Microcaptives Create Headaches for Professionals

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Captive insurance companies have long been a popular vehicle for companies that require insurance in areas where it is hard to find coverage. Although the IRS has been somewhat suspicious of captives for some time, it was not until the past several years that microcaptives, or captives for smaller companies, apparently piqued the interest of the IRS. After the Tax Court issued an opinion over the summer, several other similar cases have gone to trial and await opinion. The result of these cases will have a significant effect on professional firms who facilitated the creation of these microcaptives, as the businesses hit with improper deductions and tax penalties will likely look for somewhere else to lay the blame.

In the most recently issued opinion, the Tax Court looked at two microcaptives created by a company in which it was paying the maximum amount of premiums to qualify for the tax deduction. These two companies were run by the owners of the company itself, as well as family members of the owner. The captives were then transferring funds to a separate entity also owned by family members of the company, reporting them as loans so that they would only be taxed on the investment income.

In concluding these captives did not provide legitimate insurance, the Tax Court looked at a variety of factors. This included the number of total entities being insured, the number of independent risk exposures, and the amount of claims paid by the insurance company. Each of the factors weighed against the captive in this case, and so the court ruled that the company owed over $1 million in back taxes and penalties.

The key takeaway from this case is that the court weighed a multitude of factors and did not find a prior revenue ruling that used 12 entities as an example of sufficient risk sharing as dispositive. In other words, the Tax Court suggested it will review microcaptives on a case-by-case basis.

This is bad news for lawyers, accountants, and actuaries who have helped prepare these captives. Case-by-case decisions mean that all are subject to IRS review and when faced with potential seven figure liability, these companies will likely turn to those who advised them for recompense. Professionals who have already facilitated the creation of microcaptives should therefore keep a close eye on the upcoming opinions of the Tax Court, and be careful in engaging any clients who wish to create a microcaptive in the future.