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

On the surface, these micro-captives still present risk management as part of their benefits. However, these captives have been structured so that the tax and estate planning aspects completely 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 in detail the fraudulent practices of these micro-captives:

Another abuse involving a legitimate tax structure involves certain small or “micro” captive insurance companies. Tax law allows businesses to create “captive” insurance companies to enable those businesses to protect against certain risks. The insured claims deductions under the tax code for premiums paid for the insurance policies while the premiums end up with the captive insurance company owned by same owners of the insured or family members.

The captive insurance company, in turn, can elect under a separate section of the tax code [section 831(b)] to be taxed only on the investment income from the pool of premiums, excluding taxable income of up to $1.2 million per year in net written premiums.

In the abusive structure, unscrupulous promoters persuade closely held entities to participate in this scheme by assisting entities to create captive insurance companies onshore or offshore, drafting organizational documents and preparing initial filings to state insurance authorities and the IRS. The promoters assist with creating and “selling” to the entities often times poorly drafted “insurance” binders and policies to cover ordinary business risks or esoteric, implausible risks for exorbitant “premiums,” while maintaining their economical commercial coverage with traditional insurers.

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

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

The bill, called S. 905, would require the secretary of the Treasury to submit a report on the abuse of micro-captives to the Senate Finance Committee “so Congress can better understand the scope of this problem and whether legislation is necessary to address it.”

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

Special Reports /

IRS Explores Micro-Captives&rsquo; Tax Fraud

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