IRS Eyeing Micro-Captive Insurance Transactions

Investment advisors and their clients could soon find themselves under the microscope. The IRS has let it be known that "micro-captive" insurance transactions are soon going to be under increased scrutiny.

While micro-captive insurance can be a legitimate tax structure for some businesses, the IRS counted it among potential abusive tax structures in its annual "dirty dozen" tax scams last year. Under IRS Notice 2016-66, released in November 2016, people and entities that have entered into these transactions, and those who have advised them to do it, will be required to make mandatory disclosures, as well as be under increased regulatory attention.

What Is a Micro-Captive Insurer?

First, some background. In a micro-captive insurance arrangement, the owner of a small company might create another entity to act as an insurer for the company. The company pays the insurer a premium, which it claims as a deduction. Meanwhile the insurer elects 831(b) captive status, allowing it to exclude up to $1.2 million (increasing to $2.2 million in 2017) of its net premium income from taxes for the year. The only tax obligation remaining for the insurer is investment income made on the premium moneys received.

In practice, a father might own a company and create an insurance entity under his son's name. Effectively, the structure provides a means for transferring up to $1.2 million to his son via the insurance premium payment, nearly tax-free. In addition, the father's company gets a substantial deduction for the premium paid.

Notice 2016-66 does not forbid this practice. Rather, it provides general guidance on which forms of the structure are considered "transactions of interest," on which the IRS will now compel disclosure. Captive insurance arrangements will be considered transactions of interest when a company owner (or his relatives) also owns 20% or more of the company's insurer, and if either the liabilities resulting from claims for the insurer were less than 70% of premiums collected for the trailing five years, or at any point in the previous five years the insurer made premium payments available for use by the insured company.

Material Advisors, Tax Statements

Additionally, any material advisors who make a tax statement with respect to these transactions might be required to make a disclosure as well. A material advisor is defined by the Internal Revenue Code as any person who provides material aid in carrying out a reportable transaction, and receives gross income exceeding a threshold amount in exchange for such aid. The threshold for natural persons is $50,000, and $250,000 in any other case.

A "tax statement" can be any written or oral statement regarding the potential tax consequences of such a transaction. For such statement to be reportable, the advisor must receive a fee of at least $10,000 (if the client is a natural person) or $25,000 (if the client is an entity).

Entities, related individuals and material advisors must look back to any transactions since Nov. 2, 2006 (2006!) to see whether they may now have disclosure requirements. Any required disclosure must be made by Jan. 30, 2017. Failure to disclose could result in a fine of up to $50,000.

Required Disclosures Don't Equal Violations

The ultimate goal of the IRS is to identify those transactions that do not constitute legitimate insurance arrangements. The criteria for determining legitimate insurance include whether:

Coverage involves a plausible risk
Coverage matches a business need or risk
The description and scope of coverage is vague or illusory
Coverage duplicates commercially purchased coverage
Premiums are determined without actual underwriting or actuarial work
Payments are not made consistently with schedule provided in contract

This new mandatory disclosure is sure to put a heap of stress on advisors' shoulders (and will put their records retention system to the test). However, it is important to emphasize that any transactions that require disclosure are not, in and of themselves, violations of the tax code. For any transaction that is deemed a transaction of interest, any evidence pointing to the legitimacy of the insurance coverage would be advantageous.

— Read House GOP Pledges to 'Bust Up' IRS in Tax Plan on ThinkAdvisor.