IRS Captive Insurance Global Settlement Offer- Know your options.
By: Randall P. Andreozzi, Esq.
In 2016 the IRS issued Notice 2016-66, which identifies certain micro captive insurance transactions as potentially abusive. The Notice generally describes the abusive arrangement as one where owners of closely-held entities engage in a captive insurance arrangement that purports to ensure against certain risks associated with the business. The business pays “premiums” to the captive and deducts them as ordinary and necessary business expenses, while the captive does not recognize the premiums as income. Ultimately, in the IRS’ view, the arrangement lacks attributes of genuine insurance, and is essentially a vehicle that returns the money paid to the business or its owners.
In January of 2017, the IRS went one step further when its Large Business & International Division specifically identified micro captive insurance companies in a compliance campaign as transactions of interest that require a response in the form of one or multiple treatment streams to achieve compliance objectives. These “treatment streams” may include anything from “soft letters” notifying selected taxpayers of the issue to civil or criminal enforcement. These approaches make use of IRS knowledge and deploy substantial resources to address the abusive transaction.
The IRS has enjoyed a series of wins in the U.S. Tax Court on the captive insurance issue (e.g., Avrahami v. Commissioner 149, T.C 144 (2017); Reserve Mechanical Corp. v. Commissioner, T.C Memo 2018-86; and Syzygy Insurance Co. v. Commissioner, T.C Memo 2019-34) where the IRS prevailed when the Tax Court disallowed the “wholly unreasonable” premium deductions (Avrahami), and where the court concluded that the purported arrangement was not insurance (Mechanical Corp). In light of these victories, the IRS, on September 16, 2019, announced a limited time-settlement offer for certain taxpayers that the IRS believes participated in abusive micro captive insurance transactions. The settlement is not negotiable but, if the taxpayer rejects the settlement, any pending IRS audit of the taxpayer continues. The audit may ultimately be resolved or may result in the full disallowance of any deductions, inclusion of income by the captive, and penalties which can include a 40% accuracy-related penalty under Internal Revenue Code Section 6662(i). The settlement terms disallow ninety percent (90%) of any deductions claimed for captive insurance premiums for all open tax years, and allows deductions only for the remaining 10% for all open tax years. The IRS requires at least one year on the statute of limitations to process the settlement, so taxpayers with less time remaining will likely be asked to sign Forms 872 to facilitate processing.
It appears that taxpayers who are in Appeals on the captive insurance issue will not receive the settlement letter, but may work with Appeals to resolve their case based on litigation hazards. Taxpayers who have some years under examination and some in appeals may have their case sent back to exam if the taxpayer wishes to exercise the settlement option. Likewise, taxpayers with cases pending in the U.S. Tax Court under IRS Chief Counsel’s jurisdiction will not be receiving settlement letters. In those cases, IRS Counsel assigned to the case will determine whether and under what terms a settlement may be extended to taxpayers.
Of course, not all captive insurance arrangements are abusive. Therefore, consideration of the IRS settlement requires analysis of the particular micro captive arrangement, pragmatic evaluation of the risks insured, and objective review of the actuarial computations determining premiums and claims experience. Taxpayers always have the opportunity to prove the validity of the arrangement in audit, at Appeals, or in the Tax Court. They should, however, possess a sound understanding of the facts and circumstances of the cases upon which the IRS campaign is premised, and be in a position to show material distinctions from those cases. Ultimately, evaluation of any resolution with IRS should be based on the litigation hazards and anticipated costs in light of the amounts at issue. If a settlement is reached, the taxpayer’s representative should carefully review the settlement documents, closing agreements, and tax computations to ensure that the settlement protects against any risk of double taxation on the back end of the transaction, errors in interest computation, or other ambiguities that might create problems in later years. It is likely that, in any settlement, IRS will require that the transaction and relationships be unwound. This will require the involvement of the captive and any related third-party entities.
The attorneys at Andreozzi Bluestein have extensive experience with tax controversies related to these abusive micro captive insurance transactions and other issues and transactions that are the subjects of IRS compliance campaigns. If you or a client have issues relating to these settlement offers or any other tax issue, please call us at any time for a no-obligation consultation.
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