRS’s attention.

According to one expert, the IRS is focused on companies that underwrite their own terrorism policies, which often involve charging premiums that bear no relationship to the actual risk. The IRS considers such arrangements to be abusive tax shelters. To be considered legitimate insurance, there must be adequate risk shifting and risk distribution (see Rev. Rul. 2008-8).

Captive Insurance Poses Big Tax Risk for Small Businesses

The risks for small businesses that improperly set up captives are huge—the IRS can disallow the deductibility of the premiums. And an even bigger risk is that, because the IRS believes that some of these arrangements are also abusive tax shelters, it could impose civil penalties under Sec. 6707A of up to $200,000 for failure to disclose a listed transaction.

If a client plans on establishing a captive, a tax adviser should make sure he or she understands the rules or partners with another member firm or tax attorney who does. Past scams were often offered by offshore and internet promoters that possessed official-looking tax opinion letters and polished presentation materials. Unfortunately, those opinions were frequently worthless. If a client is approached by a promoter, the practitioner should be on high alert and insist the client perform some due diligence on the promoter. The author has seen several cases where the plan was considered an abusive tax shelter, and, even worse, the money was later stolen.

A version of this item originally appeared on the author’s blog.

EditorNotes

Michael Koppel is with Gray, Gray & Gray LLP, in Westwood, Mass.

For additional information about these items, contact Mr. Koppel at 781-407-0300 or mkoppel@gggcpas.com.

Mr. Mahany is a Preferred Provider to CPAmerica members. Mahany & Ertl LLC is not a member of CPAmerica.