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IRS Offers New, Stricter Settlement Offer to Micro-Captive Owners

IRS lettered in money on black background
October 23, 2020

The Internal Revenue Service (IRS) has announced a new limited-time settlement offer to certain taxpayers under audit that the agency alleges participated in abusive micro-captive insurance transactions.

In a statement, the IRS said that in the coming days that it will begin sending settlement offers with terms that are stricter than its first limited-time settlement initiative that began last year. The IRS said that its new offer comes after the agency deployed its 12 newly formed micro-captive examination teams to substantially increase the examinations of abusive micro-captive transactions.

Under the latest settlement offer, the IRS said it would "resolve certain cases by requiring substantial concession of the income tax benefits claimed by the taxpayer together with penalties that can be partly mitigated if the taxpayer can demonstrate good faith, reasonable reliance on an independent, competent tax advisor, and if the taxpayer can demonstrate it did not participate in any other reportable transactions."

"The IRS maintains a relentless agencywide commitment to combat abusive transactions," IRS Large Business and International Commissioner Douglas O'Donnell said in a statement. "Our offer terms are only getting stricter; and taxpayers would be well advised to consult with an objective, competent advisor with the aim of getting out now and putting this behind them."

So-called micro-captives, small captive insurance companies that elect to be taxed under section 831(b) of the Internal Revenue Code, which allows small insurance companies to be taxed only on their investment income, have been the target of IRS scrutiny in recent years. Until this year, micro-captives had been included for several years on the IRS's annual "Dirty Dozen" list of potentially abusive transactions.

The IRS has won several tax cases against such small captive insurance companies, though many in the industry, including some domicile organizations, have suggested the federal tax agency has gone overboard in its scrutiny.

The IRS said its new settlement offer is currently limited to taxpayers with at least one open year under examination. Taxpayers who also have unresolved years under the jurisdiction of the IRS Independent Office of Appeals may also be eligible, and the IRS said that "those with tax years involving micro-captive transactions docketed in Tax Court under Counsel's jurisdiction are generally not eligible."

The IRS said that because the terms of its second settlement initiative reflect the agency's current settlement position, some taxpayers who received but rejected the IRS's first offer may receive an additional offer under this latest settlement initiative, but under the new, stricter terms.

Taxpayers who receive settlement offers but choose not to participate will continue to be audited under normal procedures, the IRS said. Potential outcomes could include full disallowance of captive insurance deductions, the inclusion of income by the captive, withholding tax related to any foreign captives, and imposition of all applicable penalties, the IRS said.

The IRS said that while taxpayers who choose not to participate in the settlement will have full rights to appeal, "the IRS Independent Office of Appeals is aware of this settlement initiative. Given the current state of the law, taxpayers should not anticipate receiving better terms in Appeals than those offered under this initiative."

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