Abusive Microcaptive Insurance transactions are shams

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A recent Court of Appeals ruling has affirmed the IRS position that abusive Microcaptive Insurance transactions are shams. What are microcaptive insurance transactions and what does that mean for your tax position?

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What is captive insurance?

In brief, it is an insurance company set up to write insurance policies for its owners and affiliates. Why? Because amounts paid to third parties for insurance policies are deductible. Amounts set aside as a form of self-insurance are not. And there are other benefits utilized in such an arrangement that I won’t go into here.

A “microcaptive” insurance company is a captive insurance company that makes an election under section 831(b) to be taxed only on its investment income and not on its underwriting income, which must be less than $2.2 million per year. As a tradeoff, the captive insurer may not deduct its underwriting losses.

IRS court ruling

Microcaptive insurance arrangements have been under attack by IRS for years. On June 7, the IRS announced that a recent court decision upholds its long-standing position regarding abusive microcaptive insurance transactions. On May 12, in Reserve Mechanical Corp v. Commissioner, the U.S. Court of Appeals for the Tenth Circuit became the first appellate decision recognizing the IRS’s position that these abusive transactions are shams. The Tenth Circuit affirmed the Tax Court’s decision holding that the taxpayer was not engaged in the insurance business and that the purported insurance premiums it received were therefore taxable.

In addition to the premiums becoming taxable, IRS wants taxpayers to know that they have successfully asserted in many cases that microcaptive insurance transactions lack “economic substance” and as such a 20% penalty (40% if undisclosed) will automatically apply and that it cannot be waived or reduced by the IRS or the courts.

If you have any questions about the ruling, contact your Henry+Horne advisor today.

Dale Jensen, CPA

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