The exterior of the IRS building (Image: Allison Bell/ALM)

The Internal Revenue Service is moving forward with a legal battle with some users of captive insurance companies.

The IRS announced today that it has sent settlement offers to about 200 taxpayers who have used what the IRS classifies as “abusive micro-captive insurance transactions.”

“Taxpayers eligible for this offer will be notified by letter with the applicable terms,” IRS officials say in the announcement. “Taxpayers who do not receive such a letter are not eligible for this resolution.”

The IRS has included abusive micro-captive transactions on its “Dirty Dozen” list since 2014, officials say.

In 2016, the IRS put out a notice, IRS Notice 2016-66, that gave details about the kinds of arrangements the IRS would be treating as “transactions of interest.”

(Related: IRS Eyeing Micro-Captive Insurance Transactions)

The IRS said in the notice that it would look closely at captive insurers that spent less than 70% of their premium revenue on insured losses and claim administration expenses, or that made some kind of financing, loan or guarantee available to the insured during the period under review.

The IRS is sending settlement offers now because it has won three recent U.S. Tax Court cases, officials say in the new announcement.

The taxpayers receiving the offers formed captives under Section 831(b) of the Internal Revenue Code.

Many individuals and companies use real Section 831(b) captives for legitimate purposes, IRS officials say.

In the abusive structures, officials say, “promoters, accountants or wealth planners persuade owners of closely held entities to participate in schemes that lack many of the attributes of genuine insurance.”

“Although some taxpayers have challenged the IRS position in court, none have been successful,” officials say. “To the contrary, the Tax Court has now sustained the IRS’ disallowance of the claimed tax benefits in three different cases.”

Under the terms of the settlement offer, eligible taxpayers will have to agree to give up the income tax benefits received and pay “appropriate penalties (unless the taxpayer can demonstrate good faith, reasonable reliance),” officials say.

“The initiative is currently limited to taxpayers with at least one open year under exam,” officials say. “Taxpayers who also have unresolved years under the jurisdiction of the IRS appeals may also be eligible, but those with pending docketed years under Counsel’s jurisdiction are not eligible.”

The IRS may end up expanding the number of taxpayers who receive settlement offers, officials say.

Taxpayers who receive the settlement offer letters and opt out “will continue to be audited by the IRS under its normal procedures,” officials say. “Potential outcomes may include full disallowance of captive insurance deductions, inclusion of income by the captive, and imposition of all applicable penalties…. Taxpayers who are offered this private resolution and decline to participate will not be eligible for any potential future settlement initiatives.”

The IRS plans to continue to open additional exams in this area, officials say.

Arthur J. Gallagher & Company is one of the companies that has disclosed being involved in discussions with the IRS about Section 831(b) captives.

The Rolling Meadows, Illinois-based company said in July, in a quarterly report filed with the U.S. Securities and Exchange Commission, that one division of an advisory firm that was acquired in 2010 had been developing some of the Section 831(b) captives that have received IRS attention.

“The IRS has initiated audits for the 2012 tax year of over 100​​​​​​​ of the micro-captive underwriting enterprises organized and/or managed by us,” Gallagher said in the filing. “Among other matters, the IRS is investigating whether we have been acting as a tax shelter promoter in connection with these operations.”

Some of the micro-captive users filed a lawsuit against Gallagher subsidiaries and other defendants in December 2018, Gallagher said.

An adverse IRS determination could affect the lawsuit, Gallagher said.

Gallagher representatives were not immediately available to comment on the new IRS announcement.

Resources

A copy of the new IRS announcement is available here.

A PDF version of IRS Notice 2016-66 is available here.

— Read Tax Shelters and Abusive Tax Shelters: What Are They?on ThinkAdvisor.

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