The Internal Revenue Service (IRS) and Congress have launchedcampaigns to investigate small (or “micro”) captive insurers inrecent months. According to law firm Duane Morris, a number of advisors,accountants and estate planners have been using micro-captives tobenefit from tax and estate planning purposes, instead of usingthem for their intended risk management purposes.

On the surface, these micro-captives still present riskmanagement as part of their benefits. However, these captives havebeen structured so that the tax and estate planning aspectscompletely overwhelm the insurance aspects, Duane Morris claims.This practice has not gone overlooked by the IRS and Congress.

On Feb. 3, the IRS included micro-captives on its “Dirty Dozen”list. In a release, “Abusive Tax Shelters on the IRS 'Dirty Dozen'List of Tax Scams for the 2015 Filing Season,” the IRS explains indetail the fraudulent practices of these micro-captives:

Another abuse involving a legitimate tax structure involvescertain small or “micro” captive insurance companies. Tax lawallows businesses to create “captive” insurance companies to enablethose businesses to protect against certain risks. The insuredclaims deductions under the tax code for premiums paid for theinsurance policies while the premiums end up with the captiveinsurance company owned by same owners of the insured or familymembers.

The captive insurance company, in turn, can elect under aseparate section of the tax code [section 831(b)] to be taxed onlyon the investment income from the pool of premiums, excludingtaxable income of up to $1.2 million per year in net writtenpremiums.

In the abusive structure, unscrupulous promoters persuadeclosely held entities to participate in this scheme by assistingentities to create captive insurance companies onshore or offshore,drafting organizational documents and preparing initial filings tostate insurance authorities and the IRS. The promoters assist withcreating and “selling” to the entities often times poorly drafted“insurance” binders and policies to cover ordinary business risksor esoteric, implausible risks for exorbitant “premiums,” whilemaintaining their economical commercial coverage with traditionalinsurers.

Total amounts of annual premiums often equal the amount ofdeductions business entities need to reduce income for the year;or, for a wealthy entity, total premiums amount to $1.2 millionannually to take full advantage of the Code provision. Underwritingand actuarial substantiation for the insurance premiums paid areeither missing or insufficient. The promoters manage the entities'captive insurance companies year after year for hefty fees,assisting taxpayers unsophisticated in insurance to continue thecharade.

Additionally, the IRS isn't the only group that has noticedthese practices. On April 14, Sen. Orrin Hatch (R-Utah) introduceda bill that would increase the premium taxable incomelimitation for section 831(b) companies from $1.2 million to $2.2million, with an inflation adjustment for future years.

The bill, calledS. 905, would require the secretary of the Treasury to submit areport on the abuse of micro-captives to the Senate FinanceCommittee “so Congress can better understand the scope of thisproblem and whether legislation is necessary to address it.”

The bill also says the report should contain legislativerecommendations for addressing abuses. The deadline for filing thereport is Feb. 11, 2016.