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Captives enter IRS crosshairs after some cover 'implausible risks'

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SCOTTSDALE, Ariz. — A new law governing microcaptives is increasing the risk that the Internal Revenue Service will order an audit of the captive's parent company or the captive manager overseeing the company-owned insurer.

The use of the microcaptives, or those electing to be taxed under Section 831(b) of the U.S. Tax Code, has increased during the past five years, experts said.

The Protecting America from Tax Hikes Act of 2015, which was enacted last year, changed the limits and the rules governing those microcaptives.

Under the new law effective in 2017, 831(b) captives can avoid federal taxes on up to $2.2 million in annual premium income, which is up from the current limit of $1.2 million.

The higher limit is an opportunity for captive owners to place more risks in their captives, such as cyber; earthquake, wind and flood; pollution liability and cleanup; property mold; and difference in limits/difference in conditions risks, experts said during the Captive Insurance Companies Association's 2016 International Conference in Scottsdale, Arizona, earlier this month.

While the new law increases the premium income that is exempt from taxation, it also imposes stricter rules on the ownership structures of 831(b) captives, which are often used by family-run companies, to be eligible for that exemption.

“The IRS scrutinizes small captives very closely,” said Daniel Kusaila, a Hartford, Connecticut-based tax partner at law firm Crowe Horwath L.L.P.

Captive parents that try to “massage” their premium income “need to be very careful because they are putting their tax election at risk” as well as potentially putting “the captive in jeopardy,” he said.

Mr. Kusaila said the changes for microcaptives, which the Internal Revenue Service has put on its “Dirty Dozen” list of tax scams for the past two years, will only increase the IRS' scrutiny.

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.

The IRS said in its most recent “Dirty Dozen” commentary that it has been examining microcaptives covering “esoteric implausible risks” for “exorbitant premiums,” which often are double or triple the price of traditional insurance.

However, captives “by nature, contain esoteric risks because traditional insurers won't cover those risks,” said Tim Tarter, Phoenix-based captive insurance tax audit and litigation defense lawyer at Woolston & Tarter P.C. and a former IRS senior attorney. “It's a reason to have a captive.”

In addition, the IRS is investigating some captive managers to determine if they are promoting tax shelters, Mr. Tarter said.

The investigations include audits usually involving extensive interviews and comprehensive information requests, he said.

The IRS looks at the pricing of premiums, how the captive's assets are invested and the operating company's risk management program. They also will inquire about the commercial insurance in place and gaps in that coverage, 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.

Audits of captives also include requests for all emails, marketing materials from the inception of the captive, even if it precedes the years under audit, he said.

When the IRS asks about the background of the captive and the advice given by captive managers, “one of the problems” is that “they are going well beyond the year of the audit,” Mr. Tarter said.

One problem is the lack of a definition from the IRS or the Treasury Department of what constitutes an insurance company or a contract, “which is why courts will get involved,” Ms. Towle said.

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.

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.