Year-End Update on the IRS and Captives in 2020
2020 has been a busy year for the IRS and the captive industry, notwithstanding the global pandemic.
To review, the IRS sent letters to taxpayers first in March and again in July requesting information regarding continued participation in the “micro captive insurance transaction,” including statements under penalties of perjury as to when the last year deductions or tax deductions were taken and when the taxpayer discontinued participation in the captive transaction. Given that this was merely a request, the questions were vaguely worded and the IRS has all of the information they requested in these letters via the filed forms 8886, few taxpayers actually responded to either request.
In response to the March letter, Senator Gardner from Colorado asked the IRS to suspend review of the micro captives until the appeal of the Reserve Mechanical Tax Court decision has been resolved. The Senator explained that the 10th Circuit Court of Appeals is “currently considering an appeal that will likely provide significant guidance for the industry,” noting that many in the captive insurance industry believe that the Tax Court’s decision in Reserve Mechanical is contrary to established law. He went on to add that a decision reversing the Tax Court’s ruling “will aid the IRS in deciding whether it is prudent to continue to deploy several examination teams to scrutinize the industry.” Unfortunately, the Senator’s letter has fallen on deaf ears, and the IRS continues its heavy-handed approach to taxpayers participating in these transactions.
About two weeks before the October 15 tax filing deadline, the IRS issued a release encouraging taxpayers engaging in “abusive micro-captive transactions” to consult an independent tax advisor, to seriously consider exiting the program and not claim deductions associated with the insurance premiums.
On October 23 the IRS issued another announcement, stating a new settlement offer would be extended to certain taxpayers. Terms of the settlement have yet to be announced, but the announcement indicated that the offer would be less favorable than previously offered. The announcement also indicated that the appeals function of the IRS is aware of this settlement offer and better resolutions should not be expected in Appeals than that being offered by the IRS. This, in particular, is a very curious statement. On the IRS website, it states very clearly that the appeals function is “separate and independent” from the IRS. Additionally, the Taxpayers First Act of 2019 was supposed to provide increased independence to the appeals function. Based upon the IRS’s most recent statement, the appeals function doesn’t appear to be very independent at all.
No one is arguing that the IRS should not pursue transactions without economic substance. The IRS, however, has painted the entire micro captive industry with the same overly broad brush, implying that all micro captives are improperly organized and operated. They seem to have glossed over the fact that Congress approved of the micro captive insurance transaction when Section 831(b) was amended by the PATH Act. The actions taken by the IRS this year are attempts to frighten taxpayers into submission. All of this against a backdrop of a global pandemic, losses from which are generally not covered by the commercial marketplace.
So why does the IRS continue down this path? Most likely, they realize that the landscape will be shifting over the next several months. Their argument that there haven’t been losses in many captives will be rendered moot given the events of 2020. The “logic” employed by the Tax Court in the Reserve Mechanical case is incredibly flawed. Finally, we know that there are cases pending in Tax Court with far more favorable fact patterns from the taxpayers’ perspectives. Captives, utilized correctly, remain an invaluable business and risk financing tool.