Philip Karter (Photo: Chamberlain Hrdlicka) Philip Karter (Photo: Chamberlain Hrdlicka)

The Internal Revenue Service has been telling many users of “micro captive insurers” to surrender and accept a painful settlement offer or face the risk of Tax Court heck.

Few, if any, taxpayers have the kinds of life, health life, health and annuity micro captives that could be affected by the IRS crackdown on micro captives, according to Philip Karter, a tax lawyer in Philadelphia.

(Related: Captive Insurance Companies and Life Insurance: A Very Bad Combination)

But some micro captive owners have attracted the attention of the IRS by investing micro captive funds in life insurance, Karter said.

Karter — a shareholder in the Philadelphia office of one of the law offices that advises the micro captive owners, Chamberlain, Hrdlicka, White, Williams & Aughtry who has helped some of the micro captive owners cope with the IRS offers they can’t really refuse — talked about the owners’ plight in a recent interview.

Micro Captive Background

A “micro captive” is a small insurance company formed mainly to serve one taxpayer, or one group of taxpayers.

Some trade groups, for example, have formed micro captives to provide liability insurance for their members.

Even before 2014, some tax and investment advisors were warning that aggressive micro captive efforts could lead to conflicts with the IRS.

In 2014, IRS officials put micro captives that appear to exist mainly to reduce the owners’ tax bills, rather than to provide real insurance, on the IRS “Dirty Dozen” list of abusive tax arrangements.

The IRS started enforcement actions against some micro captive owners. The agency has won three federal court rulings against the micro captive owners.

This summer, the IRS ramped up the micro captives enforcement effort, by sending “limited settlement” offer letters to hundreds of micro captive owners.

The Micro Captive Settlement Offer

The IRS has sent the settlement offers to owners of micro captives that appear to be spending less than 70% of the premium revenue on insured losses and claim administration, or that have provided some kind of financing, loan or guarantee for the insured.

The IRS has told the captive owners who get the letters that it will refrain from taking those captive owners to court if they pay back the captive-related tax benefits they have received, along with penalties.

Taxpayers who get the settlement offer letters and refuse the offers “will continue to be audited by the IRS under its normal procedures,” officials said.

How Karter Sees the Situation

Karter said his firm has seen many clients in with questions about the settlement offer letters.

Karter said he has seen some micro captives with more than $3 million in assets, but that typical owners may have only a few hundred thousand dollars in assets backing a captive.

Many of the owners, such as the owners of new captives that are insuring businesses in California against catastrophic earthquake losses, appear to have good reasons for having low current loss ratios, Karter said.

“The settlement is not a particularly good one,” Karter said.

The problem for the owners with strong cases is that mounting a strong defense against the IRS might cost about $100,000, and, for many owners, that’s too much to spend to protect a captive with just a few hundred thousand dollars in assets, Karter said.

IRS officials are taking such a blunt approach because their own enforcement budget has been cut, Karter said.

From the IRS perspective, he said, using a broad, take-it-or-leave-it settlement offer, and asking the owners to show that their captives are legitimate captives, is easier than looking at each micro captive individually.

In theory, a coalition of micro captive owners could help one owner with a great case fund litigation against the IRS, and possibly win a victory that could shield all legitimate micro captives against overly broad IRS enforcement actions, Karter said.

But, in practice, Karter said, when he has tried to put such a coalition together, “it’s like herding cats.”

Life Advisors

Just about all of the micro captives getting the IRS settlement offer letters appear to be property and casualty micro captives, Karter said.

But Karter said that, in the past, some life planners had encouraged clients to invest surplus micro captive funds in corporate-owned life insurance.

“That rankles the service,” Karter said. “The IRS has its teeth into that like a junkyard dog.”

The life planners might have seen putting captive assets in life insurance as a safe, simple way to invest the assets.

The IRS, however, sees those arrangements as cases of taxpayers getting tax benefits when they put money into a micro captive, and more tax benefits when they invest the money in the life insurance, Karter said.

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

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