The IRS Is Cracking Down on an Insurance Strategy

The IRS Is Cracking Down on an Insurance Strategy Commonly Used as a Tax Shelter

The IRS
The IRS

The International Revenue Service, a bureau of the U.S. Treasury Department, is cracking down on an insurance strategy that small businesses and partnerships have used as a tax shelter.

The IRS is cracking down on using so-called micro-captive insurance—a way for companies to insure themselves—as tax shelters, as it bolsters enforcement efforts aimed at wealthy individuals and partnerships.

The IRS has long cited these insurance strategies as potentially abusive and, in recent years, created enforcement teams whose primary task is to suss out unscrupulous structures. Using new funding available under the Inflation Reduction Act, passed late last year, the agency has been building up sophisticated enforcement personnel, improving cross-departmental collaboration, and adopting cutting-edge technology to identify and audit complex abusive tax schemes.

Micro-captive insurance companies can be created by owners of small businesses or partnerships to insure against various risks that typically would be covered through commercial insurance. An advisor specializing in micro-captives often pools premiums from multiple small businesses in a single structure.

Any form of insurance coverage can be provided through a micro-captive, from healthcare and workers’ compensation to specific risks related to a particular industry, such as avian flu for an egg farm.

But significant tax benefits reaped by the creators of micro-captives have historically lured unscrupulous activity, says Bill Smith, national director of tax technical services at  CBIZ MHM’s National Tax Office in Atlanta.

The business owners or partners that create a micro-captive can deduct up to US$2.65 million in premiums. (A micro-captive can only accept gratuities up to that amount or its tax treatment changes.) The premiums are invested within the micro-captive, and eventually, any excess funds beyond those used to cover claims return to the owners. Capital gains taxes are paid on any growth.

“The reason the IRS hates these is that people were using them as an investment tool,” Smith says. “They could own the micro captive, get a deduction on premiums, have few or no claims, invest the money, and later take it out and pay capital gains taxes on the growth,” Smith says.

In the meantime, he says the owners can borrow the money they have paid in premiums. He says, “You can pay the premium, get a deduction, and then get thack by borrowing it.”

Major signs that a micro-captive may act as a tax shelter with little insurance purpose are when pretty equate the allowable deduction amount or are higher than the premiums paid for commercial insurance.

For example, in a 2017 U.S. Tthose case, taxpayers who owned jewelry stores and commercial real estate businesses in Arizona took deductions valued around US$150,000 for commercial real estate expenses until creating a micro-captive, when their deductions for premiums skyrocketed to more than US$1.1 million.

Among the risks the taxpayers covered were terrorism and an IRS audit, and most of the premiums were distributed to the taxpayers in the form of loans, according to a case summary by the New York tax firm EisnerAmper. The court determined the micro-captive was not a legitimate insurance company, and the deductions for the premiums were disallowed.

In a 2019 case, a small steel tank manufacturer in Manheim, Penn., was found to have used a captive as a tax shelter rather than to insure risk. The firm had both commercial coverage and a micro-captive. Still, all claims were submitted through commercial insurance, and the premiums paid to the micro-captive were more than four times as high as what would have been paid to a commercial insurer, according to EisnerAmper.

A rare win for a taxpayer with a micro-captive occurred in 2021, proving these structures can be legitimate in the eyes of the court. A private Delaware-based business running an egg farm was scrutinized for its micro-captive setup to protect against avian flu and other risks. The case details revealed the company had sought coverage from commercial carriers but could not find a policy that addressed its specific risks. The micro-captive was deemed legitimate.

“If you can get better or comparable premiums using a micro-captive, it’s likely to be seen as legitimate,” Smith says. “It’s important to compare the premiums of the micro-captive to what you can get commercially.

The IRS in August proposed that micro-captives be deemed “listed transactions,” which are potentially abusive strategies that must be disclosed to the IRS when attaching Form 8886 to a tax return.

Though the IRS named micro-captives, along with other tax-savings strategies such as syndicated conservation easements, as listed transactions in 2016, a recent federal Tax Court case removed this status due to a technical error in which the IRS had not allowed for a comment period before establishing the strategies as “listed.”

While the agency aims to reestablish the requirement for taxpayers to disclose the use of micro-captives, it is forging ahead with its ramped-up enforcement.

The IRS’s fierce position on these structures will likely mean that even owners with legitimate micro-captives will be scrutinized. “You could incur an expensive audit and may have to go to court,” Smith says. “The IRS has basically said these are all bad, and if they’re good, let people prove it in tax court.”

This is creating challenges for companies that have already established micro-captives, says David Slenn, a partner at Akerman, a Washington, D.C., law firm. “When you want to sell your company, what do you tell a buyer about the risk that your risk management program is creating by its nature? It’s ironic that these are risk management tools that are causing risk exposure.”

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