Risk Alert: IRS Scrutiny of Abusive Micro-Captive Insurance Companies Can Increase a CPA Firm’s Professional Liability Risk

What is an abusive micro-captive insurance company?
Generally, amounts paid to third parties for insurance policies are deductible, but amounts set aside as a form of self-insurance are not deductible. A captive insurance company is an insurance company that writes insurance policies for its owners and affiliated companies of the owner. A “micro-captive” insurance company is a captive insurance company that makes a IRC §831(b) election to be taxed only on its investment income and not on its underwriting income, currently capped at $2.2 million per year. Since the owner(s) of a Captive receives a deduction for premiums paid to the Captive, and the Captive may currently exclude up to $2.2M from its income, an unusual situation is created whereby the operating company receives a tax deduction, but the income is not taxed by the Captive service provider.
 
An abusive Captive transaction is described in IRS Notice 2016-66. Simply put, in an abusive transaction, the IRS determines that the “insurance company” does not resemble a traditional insurance company and is a form of self-insurance established to take advantage of the income exclusion under IRC §831(b). IRS Notice 2016-66 describes many situations in which the Captive may be considered abusive. Examples of abusive Captive transactions include the following:

• The insured losses and claim administration expenses are less than 70% of premium income less dividends paid.
• The insurance coverage is for an implausible risk (e.g., hurricane insurance for an operating entity located in St. Louis).
• Premiums paid are significantly greater than the prevailing market rate.
• Claim administration procedures have not been established.
• The Captive loans, or otherwise transfers, capital to the operating entity or its owners.

 
Captives have been around since the 1950s. Why should we care about them now?
The IRS is increasing its scrutiny of all Captives with the goal of targeting abusive transactions. Specifically,

• In 2014, the abusive Captive tax strategy was identified in the IRS’s annual “Dirty Dozen” list of tax schemes.
• In 2016, IRS Notice 2016-66 described abusive Captives and identified the structure as a transaction of interest requiring taxpayers to disclose the strategy to the IRS.
• In 2017, the IRS Large Business and International Division adopted an audit campaign focused on Captives.
• Between 2017 and 2021, four court decisions have held that certain Captive transactions were not eligible for the benefits provided by IRC §831(b).
• On September 16, 2019, in IR-2019-157, the IRS offered a time-limited settlement for certain taxpayers under audit who participated in abusive Captive transactions.
• During 2020 and 2021, the IRS issued the following guidance:
  • IR-2020-26:  the IRS announced that it had established 12 Captive examination teams and stated that it plans to open several thousand Captive examinations. The notice also revealed that 80% of taxpayers eligible for the 2019 program accepted a settlement offer.
  • IR-2020-226:  the IRS notified taxpayers participating in Captive transactions to consult with an independent tax advisor to determine if the transaction is abusive.
  • IR-2020-241:  the IRS offered a second, time-limited settlement for certain taxpayers under audit who participated in abusive Captive transactions.
  • Office of Chief Counsel Memorandum 20211701F finding a certain micro captive promotor’s program was similar to an abusive program described in IRS Notice 2016-66.
• On April 9, 2021, in IR-2021-82, the IRS urged those involved with abusive Captives to exit these strategies as soon as possible and not take the premium deductions.

 
What should I do if a client or prospective client asks me to provide tax services to a Captive or a business making payments to a Captive?
Providing services to clients engaging in the Captive strategy, especially if an IRC §831(b) election has been made, increases the likelihood of an IRS audit and related professional liability risk. For example, if the structure is found to be abusive and anticipated tax benefits are not received, the client may assert that the CPA improperly advised the client or should have warned the client about the potential loss of benefits.
 
Implementing additional risk management protocols will help mitigate professional liability risks associated with this potential Captive strategy client service. At a minimum these should include:

• Obtaining a thorough understanding of Notice 2016-66,
• Advising the client that these programs may be a “transaction of interest” to the IRS and require a Form 8886, Reportable Transaction Disclosure Statement, to be filed with the tax return including the import of that disclosure, and
• Providing appropriate advice on potential disallowance of deductions, penalties, and interest.

