Tax law generally allows businesses to create "captive" insurance companies to protect against certain risks. Under Section 831(b) of the Internal Revenue Code, certain small insurance companies can choose to pay tax only on their investment income. The IRS said that in abusive "micro-captive" structures, promoters, accountants, or wealth planners persuade owners of closely held entities to participate in schemes that lack many of the attributes of genuine insurance.

The IRS said that it consistently has disallowed the tax benefits claimed by taxpayers in abusive micro-captive structures. Although some taxpayers have challenged the IRS position in court, none have been successful. To the contrary, the tax court has now sustained the IRS's disallowance of the claimed tax benefits in three different cases.

The IRS said that it will continue to disallow the tax benefits claimed in these transactions and will continue to defend its position in court. The IRS added that it has decided, however, to offer to resolve certain of these cases on the terms outlined below.

"The IRS is taking this step in the interests of sound tax administration," the IRS's commissioner, Chuck Rettig, said. "We encourage taxpayers under exam and their advisors to take a realistic look at their matter and carefully review the settlement offer, which we believe is the best option for them given recent court cases. We will continue to vigorously pursue these and other similar abusive transactions going forward."

The IRS said that the settlement brings finality to taxpayers with respect to the micro-captive insurance issues. The settlement requires substantial concession of the income tax benefits claimed by the taxpayer together with appropriate penalties (unless the taxpayer can demonstrate good faith, reasonable reliance). Taxpayers eligible for the settlement will be notified of the terms by letter from the IRS. The initiative is currently limited to taxpayers with at least one open year under exam. Taxpayers who have unresolved years under IRS appeal also may be eligible, but those with pending docketed years under counsel's jurisdiction are not eligible. The IRS said that it is continuing to assess whether the settlement offer should be expanded to others.

Taxpayers who receive letters under this settlement offer, but who opt not to participate, will continue to be audited by the IRS under its normal procedures. Potential outcomes may include full disallowance of captive insurance deductions, inclusion of income by the captive, and imposition of all applicable penalties.

Although taxpayers who decline to participate will have full appeals rights, the IRS said that its office of appeals is aware of this resolution initiative. Given the current state of the law, it is the view of that office that these terms generally reflect the hazards of litigation faced by taxpayers, and taxpayers should not expect to receive better terms in appeals than those offered under this initiative.

According to the IRS, taxpayers who are offered this private resolution and decline to participate will not be eligible for any potential future settlement initiatives. The IRS also said that it plans to continue to open additional exams in this area as part of ongoing work to combat these abusive transactions.