The IRS has announced a one-time settlement offer for certain microcaptive insurance participants following an increasing number of microcaptive court cases waiting to be heard.
To qualify, taxpayers must meet a series of criteria, and taxpayers in appeals or pending docketed years under IRS counsel’s jurisdiction are ineligible for the settlement. So far, the IRS has offered settlements to approximately 200 taxpayers under examination.
Below is an overview of qualifying criteria, financial terms, and more.
In 2016, the IRS notified taxpayers that fall under Internal Revenue Code (IRC) Section 831(b), microcaptive insurance companies, that their companies were involved in a transaction of interest to the IRS.
A microcaptive transaction is one in which a taxpayer attempts to reduce taxable income using contracts that are treated as insurance contracts and a related company that is treated as a captive insurance company.
A taxpayer then treats coverage under the contracts as deductions for premiums for insurance coverage. The related captive insurance company then elects under IRC Section 831(b) to be taxed only on investment income and therefore excludes the payments directly or indirectly received under the contracts from its taxable income.
The IRS believes these transactions could lead to tax evasion.
The term insurance isn’t defined by the IRC for tax purposes. Therefore, the IRS is relying on the below four factors when determining if a company is operating as an insurance company.
All of the below factors must generally be met for a company to be considered an insurance company.
- Insurance risk. Policies must cover typical insurance risks, and there must be legitimate business reasons for acquiring insurance from the captive insurance company.
- Risk shifting. The taxpayer must transfer some of the risk of potential loss to the insurer.
- Risk distribution. The captive insurance company must pool a sufficiently large collection of unrelated risks to distribute among other companies.
- Insurance in the commonly accepted sense. The captive insurance company must operate and be regulated like an insurance company; all insurance policies must be valid and premiums and loose claims must be paid on time.
Acceptance and Financial Terms
The IRS’s general terms indicate a taxpayer has 30 days to accept the offer of settlement, but it may request a single 30-day extension. Usually, the settlement terms are as follows:
- Premiums. The IRS will deny 90% of any deductions claimed for captive insurance premiums, but the captive insurance company won’t be required to recognize taxable income for received premiums.
- Liquidation. The captive insurance company must agree to liquidate or agree to a deemed liquidation under the terms of the offer.
- Penalties. Accuracy-related penalties are imposed at a reduced rate of 10%—rather than the standard rate of 20% for negligence or 40% for lack of economic substance. The 10% rate is reduced to 5% if the taxpayer hasn’t engaged in any other reportable transactions, and it’s reduced to 0% if it provides a signed declaration from an independent tax advisor.
Approximately 80% of taxpayers who have received letters from the IRS accepted the settlement terms.
Taxpayers that receive letters under this settlement offer and decide not to participate will continue to be audited by the IRS under normal procedures. However, it’s worth noting that the recent string of microcaptive insurance court cases imposed much harsher findings than the outlined settlement guidelines.
The IRS also announced that it intends to establish 12 new examination teams to handle new microcaptive audits in 2020, signaling to taxpayers that it will continue to vigorously pursue microcaptive transactions.
While the microcaptive rules can be complex, a taxpayer’s first steps are to:
- Evaluate current business insurance needs and claims
- Make sure all insurance needs are legitimate
- Make sure microcaptive policies properly supplement commercial insurance
While the tax benefits of IRC Section 831(b) are a bonus, the IRS is targeting taxpayers who enter microcaptive insurance transactions purely from a tax savings standpoint.
We’re Here to Help
If you received correspondence from the IRS or have questions regarding your microcaptive insurance company, contact your Moss Adams professional or visit our dedicated tax services page.