On April 9, 2021, the IRS issued IR-2021-82, which urged participants in abusive micro-captive insurance arrangements to exit these transactions as soon as possible. At the time of the release, the IRS noted it has increased examinations of micro-captive arrangements and that it recently won another US Tax Court Case with the March 10, 2021 ruling in Caylor Land & Development, Inc. v. Commissioner, T.C. Memo 2021-30 (“Caylor”). In this case, the ruling stated that the arrangement failed to qualify as an insurance company for federal income tax purposes and the Taxpayer was not eligible for the tax benefits claimed.
The decision in Caylor is the fourth time in recent years that the US Tax Court determined that a micro-captive arrangement did not qualify as insurance and is the first case to apply accuracy-related penalties. Notably, to date the US Tax Court has been successful in limiting cases tried to those whose facts favor the Service, thus creating a negative bias at the examination level.
The IRS has historically challenged captive insurance arrangements and, as such, there is inherent risk in any captive insurance transaction that is heightened with respect to ‘micro-captive’ insurance arrangements. Micro-captive insurance transactions were first identified as potentially abusive tax transactions in 2014, when they were first placed on the IRS’ “Dirty Dozen” list. In Notice 2016-66, the IRS identified certain captive insurance transactions as “transactions of interest”, which required the person involved in the transaction to disclose it to the IRS on Form 8886 to avoid penalties. In 2020, the IRS significantly increased its focus on “abusive” micro-captives with the following:
- IR-2020-26 – Establishment of 12 NEW examination teams with ‘insurance’ specialists and standardized audit methodologies (January 2020).
- Letter 6336 – Two rounds of soft letters sent to participants in micro-captive insurance transactions alerting them that IRS enforcement activity in this area will be expanding significantly, requesting confirmation of the years of participation and date Taxpayer ceased participating, if applicable (March & July 2020).
- IR-2020-226 – IRS urges taxpayers to consult an ‘independent’ tax advisor and warns any future settlement offers will be not be as favorable as the first, which were in September 2019 (October 2020).
- IR-2020-241 – IRS announced that a second round of ‘limited’ settlement offers would in fact be forthcoming with stricter settlement terms. The IRS emphasizing it will be ‘relentless’ in its campaign against ‘abusive’ micro-captives (October 2020).
Industry participants and practitioners have been requesting the IRS to provide guidance on what qualifies as a valid micro-captive arrangement. Congress gave the IRS authority to undertake guidance related to ‘abusive” micro-captive arrangements as part of the PATH Act of 2015, however taxpayers are still waiting on additional guidance.
In light of the IRS’ continued focus and scrutiny of micro-captives, taxpayers and practitioners are encouraged to consult an independent tax advisor regarding their current or prospective captive insurance arrangements to determine whether the captive qualifies as an insurance company for federal income tax purposes. As highlighted by the pandemic, captives continue to serve as a legitimate risk management vehicle that allows taxpayers to navigate significant losses and survive.