The IRS’s legal battle against one of its “dirty dozen” tax scams is still young, but early victories for the agency have some wondering if a large-scale settlement is on the horizon.
The U.S. Tax Court in Syzygy Ins. Co. v. Commissioner handed the Internal Revenue Service its third straight victory in a case involving an insurance arrangement known as a micro-captive. The April decision followed successive wins in Avrahami v. Commissioner and Reserve Mechanical Corp. v. Commissioner.
The IRS has accused some of the arrangements of being tax shelters, and in 2016 it put out a notice describing its concern and imposing new disclosure requirements on the industry.
With more than 500 docketed micro-captive cases sitting at the Tax Court, according to an IRS news release, and a decision in another big case expected any day, practitioners are speculating that the agency may be considering a global settlement initiative to deal with the volume.
The IRS, however, isn’t offering any clues about a potential mass settlement program.
“The IRS is committed to addressing noncompliance to include abusive micro-captive insurance transactions,” the agency said in an email. “We have a significant number of taxpayer and promoter examinations currently open and plan to open additional examinations in the coming months.”
Jay Adkisson, a former chair of the American Bar Association’s captive insurance committee, said so far most of the talk about a global settlement is coming from the industry, not from the IRS. It’s unclear how far the agency wants to take litigation before considering such a program, he said.
The speculation that the IRS may be considering a global settlement initiative, similar to what it offered to close disputes over tax shelters promoted in the 1990s, is fueled by the large number of docketed cases.
“When you look at the amount of time it takes for one of these case to get through the system, I don’t see how they possibly have the resources to try and bring to decision over 500 captive insurance cases,” said Lawrence Kemm, a partner at Holland & Knight LLP in Tampa.
Captive insurance companies are formed to insure the risk of an operating business, which may be a corporate parent and subsidiaries of a parent.
One of the main benefits is that a captive can insure risks that otherwise would be too expensive or for which coverage isn’t available in the commercial marketplace.
Companies with $2.3 million or less in premium income can qualify as micro-captives under tax code Section 831(b), meaning they are only taxed on their investment income.
The IRS has increased scrutiny of micro-captives in recent years, asserting that some lack the attributes of genuine insurance and are merely created to dodge taxes.
There were rumblings that the IRS was working on a settlement initiative as far back as two years ago but that initiative never materialized, said Rachel L. Partain, a member of Caplin & Drysdale Chartered.
Past global initiatives, resulting from the IRS’s crackdown on tax shelters popular in the 1990s—like the 2004 “Son of Boss” settlement program—could provide clues to how the agency might craft a future micro-captive settlement deal.
But Partain said she suspects such a program has been delayed because micro-captives are so “factually specific.”
The IRS in its 2018 “Dirty Dozen” list identified the many ways in which micro-captive structures can fall short of a proper insurance arrangement. It notes transactions where “coverages may insure implausible risks, fail to match genuine business needs, or duplicate the taxpayer’s commercial coverages” as just a few that raise alarms. The arrangements also made the agency’s 2019 list of top tax scams.
For the the cases currently docketed at the Tax Court, it is likely attorneys in the IRS Office of Chief Counsel will push taxpayers toward individual settlements specific to their facts, Partain said.
Even so, she said a global settlement could be possible, despite the challenges. In theory, the IRS “could try to draw distinctions such as, ‘If you have 3 of the following 5 facts, then you get a 20% penalty; if you have less, then you get a 10% penalty,’ and then they can use whichever facts they have determined to be more problematic,” she said.
Clear Rule Needed
The agency needs to have a full understanding of the different ways micro-captives are structured before determining which arrangements would be considered most offensive under a potential global settlement option, said David J. Slenn, a partner at Shumaker, Loop & Kendrick LLP and another former chair of ABA’s captive insurance committee.
“The service is probably going to want to have a clear rule as to who’s eligible and who’s not eligible, as they’ve done in the past,” Slenn said.
The IRS has been trying in a variety of ways to gain more insight into the transactions.
In addition to adding micro-captives to its “Dirty Dozen” list, the IRS has identified certain micro-captives as “transactions of interest"—a rare move that subjects those involved in the arrangements to new reporting requirements.
Micro-captives are also the focus of one of the IRS Large Business and International Division’s tax compliance campaigns.
Adkisson suggested that the IRS may be waiting until it gets a “clear-cut” Tax Court victory where the taxpayer is subject to a 40% penalty before considering a global settlement program.
The IRS can assess a 40% penalty when a transaction lacks “economic substance"—meaning it serves no other purpose than to reap tax savings—and the facts of the transaction aren’t adequately disclosed.
Being able to assess a 40% penalty will put the IRS in a better negotiating position for a global settlement program or any future individual settlements with taxpayers, Adkisson said.
“If they’re able to ding somebody with the 40% penalty, then maybe the 20% penalty doesn’t look so bad,” he said.
The IRS’s three major Tax Court victories have been in cases where micro-captives used risk pools to achieve risk diversification necessary for the arrangements to qualify as bonafide insurance companies. In all three cases, the court held that the captive’s participation in the risk pool didn’t pass the diversification test.
The IRS’s case against Caylor Land & Development Inc., which was tried in May 2016, is expected to be the next big micro-captive case decided. It looks at a different type of arrangement.
In the Caylor case, the captive insures 12 related entities and isn’t involved in a risk pool. The judge’s decision could provide answers on the number of affiliated entities that need to be insured to provide adequate risk distribution.
The court is also expected to analyze, as it did in Avrahami, whether the arrangement had a sufficient number of diverse independent risk exposures—such as the number of cars, stores, etc. insured.
Practitioners are hoping to see more cases with stronger facts than those that have been tried and decided so far.
“Ultimately, I’m optimistic that a taxpayer will win,” Partain said. “But I think it’s going to take a while for that to happen.”