07 11 2016

IRS Scopes In On Micro-Captive Tax Evasion Risk

In Notice 2016-66, the US Internal Revenue Service (IRS) has warned that the use of so-called "micro-captive transactions" have "a potential for tax avoidance or evasion," as it believes they may be established more to avoid federal income tax rather than for their stated aim of providing additional insurance for clients.

The IRS said that it is aware of such transactions whereby taxpayers try to reduce their taxable income by entering into insurance contracts with captive micro-insurance companies, thereby claiming income tax deductions for insurance premiums.

On the other hand, the micro-captives (with annual written premiums of less than USD1.2m) are allowed to elect to pay tax only on their investment income, and can thereby exclude the payments they directly or indirectly receive under the insurance contracts from their taxable income.

The IRS believes some of these micro-captives are in place solely in order to lower their clients' taxable incomes and not to insure against risks. In February this year, the agency placed captive insurance contracts on its "Dirty Dozen" list of abusive tax scams.

The IRS added that a micro-captive is often formed to insure against "implausible" risks, which do "not match a business need or risk of the insured," and for which it "does not have capital adequate to assume the risks that the contract transfers from the insured." Micro-captives may also "use the premium income for purposes other than administering and paying claims under the insurance contracts. … For instance, premium income may be used to provide a loan to the insured."

In its Notice, the IRS said that "the manner in which the contracts are interpreted, administered and applied [can be] inconsistent with arm's length transactions and sound business practices."

However, it added that, so far, it "lacks sufficient information to identify which arrangements should be identified specifically as a tax avoidance transaction, and to define the characteristics that distinguish the tax avoidance transactions from other related-party transactions." At this stage, it can only "alert persons involved in such transactions to certain responsibilities and penalties that may arise from their involvement with these transactions," it said.

In conclusion, the agency confirmed it recognizes "that related parties may use captive insurance companies for risk management purposes that do not involve tax avoidance, but believe that there are cases in which the use of such arrangements to claim the tax benefits of treating [their transactions] as an insurance contract is improper.