Beware of IRS initiatives against microcaptive insurance arrangements.

• Author: Yasmeh, Delina

By Delina Yasmeh, Irvine, Calif.

November 2021

Editor: Mark G. Cook, CPA, CGMA

Many companies have used captive insurance arrangements for the resulting tax benefits; however, microcaptive insurance arrangements have been vigorously scrutinized recently by the IRS.

The IRS has publicly declared that it would take action against taxpayers using microcaptive insurance arrangements to improperly evade taxes (see, e.g., News Release IR-2015-16 (2/3/15)). Since then, the IRS has been aggressively pursuing abusive microcaptive schemes via litigation. As such, taxpayers involved in microcaptive insurance arrangements should be very careful to ensure that the arrangements are not abusive microcaptive transactions, and those involved in potentially abusive transactions are urged by the IRS to exit them immediately.

A captive insurance company is a subsidiary that is formed by a company to finance the company's retained losses in a formal structure under the guidance of an appropriate state insurance department. Such captive insurance companies are typically formed to supplement the commercial insurance already purchased by the company. Specifically, a microcaptive insurance company is a captive insurance company that qualifies as a small insurance company under Sec. 831(b), allowing it to enjoy a variety of tax benefits, such as paying income tax on investment income only and having dividends taxed as qualified dividends. Note that Sec. 831(b) contains some restrictions; for example, the microcaptive must receive less than $2.2 million in annual premiums.

Treasury and the IRS believe certain microcaptive transactions have a potential for tax avoidance or evasion. However, the IRS admittedly lacked sufficient information to define the characteristics that distinguish the tax-avoidance transactions from other, proper Sec. 831(b) related-party transactions. To address this issue, in 2016, the IRS issued Notice 2016-66, in which it indicated that microcaptive insurance transactions that are the same as, or substantially similar to, the transaction described in the notice would be considered "transactions of interest," requiring information reporting as "reportable transactions" under Regs. Sec. 1.6011-4 and Secs. 6011 and 6012 for taxpayers engaging in the transactions and material advisers with respect to those transactions.

The IRS stated with regard to many captive companies: "The manner in which the contracts are interpreted, administered, and...