Investment advisors and their clients could soon find themselves under the microscope. The IRS has let it be known that “micro-captive” insurance transactions are soon going to be under increased scrutiny.
While micro-captive insurance can be a legitimate tax structure for some businesses, the IRS counted it among potential abusive tax structures in its annual “dirty dozen” tax scams last year. Under IRS Notice 2016-66, released in November 2016, people and entities that have entered into these transactions, and those who have advised them to do it, will be required to make mandatory disclosures, as well as be under increased regulatory attention.
What Is a Micro-Captive Insurer?
First, some background. In a micro-captive insurance arrangement, the owner of a small company might create another entity to act as an insurer for the company. The company pays the insurer a premium, which it claims as a deduction. Meanwhile the insurer elects 831(b) captive status, allowing it to exclude up to $1.2 million (increasing to $2.2 million in 2017) of its net premium income from taxes for the year. The only tax obligation remaining for the insurer is investment income made on the premium moneys received.
In practice, a father might own a company and create an insurance entity under his son’s name. Effectively, the structure provides a means for transferring up to $1.2 million to his son via the insurance premium payment, nearly tax-free. In addition, the father’s company gets a substantial deduction for the premium paid.
Notice 2016-66 does not forbid this practice. Rather, it provides general guidance on which forms of the structure are considered “transactions of interest,” on which the IRS will now compel disclosure. Captive insurance arrangements will be considered transactions of interest when a company owner (or his relatives) also owns 20% or more of the company’s insurer, and if either the liabilities resulting from claims for the insurer were less than 70% of premiums collected for the trailing five years, or at any point in the previous five years the insurer made premium payments available for use by the insured company.