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A federal court has struck down an Internal Revenue Service regulation that automatically classifies many small captive insurance arrangements as tax-avoidance arrangements.
Senior U.S. District Judge Lee Rosenthal ruled last week that the IRS exceeded its statutory authority when it declared that many small insurance companies that serve their owners are "listed transactions," or transactions assumed to be used to evade tax obligations, not just transactions of interest, which may require the parties involved to provide extra documentation.
Drake Plastics, a Houston-based company that makes and processes polymers, objected to the IRS classifying a captive insurance company that it uses to provide many types of insurance for about 30 different entities from using factors such a low ratio of claims to premiums to classify its micro captive as presumptively tax-avoidant.
The judge concluded in his opinion that the IRS had presented many reasonable arguments, but he wrote that the IRS had failed to meet the statutory requirements for classifying an arrangement as an example of presumptive tax avoidance.
The IRS argued that the loss-ratio factor was fair and easy to administer.
But "Congress required a specific finding in order to designate transactions as listed transactions," the judge wrote.
Dustin Carlson, president of SRA 831(b) Admin, a self-insurance arrangement administrator that served as a co-plaintiff in the case, welcomed the ruling.
"We stepped into this case because small businesses were being swept into a one-size-fits-all enforcement approach that threatened legitimate risk management strategies," Carlson said. "This ruling restores balance and makes clear that those businesses deserve to be evaluated on facts, not labels."
What it means: The new ruling applies specifically to a micro captive used to provider property and casualty insurance, and most micro captives are P&C entities.
But some advisors to business owners and ultra-high-net-worth clients have set up arrangements that combine micro captives with life insurance, and, in the past, the IRS has classified some arrangements that incorporate life insurance policies or annuities as listed transactions.
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