Looking at Small Captives in a Post-Pandemic World

As the world looks eagerly towards turning the page on a very difficult year, putting 2020 in the rearview mirror is unlikely to change the near-term prospects for property and casualty insurance companies electing federal tax treatment under Tax Code Section 831(b).

Unfortunately, businesses relying on these small insurance companies to manage risk will continue to face heightened scrutiny in the new year. Besides recently announcing its second time-limited settlement initiative for participants in small captive insurance transactions that is harsher than its predecessor, the Internal Revenue Service has also deployed twelve new examination teams focused on small captive insurance transactions. The IRS has also significantly increased its small captive audit activity, making clear that it intends to make “abusive captive insurance transactions” a focus of its audit activities moving forward.

However, the problem with the IRS’ attack on small captives is that it has still not identified what distinguishes an abusive small captive insurance transaction from the types of legitimate captive insurance structures that Congress encouraged through its enactment and expansion of Section 831(b). With Covid-19 highlighting the significant limitations of traditional commercial insurance coverages, huge questions loom about taxpayers’ willingness to abandon their captive insurance programs despite the increased focus on such transactions.

2020 Small Captive Settlement Initiative

As a reflection of the ongoing onslaught against small captives, on Oct. 22, 2020, the IRS announced a second small captive settlement initiative that replaces its first initiative announced in September of 2019. When the IRS undertakes settlement initiatives, they rarely improve over time, and this one is no exception. The original initiative was already viewed by many practitioners as harsh when compared to the captive settlements previously being negotiated with IRS Appeals on a case-by-case basis. Under the original settlement program, taxpayers were required to disallow 90% of any deductions claimed and accept a 10% penalty on the tax adjustment. However, the penalty could be reduced down to zero in 5% increments by satisfying two requirements: (i) providing an affidavit that the taxpayer had not participated in any other reportable transactions; and (ii) by providing a statement from a third-party professional advisor upon whose advice the taxpayer relied. The new program requires a full concession of all deductions claimed by insureds for captive insurance premium payments. Moreover, the penalty reduction now starts at 15% so even the potential 10% reduction will not completely eliminate the penalty.

As with the original September 2019 initiative, the settlement requires taxpayers with active captive insurance companies either to liquidate their captives within 90 days or recognize a deemed liquidating dividend as if the company had already liquidated. For active captives that continue to have outstanding contractual insurance obligations and remain subject to the ongoing regulation of their respective domiciles regarding wind-up, near-term liquidation may not be an option, in which case the deemed liquidating dividend alternative may be the only option. Also, like the 2019 initiative, the 2020 settlement requires taxpayers to file gift tax returns for any direct or indirect transfers of value to the shareholders of the captive insurance program. Finally, as before, the full terms of the settlement resolution will be memorialized in a Form 906 Closing Agreement.

Increased Audit Activity

The 2020 small captive settlement initiative coincides closely with a significant increase in audit activity. In January 2020, the IRS announced the formation of 12 new examination teams focused on the examination of small captive insurance transactions. It followed that announcement with the issuance of Letter 6336 requesting information about whether taxpayers were continuing to participate in small captive insurance transactions and encouraging them to have their captive insurance program reviewed by an independent tax advisor. Since 2017, Notice 2016-66 has required participants in small captive insurance transactions to disclose their participation on Form 8886 and for material advisors to those transactions to maintain a list of their clients, which has helped the IRS identify taxpayers for potential audit (although in CIC Services, LLC v. IRS, argued before the U.S. Supreme Court on Dec. 1, 2020, the legitimacy of that Notice is being challenged).

On Oct. 1, 2020, the IRS announced it was expanding its enforcement focus on abusive small captive insurance schemes. That announcement quoted IRS Commissioner Charles Rettig who stated, “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 IRS-wide coordination with Criminal Investigation and the Office of Professional Responsibility, and our advanced data analytics and mining capabilities.” The announcement also indicated that the IRS was aware of variations on small captive insurance transactions that it believes are specifically designed to avoid the disclosure requirements imposed by Notice 2016-66. Since that announcement, professionals in the captive insurance industry has noticed a significant increase in audits of their captive insurance clients.

IRS Reliance on Tax Court Victories

In ratcheting up its attack on the captive insurance industry, the IRS can point to three victories in Avrahami v. Commissioner, Reserve Mechanical Corp. v. Commissioner, , and Syzygy Insurance Co. v. Commissioner as ammunition. It should come as no surprise that the IRS is trumpeting its victories in these three cases, all of which are cited in both Letter 6336 and the pronouncement of the 2020 settlement initiative. They are, after all, the only court opinions issued so far dealing with small captive insurance transactions (although an appeal in the Reserve Mechanical case is pending in the Tenth Circuit Court of Appeals).

But the landscape is also changing in the way captive insurance transactions are structured, with the captive insurance industry incorporating the lessons learned from those three cases, and making a concerted effort to eliminate the types of perceived abuses they brought to light. It stands to reason that these changes have improved, perhaps significantly, the prospects of successfully defending a captive audit in the future. This leaves open the question of how receptive taxpayers will be to accepting less favorable settlement terms on transactions with stronger facts.

The irony to all this is that it is happening in the midst of a pandemic, which has wrought economic turmoil on an untold number of small businesses and highlighted the limitations that traditional commercial insurance coverages can provide under such extreme circumstances. Indeed, captive insurance companies have provided many small businesses with an invaluable lifeline in the face of state and municipally mandated closures that have threatened their very existence.

When the dust finally settles, it remains possible that the IRS and the captive insurance industry can come closer to a meeting of the minds. Although no one can deny that the industry has been susceptible to periodic abuses, there should be agreement that well-structured captive insurance companies established and run in a bona fide manner to meet the risk-management needs of the businesses they insure can fill an important role in protecting a business in both good times and bad.

This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.

Author Information

Philip Karter, shareholder at law firm Chamberlain Hrdlicka and Pat McCann, associate at law firm Chamberlain Hrdlicka, both specialize in tax controversy and tax litigation matters. Philip can be reached at pkarter@chamberlainlaw.com and Pat can be reached atpatrick.mccann@chamberlainlaw.com.