For years, the Internal Revenue Service (IRS) has audited so-called “abusive micro-captive insurance transactions.” The IRS is focused on certain captive arrangements that were marketed towards small to mid-sized businesses in a manner more akin to tax shelters. In IRS Notice 2016-66, the IRS identified these types of captive insurance arrangements.
In the courts, the IRS has had a string of recent victories against these captive arrangements. For example, in three recent cases, the U.S. Tax Court has not only disallowed the deduction for insurance premiums paid but also required the captive insurance company to include the payments received in income (the “double whammy”). See Avrahami v. Commissioner, 149 T.C. 144 (2017); Syzygy Insurance Co. v. Commissioner, T.C. Memo. 2019-34; Reserve Mechanical Corp. v. Commissioner, T.C. Memo. 2018-86.
“New Stricter Settlement”
In late 2020, the IRS announced a “new stricter settlement” for these abusive micro-captive insurance transactions. The new settlement program is being offered to businesses that currently have at least one year under IRS audit, and it is not available to taxpayers who are currently in the U.S. Tax Court. Under this program, the IRS issued to taxpayers a letter titled “Proposed Resolution for Micro-Captive Insurance Transactions” (IRS Letter 6239).
The settlement proposal requires taxpayers to respond within 30 days to either accept the proposal or request one extension of 30 days. The taxpayer will not have more than 60 days to respond to the IRS settlement proposal.
Therefore, taxpayers must work quickly to understand the settlement and whether it is in the taxpayer’s best interest to accept the settlement. The main requirements of the settlement are:
- Each partner, member, and shareholder of the insured entity (usually the operating business) and the captive must agree to the settlement.
- Taxpayer’s deductions are disallowed in full for insurance premiums paid to the captive and for fees paid to captive manager for all years for which the statute of limitations is open (not just the years under audit).
- The taxpayer will owe an I.R.C. § 6662 accuracy-related penalty. The penalty will equal the amount of tax owed times a percentage between 5% and 15%. The exact percentage depends on whether the taxpayer submits a “reasonable reliance on outside advisor” declaration and a “no prior participation in another reportable transaction” declaration.
- The captive insurance company is not required to include in income the insurance premiums it received (that is, no “double whammy”).
- If captive has not liquidated, it must either liquidate within 90 days of settlement or go through the deemed distribution and contribution provided in the Appendix to the settlement proposal.
- The resulting tax liability (which can be substantial) must be paid in full or the taxpayer must agree to a monthly payment plan (installment agreement) as part of signing the settlement documents.
Evaluating the Settlement Proposal
To decide whether to accept this settlement proposal, taxpayers must weigh competing factors and calculate the amounts they would owe under the settlement versus outside the settlement.
For example, the settlement provides for no double whammy and a penalty that is substantially lower than what might result from an IRS Independent Office of Appeals settlement or Tax Court decision. These terms could result in substantial tax savings versus the results in the Avrahami, Syzygy Insurance Co., and Reserve Mechanical Corp. cases.
On the other hand, the settlement requires all stakeholders to agree to participate and some taxpayers may have strong facts to support that the captive provided valid insurance. For example, while the recent cases have all been strongly in favor of the IRS’s position, some businesses have made legitimate claims under these insurance policies, especially during the COVID-19 pandemic.
In the end, a taxpayer must consider their specific facts to decide whether to accept the IRS settlement. In addition, a taxpayer must evaluate their desire to resolve this matter now versus settlement or trial at a later date.
Contact the Former IRS Attorneys of Holtz, Slavett & Drabkin, APLC for advice on whether to accept the IRS’s micro-captive insurance settlement and for assistance with your IRS audits and tax litigation.
Holtz, Slavett & Drabkin, APLC advises clients in sensitive domestic and international tax examinations, criminal tax matters, and difficult tax collection matters. David J. Warner is a former IRS Attorney who advised the IRS on micro-captive issues and now represents clients in audits and U.S. Tax Court cases with micro-captive issues. David also taught Tax Practice and Procedure at Loyola Law School for many years. Please contact David at (949) 999-6606 to schedule a consultation.