IRS Warns On Micro-Captive Insurance Tax Shelters

For the third consecutive year, the US Internal Revenue Service (IRS) has placed abusive micro-captive insurance tax shelters on its list of top tax scams to watch out for in the 2017 filing season.

The IRS explained that the US tax code generally allows businesses to create captive insurance companies to protect against certain risks. Traditional captive insurance, established by an insurance company owned by the insured or parties related to the insured, typically allows a taxpayer to reduce insurance costs. The insured business claims deductions for premiums paid.

Micro-captive insurers (with annual written premiums of less than USD1.2m) can also elect to pay tax only on their investment income, and can thereby exclude the payments they directly or indirectly receive under the insurance contracts from their taxable income.

On November 1 last year, in Notice 2016-66, the IRS warned that the use of micro-captive transactions have “a potential for tax avoidance or evasion,” as it believes they may be established more to avoid federal income tax than for their stated aim of providing additional insurance for clients.

The agency’s concern is that, in abusive micro-captive structures, owners of closely held entities are persuaded to participate in schemes that lack many of the attributes of genuine insurance. For example, the coverage taken may insure implausible risks, fail to match genuine business needs, or duplicate the taxpayer’s commercial coverage. Premium amounts may be unsupported by underwriting or actuarial analysis, may be geared to a desired deduction amount, or may be significantly higher than premiums for comparable commercial coverage.

In addition, captives may invest in illiquid or speculative assets, or loan or otherwise transfer capital to or for the benefit of the insured, the captive’s owners, or other related persons or entities. Captives may also be formed to advance inter-generational wealth transfer objectives and avoid estate and gift taxes. Promoters, reinsurers, and captive insurance managers may also share common ownership interests that result in conflicts of interest.

Notice 2016-66 designated certain micro-captive insurance transactions as “Transactions of Interest.” It established reporting requirements for those entering into such transactions on or after November 2, 2006, and created disclosure obligations for material advisors.