While it may seem obvious, communications should be with the taxpayer, not the captive manager that purports to communicate on behalf of the taxpayer.
 
Conduct enhanced client and engagement acceptance procedures
Not all clients are appropriate candidates for the Captive strategy. Appropriate candidates should be financially sophisticated, assume responsibility for their decisions, and have the wherewithal to pay any potential liability upon examination. Also consider the client’s propensity to sue professionals. Even the most appropriate client may be upset and sue its professionals if the strategy is ultimately found to be abusive. Steer clear of clients that do not meet these criteria.

Gain an understanding of the steps taken by the client to confirm that the strategy is not abusive. Has the client engaged an independent tax attorney to evaluate the structure? If the client refuses to obtain legal advice, is that an indication of its risk tolerance? Does the client’s risk tolerance match the firm’s? If not, the client may not be a good fit.
 
Strengthen your engagement letter template
Engagement letters, for both businesses making payments to Captives and Captives themselves, should include an additional provision referencing IRS Notice 2016-66. The provision should encourage the client to have an independent tax attorney review the transaction as recommended by the IRS in IR-2020-226. For example, the following could be included in the engagement letter:

Abusive Micro-Captive Insurance Companies
In IRS Notice 2016-66, the IRS has identified certain micro-captive insurance company transactions as abusive. As a result, both micro-captive insurance companies and entities making payments to such entities are under an increased potential for IRS examination. If the structure is found to be abusive deductions may be disallowed, additional income tax may be assessed, and penalties and interest imposed. We, as well as the IRS, recommend that you engage an independent tax attorney to review the structure in order to help ensure that the strategy is not abusive.

 
Management representations
While uncommon for tax services, consider obtaining a management representation letter from the client clarifying its awareness of IRS Notice 2016-66. The management representation letter also should confirm that the client has reviewed its application to its Captive strategy with its professional advisors, and believes that the IRS will conclude that the Captive fulfills the definition of an “insurance company.” The management representation letter should also address whether the client has engaged an independent tax attorney to review its structure and conclusion.
 
Other considerations
If the client’s attorney has determined that the structure qualifies as a transaction of interest, disclosure on the tax return is required. If no determination has been made, advise the client to engage a professional to do so. If the client requests a referral, review the article Unintended Consequences of Professional Referrals and proceed accordingly. It is not recommended that the CPA firm perform the analysis to determine whether the structure qualifies as a transaction of interest as many of the “tests” are related to either general business or insurance industry specific requirements, of which most CPAs lack the requisite knowledge.

Even if the structure does not qualify as a transaction of interest, discuss whether the client should proactively disclose the structure to the IRS.
 
What if the firm provides audit services to a Captive or a business making payments to a Captive?
The same recommendations that apply to CPA firms providing tax services also apply to those performing audit services. In addition, the CPA firm must assess the accounting treatment of payments to the Captive, the Captive’s tax benefit for the exclusion of premiums from income, and whether a reserve is needed for uncertain tax positions. Finally, auditors must determine if the Captive strategy and the risks related to it should be disclosed in the footnotes to the financial statements.
 
What should I do if the firm has previously provided tax services related to a Captive or a business making payments to a Captive?
Identify those clients who may have engaged in Captive arrangements, and advise them, in writing, of the IRS’ heightened scrutiny, the likelihood that they will be audited, and recommend they consult with an independent tax attorney.
 
Conclusion
When implemented properly, using a Captive is an effective tax planning strategy. Unfortunately, some taxpayers have abused the benefits, drawing the IRS’s ire. Without a telltale sign of abuse on the face of a tax return, it is anticipated that many “innocent” taxpayers will be audited. Clients should be made aware of this potential exposure so they, and their CPA firms, can plan appropriately.
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