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September 2014

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.

More about Frazer Ryan's tax controversy practice