IRS Challenging Captive Insurance Company Arrangements
The IRS views captive
insurance companies, or "micro-captives," as a tax avoidance strategy,
and it would be a mistake to assume that the general rules associated
with a routine IRS examination are applicable.
The Internal Revenue Code allows a qualifying captive
insurance company to receive up to $1.2 million in annual premiums tax-free. This
type of insurance company, referred to as a micro-captive or 831(b) captive, provides insurance to related entities. The related entities usually deduct the
costs of the insurance as expenses, despite no realization of $1.2 million in
income by the micro-captive. Policies sold by a micro-captive usually include
non-commercially available policies, such as terrorism, administrative action or
loss of key contract insurance.
Due to a micro-captive's tax advantages, the IRS recently
began aggressively challenging many of these arrangements. The IRS playbook
appears to focus on locating captive insurance managers, obtaining their list of
clients, and auditing all of the micro-captives using the captive manager.
The IRS's standard method of attacking these arrangements is
to disallow the insurance expense deduction of the operating company on the
grounds that the insurance expense is not "ordinary and necessary." Part of this
attack includes taking the position that the insurance policy premium is too
high (i.e., not reasonable). The IRS further challenges micro-captive
arrangements through the IRS's usual tax shelter doctrines of substance-over-form, economic substance, and step transaction.
If your captive is selected for examination, it is critical
that your legal advisor carefully respond to the voluminous inquiries that will
be made. The IRS views micro-captives as a tax avoidance strategy, and it is a
mistake to enter into the examination under the belief that the general rules
associated with a routine IRS examination are applicable.
If you would like to
discuss the examination exposure that your captive may face, you may contact
Derek Kaczmarek or
David Jojola, both of whom offer
experience in representing captive clients before the IRS.
About the Authors
A Certified Specialist in Tax Law,
Derek W. Kaczmarek represents
taxpayers and employers in federal and state income, gift, estate, excise and
employment tax controversies. For seven years, he was a trial attorney with the
IRS. Derek earned his law degree at Indiana University School of Law and an
LL.M. in Taxation from New York University School of Law.
David R. Jojola is a Certified
Tax Law Specialist who, for 11 years before entering private practice, was a
senior trial attorney with the IRS. David represents clients in tax
controversies involving income, gift, estate, excise and employment tax matters.
He also has extensive experience in successfully representing individual
taxpayers seeking innocent spouse relief.
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