In September of 2019, I wrote about the IRS offering a settlement to 200 taxpayers who were currently under audit in relation to their risk-pooled 831(b) captive insurance company, which is sometimes referred to as a “microcaptive”.
Now, four months later, the IRS has disclosed the results of that settlement initiative, with nearly 80% of the taxpayers (or about 160 of them) having elected the settlement terms. If we assume that each taxpayer had taken at least a $1 million in deductions to their captive — which is probably a low number — that means that the IRS has raked in $160 million in payments with very little effort on its part and likely less than $1 million in IRS agent salaries.
That’s a pretty nice return. Such a nice return, in fact, that the IRS is going to substantially beef up its enforcement efforts in this area, per its announcement that:
“Enforcement activity in this area is being significantly increased. To that end, the IRS is deploying additional resources, which includes standing up 12 new examination teams comprised of employees from the IRS Large Business and International and Small Business/Self-Employed divisions that will be working to address these abusive transactions and open additional exams. These teams will use all available enforcement tools, including summonses, to obtain necessary information.”
I will start out this article with the standard caveat that I have given for the last several years: What the IRS is doing only affects a very small portion of the captive insurance sector, being risk-pooled 831(b) captives. The IRS is not taking any actions against captive insurance companies generally, and has not stepped up enforcement action against the large corporate captives that make up greater than 90% of the premiums paid nationwide by American companies to captives. The IRS is not even pursuing all captive insurance companies that have made the 831(b) election: There are a bunch of farm cooperative captives, auto warranty captives, workers compensation captives, etc., etc., that are not facing any heightened scrutiny from the IRS at all.
Instead, the IRS is concentrating on the captive clients of a number of captive managers who for years made it their business to sell tax shelter captives on a wink-wink nod-nod basis, drafting thick paperwork to say that the captives were not formed with any tax motivations, when in fact that was the sine qua non of the captive arrangement being created. Those captive owners (and those captive managers by way of promoter penalties) are who, and only who, are in the IRS’s current bullseye, but not captives generally — and it irks me when some idiot says “captives no longer work” because that is demonstrably false. Now, back to the IRS’s announcement.
What is happening here is that the IRS realizes that the three-year limitations period for opening new cases has already expired for many taxpayers as to tax years 2015 and before, recalling that the limitations period expires three years after tax returns are filed which would have been in 2016.
So, the IRS is now about to make a big push to open as many cases as possible in 2020 so that they pick up all the captive arrangements they consider to be abusive for tax years 2016 and later. Because the IRS issued Notice 2016-66 in 2016, the IRS considers abusive risk-pooled 831(b) arrangements to be in the nature of “penalty roadkill” for that and later years, since it will be impossible for taxpayers to claim after the Notice was issued that they were not aware that there were any problems with their captives.
Taxpayers who have risk-pooled 831(b) captives that are under audit are currently facing not just the loss of their deductions, but also 40% penalties. While the IRS has reported negotiated these penalties down in a few cases, in the vast majority of cases they are telling taxpayers to either pay the 40% or go pound sand (and go to the U.S. Tax Court) — and why not? In the three cases decided so far by the U.S. Tax Court, the taxpayers all suffered decisive losses, with each opinion getting worse for taxpayers than the one before it. Barring an IRS loss before the U.S. Court of Appeals (the Reserve Mechanical decision is being appealed), there is little reason to suspect that the law in this area will get better for owners of such captives.
The Service’s announcement that it will be creating 12 new audit teams for captives also indicates that it will start expanding its search for abusive risk-pooled 831(b) captive arrangements well beyond the small handful of not more than a dozen captive insurance managers (“promoters”, in tax shelter vernacular) for which the IRS has so far limited its efforts. With a dozen new audit teams, the IRS can now throw a substantially wider net and go after the captive clients of managers previously unaffected, in addition to fully taking down each and every of the captives of the managers they have identified so far as running abusive programs.
Some folks in the captive insurance industry started to express towards the end of 2019 that it seems that the IRS was starting to wind down their efforts against risk-pooled 831(b) captives and that perhaps this storm was starting to blow over. They were wrong, bigtime: This storm is going from a severe-yet-local thunderstorm to a full blown area-wide hurricane.
Taxpayers who have an 831(b) captive that is in a risk pool can no longer hope that they win the “audit lottery” and thereby stay off the IRS’s radar screen. They would be well-advised to seek a truly independent second opinion, i.e., not somebody suggested by their captive manager or anybody else who got them into the program in the first place, and to re-evaluate their situation and explore alternatives. Anecdotally, such captive owners who have voluntarily come forward to rectify their situation have fared much better in avoiding penalties than those who waited for the taxman to come.
Interesting, all the captive managers who have been hit with promoter audits have lately been trying to “tweak” their risk pools with the hopes that they can somehow become compliant in the future. This is probably fool’s gold: If the captive manager couldn’t get their risk pool right the first time around, they are quite unlikely to get it fix on subsequent tries either — particularly when their “tweaking” seems to be little more than trying to put additional makeup on the pig.
To summarize: With risk-pooled 831(b) captives, the IRS has found a rich seam of gold and is sending in additional miners. Many additional miners.
To further summarize: Those folks in the captive industry who claimed that the IRS was winding down its efforts against risk-pooled 831(b) captives were wrong. Again.
On a completely different note, probably the vast majority of the 160 or so taxpayers who have accepted the IRS’s settlement offer have probably committed to wind down their captive. It will be interesting to see how this is reflected in the captive numbers that are put out by the states whose insurance departments have in the past made a big deal about mass-licensing so many captives, nearly all of which were 831(b) captives of the risk-pooled varietal. No insurance commissioner likes to report diminishing license numbers, and I’ve got the strong impression that a few states have been fudging their numbers anyway.
The insurance commissioners of three states in particular, being Delaware, Tennessee, and North Carolina, grew those captive domiciles by specifically attracting tax-shelter captives. Far from putting in place controls to try to keep out captive insurance companies lacking a bona fide insurance purpose, the insurance commissioners (usually through their “captive deputy” or similar assistant commissioner) went well out of their way at captive conferences to make it clear that their doors were wide open for captives that didn’t have any purpose but to save federal income taxes. Those domiciles didn’t have any controls to screen out tax shelter captives then, and as far as I am aware they have no such controls (much less effective controls) today. So, it is going to be interesting to see if they follow the “Arizona experience”, recalling that in around 2005 the Arizona insurance commissioner took in a bunch of tax shelter § 501(c)(15) captives — and then spent the next decade trying to regurgitate them. Frankly, the IRS could take its 12 new audit teams and just have them look at Delaware, North Carolina, and Tennessee captives and they would have plenty of easy work.
Again — and this cannot be emphasized enough — what is going on here does not affect the vast majority of captive insurance arrangements, but only a finite set of abusive tax shelter captives that have made the 831(b) risk pool and have participated in risk pools that the IRS has determined has inadequate real risk (in addition to being marketed primarily as a tax device, disclaimers notwithstanding). This is thankfully a very small piece of the overall captive sector, which is otherwise completely unaffected by any of this. The industry may not like the nasty headlines, but many of those in the legitimate captive industry are breathing a sigh of relief that the IRS is finally removing this particular cancer from the industry.
An overall much healthier captive insurance industry will result therefrom.
IR-2020-26 of January 31, 2020. Available at: