IRS Offers to Settle Microcaptive Insurance Cases

By Heroux, Mark | Journal of Accountancy, February 2020 | Go to article overview

IRS Offers to Settle Microcaptive Insurance Cases


Heroux, Mark, Journal of Accountancy


In September, the IRS announced it would mail time-limited settlement offers to certain taxpayers under audit who had participated in abusive micro-captive insurance transactions (IRS News Release IR-2019-157). Only taxpayers who receive an offer by mail are eligible.

A captive insurance arrangement is one in which an insurance company insures only the risks of companies related to it. Captive insurers designated "micro" are generally those intended to qualify as eligible to make a Sec. 831(b) election, by which certain small insurance companies may be taxed only on their investment income. But as part of that eligibility (or for a company to be subject to taxation more generally as an insurance company), taxpayers must be able to show the insurer is in fact a bona fide insurance company within the meaning of Secs. 831(c) and 816(a). Case law guidance requires consideration of all the facts and circumstances in making this determination, and courts have applied four criteria: (1) The arrangement involves insurance risk; (2) the arrangement shifts risk of loss to the insurer; (3) the insurer distributes risk among policyholders; and (4) the arrangement meets commonly accepted notions of insurance.

RISK CRITERIA

Examples of insurance risk include workers' compensation, property and casualty loss, general liability, and other acceptable commercial risk relevant to the industry of the insured. Risk distribution occurs when an insurer pools a large enough collection of unrelated risks (i.e., risks that are generally unaffected by the same event or circumstance) (see Rent-A-Center, Inc., 142 T.C. 1,24 (2014)).The analysis focuses on both the number of independent risk exposures and the number of related entities that are insured (see Avrahami, 149 T.C. 144 (2017)). In looking into whether risk shifted from an insured to a captive, the court will apply the step-transaction, substance-over-form, and economic substance doctrines. The analysis focuses on whether the insured or the captive bears the economic risks relevant to the insurance policy.

IRS COURT VICTORIES

To determine whether an arrangement constitutes insurance in the commonly accepted sense, courts have looked at the following facts: (1) whether the company was organized, operated, and regulated as an insurance company; (2) whether it was adequately capitalized; (3) whether the policies were valid and binding; (4) whether premiums were reasonable and the result of arm's-length transactions; and (5) whether claims were paid. None of these factors are mutually exclusive.

The IRS has won the following Tax Court cases in recent years involving captive and microcaptive insurance transactions: In Avrahami, the individual petitioners took large loans from their captive after it had accumulated a surplus. The Tax Court found there was no risk distribution when the captive insured only seven types of direct policies covering exposures for four related entities. A portion of the loans were considered distributions, and the Sec. 831(b) election of the captive was invalidated, resulting in the disallowance of deductions for paid insurance premiums (see also "Tax Matters: Microcaptive Premium Deductions Disallowed," JofA, Nov. 2017, tinyurl.com/y8bj5psj).

In Reserve Mechanical Corp., T.C. Memo. 201886, a captive was formed to provide additional coverage that the petitioner's third-party insurers would not cover. The Tax Court found there was no risk distribution because the policies were "cookie-cutter" and not necessarily appropriate for the petitioner's business. The policies indicated on their face that they were copyrighted material of a company that managed and administered the microcaptive through a "turnkey" operation and did not meet the needs of each of the insureds; rather, all the entities in the group had the same policy with the same premium, regardless of their size or risk. …

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