The IRS is cracking down on the use of so-called micro-captive insurance – a way for businesses to insure themselves – as a tax shelter as it steps up enforcement efforts targeting wealthy individuals and partnerships.
The IRS has long identified these insurance strategies as potentially abusive, and in recent years has created enforcement teams whose primary task is to ferret out unscrupulous structures. Now, with new funding from the Inflation Reduction Act passed late last year, the agency is building a sophisticated enforcement staff, improving cross-departmental cooperation, and deploying cutting-edge technology to identify and examine complex abusive tax schemes.
Micro-captive insurance companies can be set up by owners of small businesses or partnerships to insure against various risks that would normally be covered by commercial insurance. An adviser who specialises in micro-captives will often pool premiums from several small businesses into a single structure.
Almost any type of insurance coverage can be provided through a micro-captive, from healthcare and workers’ compensation to industry-specific risks, such as avian flu for an egg farm.
But the significant tax benefits enjoyed by micro-captive creators have in the past attracted unscrupulous activity, says Bill Smith, national director of tax technical services at CBIZ MHM’s national tax office in Atlanta.
The owners or partners of a company that forms a micro-captive can deduct up to US$2.65 million in premiums. (A micro-captive can only accept premiums up to this amount or its tax treatment will change). Premiums are invested within the micro-captive and any excess funds over and above those used to cover claims are eventually returned to the owners. Capital gains tax is paid on any growth.
“The reason the IRS hates these is that people were using them as an investment vehicle,” says Smith. “They could own the micro captive, get a deduction on the premiums, have few or no claims, invest the money and take it out later and pay capital gains taxes on the growth,” Smith says.
In the meantime, the owners can borrow the money they have paid in premiums, he says. “They can pay the premium, get a deduction and then get the money back by borrowing it.”
Key signs that a micro-captive may be acting as a tax shelter with little insurance purpose are when premiums are close to the allowable deduction amount or higher than premiums paid for commercial insurance.
For example, in a 2017 US Tax Court case, taxpayers who owned jewellery stores and commercial real estate businesses in Arizona took about $150,000 in deductions for commercial real estate expenses until they formed a micro-captive, when their deductions for premiums jumped to more than $1.1 million.
The risks the taxpayers were covering included 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 New York tax firm EisnerAmper. The court ruled that 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, Pennsylvania, was found to have used a captive as a tax shelter rather than to insure risks. The company had both commercial insurance and a microcaptive, but all claims were submitted through the commercial insurance, and premiums paid to the microcaptive were more than four times what would have been paid to a commercial insurer, according to EisnerAmper.
A rare victory for a taxpayer with a micro-captive occurred in 2021, proving that these structures can be legitimate in the eyes of the court. A Delaware-based private company operating an egg farm came under scrutiny for its micro-captive, which was set up to protect against avian flu and other risks. The details of the case revealed that the company had sought coverage from commercial carriers but was unable to find a policy that addressed its specific risks. The micro-captive was deemed legitimate.
“If you can get better or comparable premiums through a micro-captive, it’s likely to be seen as legitimate,” says Smith. “It’s important to compare the micro-captive’s premiums to what you can get commercially.
The IRS proposed in August that micro-captives be considered “listed transactions”, which are potentially abusive strategies that must be disclosed to the IRS when used by attaching a Form 8886 to a tax return.
Although the IRS designated micro-captives, along with other tax-saving strategies such as syndicated conservation easements, as listed transactions in 2016, a recent federal tax court case overturned that status due to a technical error in which the IRS did not allow for a comment period before designating the strategies as listed.
While the agency is seeking to reinstate the requirement for taxpayers to disclose the use of micro-captives, it is continuing its increased enforcement.
It is likely that the IRS’s tough stance on these structures will mean that even owners with legitimate micro-captives will come under scrutiny. “They could be subject to an expensive audit and may have to go to court,” says Smith. “The IRS has basically said these are all bad, and if they’re good, let people prove it in tax court.”
This creates challenges for companies that have already established micro-captives, says David Slenn, a partner at Akerman, a Washington, D.C., law firm. “If you want to sell your company, what do you tell a buyer about the risk that your risk management programme inherently creates? It’s ironic that it’s the risk management tools that create the risk exposure.
