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IRS Dirty Dozen Abusive Tax Structures Single Out Micro-Captives

IRS Building
February 06, 2015

By P. Bruce Wright, M. Kristan Rizzolo, and Saren Goldner
Sutherland Asbill & Brennan LLP

Abusive tax shelters and structures used by taxpayers to avoid paying taxes will remain on the Internal Revenue Service annual list of tax scams known as the “Dirty Dozen” for the 2015 filing season, the IRS explained in IR-2015-19, issued on February 3, 2015.

In particular, the IRS noted that the use of captive insurance companies may be considered abusive in certain circumstances.

The IRS explained that abusive tax structures involving captive insurance companies are generally set up to take advantage of the fact that the insured can claim deductions for premiums paid on insurance policies with the captive insurance company. The captive insurance company can elect, under Section 831(b) of the Internal Revenue Code, to be taxed only on investment income, provided that the captive insurance company’s net written premiums (or direct written premiums, if larger) do not exceed $1.2 million per year. This effectively excludes $1.2 million from taxable income annually. Such captives are also frequently called “micro-captives.”

The IRS was specific in noting that not all captive insurance arrangements will be deemed to be abusive. In fact, the IRS conceded that a business using a small captive insurance company to protect against certain risks is a “legitimate tax structure.”

Rather, the IRS will look to the form of the insurance policy and the nature of the risks insured to determine whether a captive insurance arrangement is abusive. If a captive insurance company issues an insurance policy that is poorly drafted, is covering implausible risks, or provides for exorbitant premiums, then there is a greater likelihood that the IRS will consider such a captive insurance arrangement to be an abusive tax structure.

In addition to captive insurance arrangements, the IRS also noted that taxpayers should be careful in using trust arrangements because trusts are commonly used in abusive tax structures. For example, a taxpayer may be considering the use of a tax structure that involves both a captive insurance company (as described above) and a trust, such as where a taxpayer sets up a trust for the benefit of the taxpayer’s children, and the trust then sets up a captive insurance company (as described above) that enters into an insurance arrangement with the taxpayer’s business. In a situation like this, the taxpayer should be extremely diligent because such an arrangement involves two structures that the IRS considers to be potentially abusive.

P. Bruce Wright and M. Kristan Rizzolo are partners in the tax department of Sutherland Asbill & Brennan LLP located in the New York and Washington offices, respectively. Saren Goldner is counsel in the tax department of Sutherland Asbill & Brennan LLP located in New York.

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