The Internal Revenue Service (IRS) has expanded its enforcement focus on ‘abusive’ micro captives insurance schemes, urging taxpayers to consult an independent tax advisor before the 15 October filing deadline.
The IRS said taxpayers should not assume it will able to settle any transactions with the IRS or chief counsel on terms more favourable than the previously announced settlement offers.
The service also highlighted that any potential future settlement initiative that it considers will require additional concessions by the taxpayer.
The IRS suggested taxpayers “should seriously consider” exiting the transaction and not claiming deductions associated with micro captive transactions.
For those taxpayers that do not exit the transaction and continue taking deductions, the IRS said it will disallow tax benefits from transactions that it determines to be “abusive”.
The IRS noted that it may also require domestic captives to include premium payments in income and assert a withholding liability related to foreign captives.
Penalties will also be enforced as appropriate, including the strict liability penalty that applies to transactions that lack economic substance, according to the service.
The IRS also stated that it will “continue to litigate these abusive transactions in tax court”.
As part of the IRS’ continued focus in this area, the service said it has become aware of variations of the ‘abusive’ micro captive insurance transactions, including certain Puerto Rico-based and offshore captive insurance arrangements that do not involve section 831(b) elections.
It said: “These variations appear to be designed and marketed with the express intent of avoiding reporting under Notice 2016-66 and yet perpetuating in some cases the same or similar abusive elements as abusive micro captive insurance transactions.”
“The IRS is aware of these abusive transactions and is actively working to counter their proliferation. The IRS cautions taxpayers that, to the extent they engage in variations of abusive micro-captive transactions that are substantially similar to Notice 2016-66, they must be disclosed. Otherwise, the IRS will impose penalties for the failure to disclose.”
IRS commissioner Chuck Rettig said enforcement efforts will continue and any future settlement terms “will only get worse, not better”.
Rettig explained that the IRS has “never been better positioned in its quest to eradicate abusive transactions following the stand-up of a dedicated promoter office, a new fraud enforcement office, enhanced service-wide coordination with criminal investigation and the office of professional responsibility, and our advanced data analytics and mining capabilities”.
He added: “Taxpayers are strongly encouraged to use this opportunity to put this behind them and get into compliance.”
For the first time since 2014, micro captives were not listed on the 2020 IRS’ ‘Dirty Dozen’ list of tax scams.
The annual list is a compilation of a variety of common scams that the IRS said represents “the worst of the worst tax scams” and should be avoided by taxpayers.
Although micro captives were not featured on the IRS’ official list, it did state that an upcoming series of releases will be published on topics such as abusive micro captives and fraudulent conservation easements.
The IRS ramped up its scrutiny in November 2016 with the release of Notice 2016-66, which identified certain micro captive transactions as having the potential for tax avoidance and evasion.
In March and July this year, the IRS issued letters to taxpayers who participated in a Notice 2016-66 transaction alerting them that IRS enforcement activity in this area will be expanding significantly and providing them with the opportunity to tell it if they’ve discontinued their participation in this transaction before the IRS initiates examinations.
The IRS revealed that early responses indicated that a significant number of taxpayers who participated in these transactions have exited the transaction.
However, the issued letters were not received well by the industry, with various captive insurance associations sharing concerns about the timing of the letter during the ongoing COVID-19 pandemic.
At the time the letters were issued, Richard Smith, president of the VCIA, stated that it came at a “time of extraordinary circumstances as every organisation including the federal government, is struggling to endure the pandemic crisis we now face”.
Elsewhere, Rae Brown, president of the Arizona Captive Insurance Association, said the association was left “astonished and frustrated to receive” the IRS letter during “this difficult crisis”.
The associations, among others in the industry, requested the IRS withdraw the letter and suspend its audit activities of micro captives until the COVID-19 crisis is over and the economy is on the road to recovery.
Although the IRS did not suspend the letters, it did move the deadline from 4 May to 4 June 2020.
In a statement, the IRS said that due to the conditions of COVID-19, taxpayers may need additional time beyond the original deadline in May due date to provide written responses.
The Self-Insurance Institute of America (SIIA) said that although it was good news for captive owners, the association would continue advocating for the IRS to stand down on its “unnecessary data collection and more appropriately focus its activities on narrowing guidance”.
The service has continued its enforcement with the release of a new batch of letters this summer as well as 12 newly formed micro captive examination teams to increase the examinations of ongoing micro captive insurance transactions.