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IRS Has a Tough Letter for Micro Captive Owners

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What You Need to Know

  • The letter involves a long-running battle between the IRS and micro captive users.
  • The micro captives themselves generally said they were insuring the owners against property or casualty risks.
  • Some of the micro captives bought corporate-owned life insurance or other life products.

The Internal Revenue Service is trying to make life even worse for the owners of what it classifies as abusive micro captive insurance arrangements.

In a recent ruling, the agency said that owners of abusive micro captives owe the IRS adjustment payments linked to their failures to withhold taxes on the cash used to make the micro captive premium payments.

A captive insurance company is an arrangement that a company, individual or group sets up to insure the owner, or owners, against risk.

The IRS already has refused to let the micro captive owners take deductions for the micro captive premium payments.

The affected micro captive owners must pay withholding tax adjustments on top of paying the IRS back for the amounts owed due to premium deduction denials, the agency states.

The withholding tax adjustment is equal to 30% of the total payments made to the captive insurer involved in the enforcement action in all tax years at issue, according to the IRS.

The agency’s office of associate chief counsel, international, recently gave that interpretation in a letter ruling sent to James Hartford and Doreen Susi, two IRS officials involved with micro captive regulation.

Letter Rulings

A letter ruling is supposed to help a taxpayer or tax advisor understand how the IRS sees an issue. In theory, a letter ruling is not supposed to serve as a precedent. In practice, taxpayers tend to see a letter ruling as a sign of how the IRS might handle a question in the future.

Letter rulings usually are issued without identifying the parties that asked for a ruling. Although the header of the new micro captive letter ruling shows that it’s directed at Hartford and Susi, it does not indicate whether taxpayers or taxpayers’ advisors asked for the ruling.

The IRS does not indicate how many taxpayers might be affected by the withholding tax adjustment ruling.

Micro Captives

An example of this practice is a large group medical practice that sets up a captive insurer to insure the doctor owners against medical malpractice risk.

The owner, or owners, typically set up a captive outside the United States, or in a U.S. state that has adopted a special legal framework for overseeing captive insurers.

In recent years, some wealthy individuals have set up small captive insurers. The owners say the captives have helped them manage risk. The IRS contends that some of the arrangements provide no meaningful protection against risk and serve mainly to reduce the owners’ income taxes.

Some large companies, for example, may set up their own insurers to provide property and casualty insurance for their own building.

Lawyers who track these entities say some of the advisors who helped taxpayers set up micro captives encouraged the groups to invest the micro captives’ cash in corporate-owned life insurance policies or other life insurance products.

The IRS put micro captives on its “Dirty Dozen” enforcement target list in 2014, and it warned in a 2019 letter sent that owners of micro captives found to be abusive should accept IRS settlement offers or prepare to face IRS enforcement actions.

About a year ago, the IRS warned it would “assert a withholding liability related to foreign captives” as well as demand that the taxpayers give up on deductions received.

The Taxpayers’ Argument

In the new letter, IRS officials note that a taxpayer might contend it believed it had the right to deduct the micro captive premiums and should not be responsible for withholding tax adjustments.

In the case of a micro captive, “a withholding agent cannot rely upon a payee’s claim of status as a U.S. or foreign person when it has actual knowledge or reason to know that the claim is unreliable or incorrect,” officials write.

A taxpayer who owns an abusive micro captive “should be treated as having knowledge of captive’s status as a foreign corporation” for withholding purposes, officials say.

What It Means

Typical financial professionals may not work with clients who have micro captives, but the IRS approach to the micro captive issue could indicate how the agency will approach other, more common arrangements on its annual “Dirty Dozen” list.

One item on this year’s list that could affect ordinary financial services clients is efforts by some organizations to promote tax-free pensions in Malta. The promoters say a tax treaty with Malta allows the sale of tax-free Maltese pensions. IRS officials say they’re looking into that.

(Photo: Allison Bell/ALM)