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Microcaptive parents, managers targeted by IRS

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SCOTTSDALE, Ariz. — The parent companies and the managers of microcaptive insurers face growing IRS scrutiny and should be prepared for an IRS audit, captive experts say.

Under recently enacted federal legislation, captives electing to follow Section 831(b) of the U.S. Tax Code will be able to avoid federal taxes on up to $2.2 million in annual premium income effective in 2017. That's up from the current limit of $1.2 million.

But the legislative changes also include stricter rules on the ownership structures of microcaptives, which often are used by family-owned companies, to be eligible for the tax exclusion.

Speaking Monday at the Captive Insurance Cos. Association's 2016 International Conference, experts said the changes will serve only to increase scrutiny of the IRS, which put microcaptives on its “Dirty Dozen” list of tax scams for the past two years.

“The IRS scrutinizes small captives very closely,” said Daniel Kusaila, Hartford, Connecticut-based tax partner at Crowe Horwath L.L.P. Captive parents that “are trying to massage” their premium income “need to be very careful because they are putting their tax election at risk.” It also could “put the captive in jeopardy,” he said.

Some microcaptives are stretching the limits of the tax laws, said Anne Marie Towle, a vice president and senior captive consultant at Willis Towers Watson P.L.C. in Chicago.

Mr. Kusaila recommends getting sound guidance in structuring a captive to avoid IRS questioning. “These should be set up as insurance first, insurance second and insurance third,” he said.

Tim Tarter, Phoenix-based captive insurance tax audit and litigation defense lawyer at Woolston & Tarter P.C. and a former IRS senior attorney, said the IRS is auditing a “substantial” number of microcaptives, including comprehensive interviews and information requests.

Some captive managers also are being investigated to determine if they are promoting tax shelters, he said.

“The IRS records their interviews in the hopes of getting someone to say the captive was put together for tax purposes,” rather than for legitimate insurance purposes, Mr. Tarter said. When the IRS inquires about the background of the captive and the advice given, “one of the problems” is that “they are going well beyond the year of the audit.”

In 18 months of examinations at the IRS, Mr. Tarter said the stance he saw most often was disallowing premiums at the audit level.

“We see penalties regardless of the facts,” he said.

“The good news is that we are getting some gray matter applied in IRS appeals, and as these cases are decided by courts, there will be more open-mindedness because everyone is just on autopilot right now at the exam,” Mr. Tarter said.