It’s Time for Treasury to End the Backlog of Microcaptive Cases

Acting IRS Chief Counsel Ken Kies announced in January that the IRS would be making final settlement offers to taxpayers with syndicated conservation easement, or SCE, cases. The reason: The backlog of hundreds of SCE cases in the US Tax Court has become untenable.

Any attempt to clear the SCE bottleneck and free up limited administrative and judicial resources is a welcome development. But where is the settlement offer for the thousand-plus microcaptive insurance cases sitting on the Tax Court’s docket?

If the SCE backlog is untenable, the small captive backlog is bordering on insurmountable.

Kies, who also is assistant secretary for tax policy at the Treasury Department, said there are approximately 700 SCE cases before the court, with 400 more on their way from audits.

By last count, in late 2024, there were over 1,000 cases involving small captive insurers pending in the Tax Court, with many more under audit.

The first of these so-called “microcaptive” cases, Avrahami v. Commissioner, was decided in 2017. Since then, there have been fewer than a dozen small captive cases tried and decided by the court.

Neither the IRS nor the Tax Court have the resources to handle this volume of cases, particularly not at the glacial pace at which they have been progressing over the past decade. Moreover, taxpayers deserve a fair, realistic mechanism to settle their cases short of a multiweek trial, something previous IRS settlement programs haven’t offered.

Microcaptive History

Section 831(b) of the Internal Revenue Code allows small captive insurance companies to elect to be taxed solely on their investment income, thus avoiding taxation on their premium income. Congress’s goal in enacting the statutes was to provide economic advantages to small businesses to self-insure through a captive (or self-owned) insurance company.

The law, part of the Tax Reform Act of 1986, was inspired in part by the difficult market for liability insurance in the 1980s. At the outset, only captives with annual premiums of $1.2 million or less qualified. For tax year 2016, the premium limit increased to $2.2 million, an amount that is now inflation adjusted on an annual basis.

Also beginning in tax year 2016, Congress added a diversification requirement to Section 831(b), requiring that no more than 20% of an electing captive’s premiums can come from a single policyholder. This addition sought to address concerns that 831(b)-electing captives were being used as tax shelters, generating premium deductions for the insured company but no corresponding taxable premium income for the captive itself. When the captive amassed enough reserves from unused premiums, it could simply dividend the amounts back to its owner, creating a circular (and virtually tax-free) flow of funds.

The IRS noticed and began issuing subpoenas to captive insurance company managers, the insurance professionals who run the day-to-day operations of captive insurance companies. The subpoenas led to promoter audits and to microcaptives’ appearance on the IRS’s Dirty Dozen list from 2015 until 2024.

A decade ago, in Notice 2016-66, the IRS designated microcaptives as a transaction of interest requiring reporting by both taxpayers and their material advisers. Following a series of legal challenges that invalidated Notice 2016-66, the IRS issued regulations designating some microcaptives as listed transactions and others as transactions of interest.

Along the way, the IRS opened hundreds of captive insurance company examinations and, in 2020, announced that it had formed a dozen teams of auditors to conduct thousands of captive insurance company examinations.

Settlement Offers

The IRS issued a settlement offer to “up to 200” taxpayers who were still under audit at the end of 2019. A year later, a second, “stricter” settlement offer was issued to select taxpayers under audit.

Neither offer applied to any taxpayer with a captive case docketed in the Tax Court—a significant limiting factor considering how long the IRS had been auditing microcaptives and how many of those audits had concluded and moved on to the court.

Both offers required that the taxpayer close down their captive and concede the majority of the claimed tax benefits. In the words of one taxpayer, “If I close down the captive, where am I supposed to get my insurance?”

This rings particularly true in a hardening insurance market like today’s, where some coverages are either not available in the commercial market or are prohibitively expensive. Ironically, the kind of market that inspired Congress to enact Section 831(b) in the first place made these prior settlement offers a nonstarter for many captive owners.

Rock, Hard Place

The lack of a viable settlement offer in the small captive insurer space is a primary cause of the immense backlog in the Tax Court and in the IRS’s exam function. With each closed exam cycle comes another petition to the Tax Court and, shortly thereafter, another audit of the most recent tax year.

I have clients whose captives have been under audit since tax year 2018. Some of their tax years have been sitting in the Tax Court for years, while others are at various stages of the administrative process.

It often feels as though there is no end in sight. Sure, they could quit now and give up their case. But they believe in the legitimacy of their captive program, need it to manage their unique risks, and have invested so much in legal and professional fees at this point that conceding simply isn’t an option.

The best they and others like them can do is hope for a reasonable settlement offer that is more attractive than continuing down the path toward a lengthy, fact-intensive trial. In an era of reduced IRS funding and significant reductions in staff, the government should want that, too.

This article does not necessarily reflect the opinion of Bloomberg Industry Group, Inc., the publisher of Bloomberg Law, Bloomberg Tax, and Bloomberg Government, or its owners.

Author Information

Melissa Wiley is a partner at Kostelanetz focused on administrative tax controversy, including audits and cases before the IRS Office of Appeals.

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