Micro-captive tax shelters are not popular with the Internal Revenue Service (IRS). What are they and what is the problem with micro-captives?
Under federal law, corporations or business groups can form their own insurance companies to serve the needs of their specialized industry or business model. Called a “captive,” these custom-built insurance entities allow their owners to create the insurance opportunities they need, participate in managing their risks and costs, and control and redirect premium that is not used to pay out claims.
As you might imagine, many captive insurance companies take up business in offshore tax jurisdictions with preferential, opaque tax regulations that work in favor of the owner or parent company of the captive. Captives reduce some of the overhead, volatility, and lost premium associated with commercial insurance.
A company or group of businesses may also elect to form a “micro-captive” company, which is basically a small insurance company. Under IRS Code section 831 (b), these small companies can realize some special benefits like only paying taxes annually on its investment income. According to the IRS, micro-captives are a hotbed of tax fraud including sheltering assets, dodging taxes on transferring generational wealth, and a host of other questionable tax practices.
To address the tide of abusive micro-captives, the IRS recently announced it made settlement offers to approximately 200 taxpayers concerning their involvement in micro-captives. In a news release, the IRS announced about 80 percent of those who received the letters opted to accept.
Beyond that, the IRS announced formation of 12 teams with a mandate to open IRS audits for taxpayers involved with micro-captives. IRS Commission Chuck Rettig remarked, “Taxpayers who elected to accept the IRS' terms have done the right thing by coming into compliance with their federal tax obligations and putting this behind them. Putting an end to abusive schemes is a high priority for the IRS."
In recent years, the IRS has gained the upper hand with judicial decisions that favor disallowing deductions taken by micro-captives.
At present, it is still possible to obtain the tax breaks offered by a micro-captive under certain, specific conditions. If you are considering participating in, or creating, a micro-captive for reasons or benefits not specifically entailed by the tax code—speak with an experienced tax attorney before you make up your mind.
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