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For the Fourth Consecutive Year, Captives Make IRS "Dirty Dozen" List

IRS Dirty Dozen-SF
April 02, 2018

By David J. Slenn
Shumaker, Loop & Kendrick, LLP

For the fourth consecutive year, "abusive micro-captives" make an appearance on the Internal Revenue Service (IRS) annual "Dirty Dozen" list of tax scams, reflected in IR-2018-62. Last year's information release on abusive tax shelters (found in IR-2017–31) referred generally to "phony tax shelters" but focused primarily on captives small enough to qualify for a Section 831(b) election (referred to as "micro-captives"). In the 2018 version, the IRS again warns taxpayers about the abuse of micro-captives and includes commentary on the IRS victory in Avrahami v. Commissioner.

The same "bad facts" listed in the 2017 version of the Dirty Dozen appear in the 2018 version, which can be summarized as follows.

  • Promoters, accountants, or wealth planners persuade owners of closely held entities to participate (the 2018 version uses the phrase "peddled by promoters");

  • Coverages insure implausible risks, fail to match genuine business needs, or duplicate the taxpayer's commercial coverages;

  • Premium amounts may be unsupported by underwriting or actuarial analysis, may be geared to a desired deduction amount, or may be significantly higher than premiums for comparable commercial coverage;

  • Policies may contain vague, ambiguous, or deceptive terms and otherwise fail to meet industry or regulatory standards;

  • Claims administrative processes may be insufficient or altogether absent;

  • Insureds may fail to file claims that are seemingly covered by the captive insurance;

  • Micro-captives may invest in illiquid or speculative assets or loans or otherwise transfer capital to or for the benefit of the insured, the captive's owners, or other related persons or entities;

  • Captives may also be formed to advance intergenerational wealth transfer objectives and avoid estate and gift taxes; and

  • Promoters, reinsurers, and captive insurance managers may share common ownership interests that result in conflicts of interest.

The most noticeable addition to the 2018 version is coverage of the IRS victory in Avrahami. Here, the IRS notes that the Avrahami micro-captive did not comport with insurance under "long established decisional law principles"—of course, no mention is made of the string of taxpayer victories leading up to Avrahami. The IRS summary of Avrahami incorporates the Dirty Dozen "bad facts" in checklist fashion: "The court pointed to a number of facts that it found problematic, including … grossly excessive premiums, non-arm's length contracts … ultra-low probability of claims being paid … investments in illiquid assets, unclear policies, and inflated premiums."

The US Tax Court, in Avrahami, also acknowledged prior versions of the Dirty Dozen addressing abusive micro-captive transactions, noting, "The IRS has applied increased scrutiny to these transactions, adding them to the 'dirty dozen' list of tax scams in 2015 and declaring them 'transactions of interest' in 2016. See Notice 2016–66, 2016–47 I.R.B. 745; I.R.S. News Release IR–2015–19 (Feb. 3, 2015). The Avrahamis', however, is the first section 831(b) case to make it to trial."

In the 2018 version, the IRS again cites Notice 2016–66, which establishes reporting requirements related to micro-captives that engage in certain financing transactions or meet a liability and expense percentage test. The IRS closes the 2018 version by again citing Congressional action related to micro-captives (the amendments to Section 831(b)), this time referring to "strict" diversification and reporting requirements for new and existing captives. It should be noted that Section 831(b) was recently amended as part of the Consolidated Appropriations Act of 2018 to address certain issues raised under the diversification requirements. The amendment provides clarification as to both the term "policyholder" in the context of reinsurance and fronting arrangements and certain terms used for purposes of the ownership rules (e.g., "relevant specified assets," aggregation of spousal interests, and "specified holder").

David J. Slenn is a partner in the Tampa, Florida, office of Shumaker, Loop & Kendrick, LLP, and concentrates his practice in tax, estate and business planning with an emphasis on risk mitigation. He is a past chair of the American Bar Association's (ABA) Captive Insurance Committee and a former ABA adviser to the Uniform Law Commission Drafting Committee for the Uniform Voidable Transactions Act. Mr. Slenn served as editor and a contributing author to the newly released "Captive Insurance Deskbook for the Business Lawyer," available on the ABA website.

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