The following is informational only and does not constitute advice. Please forward this information to your independent tax advisor for specific recommendations or advice regarding your captive insurance structure.
Over the last week or so, the IRS appears to have sent a standard form letter to many participants in captive insurance transactions covered by IRS Notice 2016-66. This letter is essentially identical to the ones it sent previously many months ago, and it does NOT appear to be a letter targeted at only specific taxpayers but rather something widely distributed among many captives that complied with Notice 2016-66.
As you may recall, Notice 2016-66 required taxpayers disclose to the IRS certain information about their captive insurance transaction. The purpose of the Notice was purportedly so that the IRS could obtain the information needed to differentiate legitimate insurance transactions from “abusive” ones and to subsequently provide taxpayers with guidance.
However, not surprisingly (given its track record on this subject), and despite having nearly five years to analyze the data, the IRS has yet to issue ANY substantive guidance to taxpayers in response to Notice 2016-66. The IRS has clearly concluded that it can raise more revenue by spreading fear, uncertainty, and doubt (FUD) than by advising taxpayers on how to best comply with the law. By ensuring that its view of the relevant rules remains unclear, the IRS ensures that it may arbitrarily attack most any captive insurance transaction as illegitimate and thereby attempt to extort a settlement from the taxpayer, an attempt that is regrettably all too often successful. By contrast, offering clear guidance that taxpayers actually follow would deprive it of such an opportunity.
The latest letter from the IRS to captive owners is just another in a long series of attempts to use FUD to dissuade even legitimate captive insurance arrangements from continuing.
What Does the Letter Say?
Essentially, the letter reaffirms that the IRS believes some captive insurance companies to be illegitimate and therefore has stepped up audit enforcement of captive insurance transactions. This should come as no surprise. The IRS had made its intentions clear over the years in various ways (e.g., by including captive insurance transactions on its “Dirty Dozen” list, by issuing Notice 2016-66, via its audit settlement program, and in various other ways). We’ve kept our clients informed of these developments all along.
However, the IRS has limited audit resources, and so the Service naturally wants to take a “targeted” approach to these audits, focusing on those taxpayers it deems most likely to have engaged in abusive transactions or those most susceptible to its intimidation. Even better, the Service (via the recent letter) wants to persuade taxpayers to “voluntarily” cease participation in captive insurance transactions (even perfectly legitimate ones) by IMPLYING that such taxpayers MAY avoid audit if they send the IRS a sworn statement stating that they have wound down their captive insurance company (and providing sufficient relevant details about having done so).
Why is the Letter Being Sent Now?
The IRS has viciously attacked captive insurance companies since the 1970s, and until very recently it lost nearly every single tax court case of consequence involving them. It lost the UPS case, the Humana case, the Rent-A-Center case, the Securitas case, and the RVI case (among others).
However, over the last few years, the IRS has managed to win several cases in a row against smaller 831(b) electing captive insurance companies by targeting comparatively weak captive insurance structures. These victories have both unnecessarily alarmed taxpayers operating legitimate structures and emboldened the IRS into being more aggressive with its FUD and extortion tactics.
Fortunately, there are presently many cases pending in tax court involving much stronger captive insurance structures, some of which the IRS is all but certain to lose. In fact, just late last month the IRS agreed to settle a case that had been pending for years in US tax court by agreeing to forfeit its claim to all back taxes that had been assessed, forfeiting all penalties it alleged were owed and agreeing not to audit the captive for certain subsequent years. This proves two things beyond any real doubt: (1) the IRS has attempted to extort settlements from even legitimate captive structures and (2) legitimate structures can win or force the IRS into conceding when they are prepared to resist the extortion.
As more and more taxpayer victories pile up, the IRS’s FUD campaign will start to lose its impact, depriving the IRS of psychological leverage over those taxpayers that it needs to force settlements upon legitimate arrangements. Consequently, the IRS wants to wind up/down as many of the presently-existing 831(b) arrangements as it can before these favorable precedents are established and its leverage is lost. Intimidating even legitimate captives into winding up appears to be the real purpose of this latest letter.
What the Letter Does NOT Say?
The letter does NOT indicate that your specific captive insurance transaction has been found lacking or non-compliant in any way, or even that it’s suspected of being so. Nor does it indicate that you’ve been selected for audit or will be selected for audit if you don’t reply (though it seeks to imply the latter).
Should I Reply to the Letter?
Again, each taxpayer should consult his independent tax adviser for specific guidance, but here are some general considerations:
You are under no obligation to reply to the letter. Though the letter IMPLIES that your chances of audit MAY be reduced if you do respond in the IRS’s desired manner, it does not actually say so. The IRS can, and perhaps will still audit you even if you do respond. Or not.
It seems to us that taxpayers in the following situations are unlikely to respond to the letter:
Taxpayers are already under audit.
Taxpayers who have NOT taken any captive insurance-related tax deductions for any year remain open under the statute of limitations (which for most taxpayers would be after 2017).
Taxpayers who in good faith intend to continue participating in legitimate captive insurance arrangements to protect your businesses from real and important risks (which in light of the coronavirus pandemic may now be more important to the survival of many businesses than ever).
However, taxpayers in the following situations MAY find that replying to the letter reduces the odds of future audits:
Taxpayers who are not already under audit, who have chosen not to participate in captive insurance transactions covered by Notice 2016-66 going forward, and who have taken steps to wind down their captive insurance company.
Taxpayers who have skeletons in the closet and therefore want to seize upon every opportunity to even possibly reduce the chance of a future audit.
The Critical Importance of Captive Insurance
As recent events have shown, small and mid-sized businesses are uniquely fragile. Unlike their Fortune 1000 counterparts, small businesses generally:
Lack of access to capital and credit markets
Have geographically concentrated revenue streams that are dependent upon a few key suppliers, customers, or contracts
Aren’t the beneficiaries of massive bailouts in times of trouble.
Therefore small business owners who don’t sufficiently protect themselves from supply chain interruptions; loss of key contracts, suppliers, or customers; governmental actions (including regulatory and legislative changes, forced business closures, etc.), and a great many other risks simply won’t be small business owners for long.
Most of our clients are more likely than their competitors to survive today’s devastating business environment thanks to the various types of business interruption insurance and other forms of critical coverage purchased from their captive insurance companies. Quite simply, captive insurance is more necessary, legitimate, and important than ever, and the tax court will eventually make that fact clear to the IRS the hard way.
Even so, completely disregard the tax benefits for a moment and ask yourself this: Knowing what I know NOW, would I purchase these critical coverages from my captive even if there was no possibility of tax benefits?
For most of our clients, the answer is an unequivocal YES! For some of them, their decision to purchase captive insurance will in fact be the difference between their survival and their demise.
Conclusion
The latest IRS letter is nothing new. It’s a continuation of a strategy that the IRS has employed for several years now, a strategy that tax court developments will eventually make mostly moot. The letter comes at the IRS’s point of maximum psychological leverage over taxpayers and is intended to induce taxpayers into voluntarily surrendering the statutory tax benefits associated with their captive insurance company.
If you’ve been operating a bad captive and so were never entitled to those benefits anyway, then responding to the letter may provide you with some bit of additional protection. But if you’ve been operating a real company that insures real risks and pays real claims (including those of unrelated third parties), then the IRS’s latest letter is just more of the same.
