Captive insurance arrangements face IRS scrutiny.

• Author: Mahany, Brian

Tax practitioners are seeing a rise in IRS audits directed at companies using captive insurance arrangements (captives). While big businesses have long used captives as a way to manage risk, IRS efforts appear to be directed at smaller companies that rely on Sec. 831(b) (small captives with premiums of $1.2 million or less for the tax year qualify for special tax treatment).

For a captive insurance arrangement to qualify as legitimate, the taxpayer must demonstrate that the premiums charged are appropriate and that the need for insurance is real. Companies that create captives to shelter taxable income can expect an audit and hefty penalties. Years ago, the captives industry was marred by widespread fraud. The resurgence of cell captives, which involve a parent company setting up separate cell insurance subsidiaries whose assets are kept separate from each other, has again attracted the IRS's attention.

According to one expert, the IRS is focused on companies that underwrite their own terrorism policies, which often involve charging premiums that bear no relationship to the actual risk. The IRS considers such arrangements to be abusive tax shelters. To be considered legitimate insurance, there must be adequate risk shifting and risk distribution (see Rev. Ru!. 2008-8).

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