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

The IRS continues to successfully challenge in court that certain micro-captive insurance companies (hereinafter referred to as “Micro-Captive(s)”) are not eligible for the benefits provided by IRC §831(b), recently winning multiple Tax Court decisions. CPA firms with clients who have established, or are considering establishing, a Micro-Captive should pay special attention to this Risk Alert.
 
Tax practitioners should be cognizant of the Internal Revenue Service’s (“IRS”) latest activity, which is increasing and focused on Micro-Captives. Additional scrutiny and skepticism of Micro-Captives may increase the professional liability risk of a CPA firm.
 

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 is a captive insurance company that meets the statutory written premium limit, indexed for inflation, required to make a IRC §831(b) election. A Micro-Captive that makes this election is taxed only on its investment income and not on its underwriting income, but only in years where its written premiums do not exceed the annual limit. Since the owner(s) of a Micro-Captive receive(s) a deduction for premiums paid to the Micro-Captive, and the Micro-Captive may exclude those same premiums from its income in years when it meets the IRC §831(b) premium limit, an unusual situation is created whereby cash transactions between related parties are deducted but not correspondingly taxed as income, reducing the overall tax burden of the combined group.

The IRS responded to this mismatch in 2016 by publishing Notice 2016-66, identifying certain Micro-Captive transactions as “transactions of interest.” In response to court decisions ruling against the IRS for its failure to comply with the Administrative Procedure Act, Treasury vacated Notice 2016-66 in 2023. In April, 2023 the IRS issued Proposed Regulations identifying certain micro-captive transactions as either “listed transactions” or “transactions of interest” (herein referred to as “abusive Micro-Captives”). Simply put, in an abusive Micro-Captive 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). Examples in the Proposed Regulations of abusive Micro-Captive transactions include the following:

• The insured losses and claim administration expenses are less than 65% of premium income less dividends paid.
   

• The Micro-Captive loans, or otherwise transfers, capital to the operating entity or its owners.
   

To demonstrate the IRS’s thoughts, previous guidance included the following Micro-Captive transactions as indicative of abuse:
 

• 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 rules regarding these transactions are complex, and clients should consider engaging an experienced micro-captive insurance company attorney to review them.
 

Captives have been around since the 1950s. Why should we care about them now?

The IRS continues to increase its scrutiny of Micro-Captives with the goal of targeting abusive Micro-Captive transactions. Specifically,
 

• In 2014, the abusive Micro-Captive tax strategy was identified in the IRS’s annual “Dirty Dozen” list of tax schemes.
   

• In 2016, IRS Notice 2016-66 described Micro-Captives and identified abusive structures 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 Micro-Captives.
   

• Between 2017 and 2021, several court decisions held that certain Micro-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 Micro-Captive transactions.
   

• During 2020 and 2021, the IRS issued the following guidance:
   

  • IR-2020-26:  the IRS announced that it had established 12 Micro-Captive examination teams and stated that it plans to open several thousand Micro-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 Micro-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 Micro-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 Micro-Captives to exit these strategies as soon as possible and not claim tax benefits under IRC §831(b).
   

• In 2024, the IRS continues to successfully challenge in court that certain Micro-Captive insurance companies are not eligible for the benefits provided by IRC §831(b), recently winning multiple Tax Court decisions.
   

What should I do if a client or prospective client asks me to provide tax services to a Micro-Captive or a business making payments to a Micro-Captive?

Providing services to clients engaging in the Micro-Captive strategy, especially if an IRC §831(b) election has been made, increases the potential 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 helps mitigate professional liability risks associated with this potential Micro-Captive strategy client service. At a minimum these should include:
 

• Obtaining a thorough understanding of  the Proposed Regulations,
   

• Advising the client that these programs may be considered “abusive” 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,
   

• In situations where the CPA is engaged to provide advice or consult regarding Micro-Captives, considering whether or not a Form 8918, Material Advisor Disclosure Statement, should be filed by the CPA firm, and
   

• Providing advice on potential disallowance of tax benefits, penalties, and interest if the taxpayer does not qualify under IRC §831(b).
   

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 using the Micro-Captive strategy may be appropriate candidates for the CPA firm. 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 most recent 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 Micro-Captives and Micro-Captives themselves, should include an additional provision referencing the Proposed Regulations. 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 Prop. Reg. 1.6011-10 and -11, the IRS has identified certain micro-captive insurance company transactions as abusive and others as transactions of interest. 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, tax benefits may be disallowed, resulting in additional income tax, penalties and interest being 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 the Proposed Regulations. The management representation letter also should confirm that the client has reviewed the Proposed Regulations’ application to its Micro-Captive strategy with its professional advisors, and that the Micro-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, the date of the review, and its conclusion.
 

Other considerations

If the client’s attorney has determined that the structure qualifies as abusive, 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 abusive because 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 abusive, discuss whether the client should proactively disclose the structure to the IRS.
 

What if the firm provides audit services to a
Micro-Captive or a business making payments to a Micro-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 Micro-Captive, the Micro-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 Micro-Captive strategy and the risks related to it should be disclosed in the footnotes to the financial statements.
 

Identify those clients who may have engaged in Micro-Captive arrangements, and advise them, potentially a second time, 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 Micro-Captive is an effective tax planning strategy. Unfortunately, some taxpayers have abused the benefits, drawing the IRS’ 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.