Editor: Mark G. Cook, CPA, CGMA
Many companies have used captive insurance arrangements for the resulting tax benefits; however, microcaptive insurance arrangements have been vigorously scrutinized recently by the IRS.
The IRS has publicly declared that it would take action against taxpayers using microcaptive insurance arrangements to improperly evade taxes (see, e.g., News Release IR-2015-16 (2/3/15)). Since then, the IRS has been aggressively pursuing abusive microcaptive schemes via litigation. As such, taxpayers involved in microcaptive insurance arrangements should be very careful to ensure that the arrangements are not abusive microcaptive transactions, and those involved in potentially abusive transactions are urged by the IRS to exit them immediately.
A captive insurance company is a subsidiary that is formed by a company to finance the company's retained losses in a formal structure under the guidance of an appropriate state insurance department. Such captive insurance companies are typically formed to supplement the commercial insurance already purchased by the company. Specifically, a microcaptive insurance company is a captive insurance company that qualifies as a small insurance company under Sec. 831(b), allowing it to enjoy a variety of tax benefits, such as paying income tax on investment income only and having dividends taxed as qualified dividends. Note that Sec. 831(b) contains some restrictions; for example, the microcaptive must receive less than $2.2 million in annual premiums.
Treasury and the IRS believe certain microcaptive transactions have a potential for tax avoidance or evasion. However, the IRS admittedly lacked sufficient information to define the characteristics that distinguish the tax-avoidance transactions from other, proper Sec. 831(b) related-party transactions. To address this issue, in 2016, the IRS issued Notice 2016-66, in which it indicated that microcaptive insurance transactions that are the same as, or substantially similar to, the transaction described in the notice would be considered "transactions of interest," requiring information reporting as "reportable transactions" under Regs. Sec. 1.6011-4 and Secs. 6011 and 6012 for taxpayers engaging in the transactions and material advisers with respect to those transactions.
The IRS stated with regard to many captive companies: "The manner in which the contracts are interpreted, administered, and applied is inconsistent with arm's length transactions and sound business practices." The IRS explained that its objective is to identify microcaptive transactions with a potential for abuse, emphasizing that if the transaction is substantially similar to arrangements the Service described in the notice, the transaction will be deemed a transaction of interest and require the filing of a Form 8886, Reportable Transaction Disclosure Statement, by all participants in the transaction, including the captive insurer. In addition to requiring taxpayers to provide this notice, the IRS has made it clear that it will aggressively litigate Sec. 831(b) elections that appear to be tax-evasive.
In 2020, the IRS developed 12 new microcaptive examination teams to aid these efforts as it continues to target and litigate potentially abusive microcaptives (News Release IR-2020-26 (1/31/20)).
In a decision on March 10, 2021, the U.S. Tax Court held in Caylor Land & Development, Inc., T.C. Memo. 2021-30, that a microcaptive arrangement failed to qualify as insurance for federal tax purposes. This decision follows several similar cases, indicating that the courts are in agreement with the IRS on this matter.
Taxpayers using microcaptives should note the criteria laid out in Caylor, in which the Tax Court analyzed whether insurance is deductible by determining whether the insurance satisfied four criteria: (1) risk shifting, (2) risk distribution, (3) insurance risk, and (4) whether an arrangement looks like commonly accepted notions of insurance. No single factor is dispositive, but in Caylor, as it had in previous cases, the court focused on the second and fourth criteria in making its determination that the microcaptive did not provide insurance and that the premiums paid it and deducted by the taxpayer were not for insurance for federal tax purposes.
In light of the above, as well as of the fact-specific nature of these deductions, taxpayers that continue to use microcaptives should be very clear in making a proper insurance agreement under Sec. 831(b). They are encouraged to review each of the four factors carefully and take proactive steps to ensure their microcaptive would survive scrutiny from the IRS and the courts. Those currently involved in microcaptive insurance arrangements that would likely be considered abusive by the IRS and the courts would be wise to exit them as soon as possible and to consult with a tax adviser prior to filing their tax returns.
Mark G. Cook, CPA, CGMA, MBA, is the lead tax partner with SingerLewak LLP in Irvine, Calif.
For additional information about these items, contact Mr. Cook at 949-623-0478 or firstname.lastname@example.org.
Contributors are members of SingerLewak LLP.