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IRS tightens insurance rule for small businesses

IRS tightens insurance rule for small businesses

The Internal Revenue Service (IRS) is targeting a small company's in-house insurance provider in the agency's latest effort to crack down on abusive tax schemes.

The transaction in question deals with a micro captive insurance company, also known as small or micro captives. They are formed abroad or stateside to manage the risk of parent companies or related subsidiaries.

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They are susceptible to being used as a tax shelter because they can accumulate tax-deferred investment income indefinitely unlike traditional insurance providers. 

Mid-size to small businesses set up this kind of self-insurance to protect products, services or property from certain types of risks that may be too expensive or out-of-range for traditional third-party insurance companies to cover. In some cases, businesses can customize the coverage they need, thereby having more control of the investment decisions and less administrative costs.

For example, an auto dealer franchise can have a captive for its dealerships so they can offer auto warranty services for customers. A construction company could create one to cover workers compensation risks.

In January, the tax-free premium limit for these captives will increase to $2.2 million from the current $1.1 million and will be tied to inflation as a result of the 2015 omnibus bill enacted into law late last year. 

The IRS announced Nov. 1 that it is tightening rules around questionable transactions tied to small captives or micro captive transactions under the tax code section 831 (b). But that move frustrated industry members and practitioners who have been counting on the final ruling of a pending U.S. Tax Court case called Avrahami v. Commissioner as guidance. 

The high-profile 2015 case questions the legitimacy of two Arizona jewelers’ self-insurance for their business against a nuclear or terrorist attack. 

Too soon?

The recurring question from industry members following the release of the notice was: “Why couldn’t the IRS just wait until after Avrahami?” according to Ryan Work, vice president of government relations for the Self-Insurance Institute of America.

“It would be a lot easier for everybody to deal with when we have the court case settled,” Work said. 

In 2015, captive insurance earned a spot in the “Dirty Dozen,” the IRS’s annual list that warns taxpayers of scams that spike in activity during the tax-filing season. 

Such captive schemes can include unscrupulous sellers or managers persuading businesses to setup their own insurance arm, which they would manage every year for hefty fees with poor underwriting and actuarial record keeping, according to the IRS’s online description.

Small captive insurance has also been tied to abusive estate planning. In an attempt to curb that practice, Congress put in place two kinds of tests to prevent certain familial ownership arrangements through the omnibus bill. The new requirements will take into effect Jan. 1, 2017 along with the new $2.2 million premium threshold.

“You see these small captives show up in the IRS Dirty Dozen list [and] you know it’s not going to go away without some fixes,” said John R. Capasso, president and CEO of Captive Planning Associates.

Capasso said the “transactions of interest” in the IRS notice mainly targets the way shady promoters attempt to sell captive insurance, which they package as a product.

“A captive is an insurance company. It’s not a product,” Capasso said. “That’s what we’re concerned about — you’re seeing that some of the promoters package [captives] as if they’re a product. I think that’s leading to the conclusion that this could smell like a tax shelter.”

Still awaiting guidance.

As industry members said they are still unpacking the details in the notice, some of them noted that the IRS still has not yet issued any clarification on how to report the changes made in the PATH Act, which will take into effect in less than two months, Dennis P. Harwick, president of the Captive Insurance Companies Association, pointed out.

The IRS notice also raises a problem on how to deal with captives that have already been drawn out since the agency wants retroactive transactions that date back to November 2006, Work said. 

Through the notice, the agency is likely gathering more information to determine definitive legitimate captive, according to F. Hale Stewart, attorney and co-author of U.S. Captive Insurance Law.

“It’s a complex transaction with lots of nuance. It’s impossible to come up with bright-line rules,” Stewart said. “That’s the fly in the ointment of this issue.

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