The IRS has recently notified taxpayers who use so-called “micro-captive” insurance transactions that the agency is taking an interest in potential abuses associated with the transactions. As of November 2, 2016, the IRS will highly scrutinize these transactions.
Take away. At the end of 2015, the Protecting Americans from Tax Hikes Act of 2015 (PATH Act) included provisions to help the IRS combat certain micro-captive insurance transactions by implementing modifications to provisions of the tax code related to Code Sec. 831(b) micro-captive transactions. With these types of transactions, a taxpayer may attempt to reduce the aggregate taxable income of the taxpayer and/or related persons using contracts that the parties treat as insurance contracts and a related company that the parties treat as a captive insurance company.
Generally, micro-captive insurance companies are a legitimate tax structure, the IRS explained. The insured is able to claim tax deductions for premiums paid for the insurance policies while the premiums end up with a captive insurance company owned by the owners of the insured or family members.
Although such transactions may be legally permissible, the IRS identified, instances where in an abusive structure, owners of closely held entities create captive insurance companies and cause the creation and sale of the captive insurance policies to the closely held entities. The policies may cover ordinary business risks or esoteric, implausible risks for exorbitant “premiums,” while the insureds continue to maintain their far less costly commercial coverages with traditional insurers. Captive insurance policies may attempt to cover the same risks as are covered by the entities’ existing commercial coverage, but the captive policies’ “premiums” may be double or triple the premiums of the policy owners’ commercial policies, according to the IRS.
The IRS explained that the annual premium amounts in such transactions are frequently targeted to the amounts of deductions business entities seek in order to reduce their taxable income. In abusive situations, total premiums can equal up to $1.2 million annually to take full advantage of the premium income exclusion provision. In such situations, according to the IRS, underwriting and actuarial substantiation for the insurance payments pair are either absent or illusory.
In Notice 2016-66, the IRS notified persons involved in certain micro-captive insurance transactions that such transactions are transactions of interest, and that reporting obligations and penalties may arise from involvement with such transactions. The IRS did admit that it lacks sufficient information to identify which Code Sec. 831(b) arrangements should be identified specifically as a tax avoidance from other Code Sec. 831(b) related-party transactions.
Section 2.01 of Notice 2016-66 identifies the transaction as follows:
A, a person, directly or indirectly owns an interest in an entity (or entities) ( “Insured”) conducting a trade or business;
An entity (or entities) directly or indirectly owned by A, Insured, or persons related to A or Insured ( “Captive”) enters into a contract (or contracts) (the “Contracts”) with Insured that Captive and Insured treat as insurance, or reinsures risks that Insured has initially insured with an intermediary, Company C;
Captive makes an election under Code Sec. 831(b) to be taxed only on taxable investment income;
A, Insured, or one or more persons related (within the meaning of Code Secs. 267(b) or 707(b)) to A or Insured directly or indirectly own at least 20 percent of the voting power or value of the outstanding stock of Captive; and
One or both of the following apply: (1) the amount of the liabilities incurred by Captive for insured losses and claim administration expenses during the Computation Period (defined in section 2.02 of the notice) is less than 70 percent of the following: (A) premiums earned by Captive during the Computation Period, less (B) policyholder dividends paid by Captive during the Computation Period; or (2) Captive has at any time during the Computation Period directly or indirectly made available as financing or otherwise conveyed or agreed to make available or convey to A, Insured, or a person related (within the meaning of Code Secs. 267(b) or 707(b)) to A or Insured (collectively, the “Recipient”) in a transaction that did not result in taxable income or gain to Recipient, any portion of the payments under the Contract, such as through a guarantee, a loan, or other transfer of Captive’s capital.
Transactions that are either the same as the one described in Notice 2016-66, or are substantially similar, are transactions of interest as of November 1, 2016, the IRS explained. Taxpayers who enter into the transactions on or after November 2, 2016, must disclose the transaction in accordance with the notice or be subjected to penalties.
If you have any questions regarding the impact of these rules on your captive insurance company or the related compliance issues, please do not hesitate to contact us.