The ‘Dirty Dozen’ list calls out tax scams that the IRS will be targeting in the coming year. Under section 831(b) of the tax code, captive insurers that qualify as small insurance companies can elect to exclude limited amounts of annual net premiums from income, so that the captive pays tax only on its investment income.
The IRS warned that in abusive micro-captive structures, promoters, accountants or wealth planners could persuade owners of closely held entities to participate in schemes that lack many of the attributes of genuine insurance.
Captive insurance policies may attempt to cover the same risks that are covered by the entities’ existing commercial coverage, but the captive policies’ ‘premiums’ may in fact be double or triple the premiums of the policy owners’ commercial policies, according to the IRS.
The IRS suggested that captives may invest in illiquid or speculative assets. They could also loan or otherwise transfer capital to, or for the benefit of, the insured, the captive’s owners or other related persons or entities.
Captives may also be formed to advance inter-generational wealth-transfer objectives to avoid estate and gift taxes. Promoters, reinsurers and captive insurance managers may share common ownership interests that result in conflicts of interest, the IRS noted.
John Koskinen, IRS commissioner, said: “Taxpayers should avoid unscrupulous promoters who encourage the use of phony tax shelters designed to avoid paying what is owed. These scams can end up costing taxpayers more in penalties, back taxes and interest than they saved in the first place.”
On 1 November last year, the IRS released Notice 2016-66, which formally labelled micro captives as ‘transactions of interest’. The IRS advised that micro-captive insurance transactions have the potential for tax avoidance or evasion.
Transactions of interest are a type of reportable transaction first established by the IRS in 2006 and since then, only six transactions have been labelled as such, including micro-captive transactions.
The notice requires reporting by any taxpayer involved in micro captive transactions over a number of past years, in which the open statutes of limitations applies.
Tim Tarter, a captive audit defence expert, suggested that the notice “fails to provide any definitive guidance” as to which micro-captive entities will survive Tax Court scrutiny, adding that “it is unlikely to deter most informed micro-captive participants from moving forward with their planned captive transactions”.
On 29 December last year, the IRS granted a 90-day deadline extension to the 1 May for 831(b) captives that need to comply with the notice.
In addition to Notice 2016-66, Congress has also acted to curb micro-captive abuses. The Protecting Americans from Tax Hikes Act, effective 1 January, established diversification and reporting requirements for new and existing captives.