When Can Micro-Captive Transactions Lead to Tax Penalties?

 Posted on May 23, 2023 in Taxation Law

The IRS regularly reviews the documentation filed by individual taxpayers, businesses, and organizations, and it has identified numerous ways that taxpayers may engage in tax avoidance or tax evasion. The "abusive tax schemes" that are recognized by the IRS may lead to tax audits, and a taxpayer that has failed to pay taxes as required or meet other requirements for reporting information to the IRS may be subject to penalties. One abusive tax scheme recently highlighted by the IRS involves micro-captive transactions, and companies that engage in these types of transactions will need to be aware of what requirements may apply to them and how they can avoid potential penalties.

What Are Micro-Captive Transactions?

In some cases, businesses may establish "captive" insurance companies that are owned and operated by the parties who are insured by these companies. This can be an effective way to ensure that a company has appropriate insurance coverage to address unique issues, and it can provide other benefits as well. However, the IRS has identified certain types of captive insurance companies as "micro-captives" that may be used to reduce the amount of taxes a business may be required to pay.

In general, insurance companies are taxed based on their taxable income under Section 831(a) of the Internal Revenue Code. However, some companies may be eligible for an alternative tax under Section 831(b), and this tax is calculated based on a company's investment income in a given tax year. Because the income generated through premiums is not included in an insurance company's investment income, this may allow for a reduction in the taxes a company is required to pay.

To qualify for the alternative tax under Section 831(b), an insurance company must meet the following requirements:

• It must not be a life insurance company.

• The company's annual premiums cannot exceed a specific threshold. This threshold is adjusted annually based on inflation, and in 2023, it is $2,650,000.

• A single policyholder cannot contribute more than 20 percent of a company's net premiums in a given tax year.

In cases where a captive insurance company elects to be taxed under Section 831(b), it is considered a micro-captive. The IRS has found that some micro-captive structures have been used in tax avoidance schemes. By participating in transactions that do not have the attributes of genuine insurance coverage, companies may attempt to avoid paying taxes on the premiums paid to micro-captive companies.

To address this issue, the IRS has proposed new regulations that would classify certain types of micro-captive transactions as "listed transactions" that are considered to be abusive tax schemes or "transactions of interest" that may potentially involve tax avoidance. If the insured owns at least a 20 percent interest in an insurance company and a micro-captive engaged in certain types of financing transactions with the insured or had insured losses and claim administration expenses of less than 65 percent of the premiums earned, these transactions may be flagged and investigated by the IRS.

Contact Our San Jose, CA Tax Audit Attorney

While captive and micro-captive transactions can provide some benefits for businesses, they may result in increased scrutiny by the IRS, and penalties may apply if the IRS determines that a taxpayer has violated tax laws. If your company is being audited by the IRS based on these or other tax-related issues, John D. Teter Law Offices can provide you with legal representation, and we can help you understand how you can demonstrate that you complied with the applicable tax laws, or we can take steps to minimize the potential penalties that may apply. Contact our San Jose tax lawyer at 408-866-1810 to arrange a consultation.

Sources:

https://www.irs.gov/newsroom/treasury-and-irs-propose-regulations-identifying-micro-captive-transactions-as-abusive-tax-transactions