The Internal Revenue Service on Tuesday called for more information on microcaptives, as its seeks to determine whether the companies are used as tax shelters.

Previously, the IRS had listed the captives, which elect Section 831(b) of the U.S. Tax Code, on its list of Dirty Dozen Tax Scams.

Captives electing Section 831(b) are taxed only on their investment income, not their underwriting income. The limit of premiums for the structures is $1.2 million a year, although that will be raised to $2.2 million in 2017.

The so-called 831(b) captives are often used by small and mid-sized firms that are too small to establish conventional captives, but many observers say they have also been used by wealthy individuals and others to avoid tax. 

In its latest notice on 831(b) captives the IRS states it believes 831(b) transactions have “a potential for tax avoidance or evasion.” It goes on to say, however, that it lacks “sufficient information to identify which 831(b) arrangements should be identified specifically as a tax avoidance transaction and may lack sufficient information to define the characteristics that distinguish the tax avoidance transactions from other 831(b) related-party transactions.”

It goes on to describe various types of transactions involving 831(b) captives that it is looking into and asks for comments on to be submitted Jan. 30, 2017 on “how the transaction might be addressed in published guidance.”

The good news for captive owners is that the comments make clear that the IRS views some 831(b) captives as legitimate, said Charles J. Lavelle, senior partner at Bingham Greenebaum Doll L.L.P. in Louisville, Kentucky. “The notice states that the primary purpose is to obtain information that distinguishes between abusive and non-abusive situations,” he said.

The notice should not affect captives that are set up for the legitimate purpose of insuring the risks of their owners, said Mike Serricchio, senior vice president with Marsh Captive Solutions, a unit of Marsh L.L.C., based in Norwalk, Connecticut.

“This notice doesn’t condemn all 831(b) captives, it’s just quite frankly saying that the IRS needs more information … There’s a lot of abuse in the small captive industry and this may be, and I hope it is, a good way of getting additional information on these captives that lack a lot of substance, that lack risk management, that lack premium parameters, that don’t have good insurable risks in the captive and have poor capital,” he said.

One section of the notice that may “raise eyebrows” among commercial insurers is that the notice says the IRS is interested in captives that have a loss ratio of less than 70%, said Mr. Lavelle.

“The commercial industry may be surprised that a loss ratio of less than 70% would be of interest to the IRS in assessing what is an insurance arrangement,” he said.

The 70% reference in the notice likely represents a lack of understanding by the IRS, said Mr. Serricchio of Marsh.

“Commercial insurers price to about a 60% loss ratio for some lines so I think this 70% rule of thumb is just the IRS not really understanding how captives operate.”