Perspective On March 2020 IRS Letter to Captive Owners

(The below is informational only and does not constitute advice. Consult your independent tax advisor for specific recommendations or advice regarding your captive insurance structure.)

Over the last week the IRS appears to have sent a standard form letter to many (perhaps all) participants in captive insurance transactions covered by IRS Notice 2016-66. This does NOT appear to be a letter targeted at only specific taxpayers but rather something widely distributed among all captives that complied with Notice 2016-66.

As you may recall, Notice 2016-66 required taxpayers to 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 subsequently provide taxpayers with guidance.

However, not surprisingly (given its track record on this subject), and despite having nearly three years to analyze the data, the IRS has yet to issue ANY substantive guidance to taxpayers. The IRS has clearly concluded that it can raise more revenue by spreading fear, uncertainty and doubt (FUD) than by offering guidance, guidance that most all taxpayers would certainly follow. By ensuring that its view of the rules remain unclear, the IRS preserves for itself the ability to arbitrarily attack most any captive insurance transaction as illegitimate in an 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 intends to step up audit enforcement of captive insurance transactions. This should come as no surprise. The IRS had made these things 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 every step of the way.

However, the IRS has limited audit resources (and this is especially true for the foreseeable future as the IRS announced just yesterday that it was closing all of its offices and ceasing all face-to-face meetings indefinitely in light of the coronavirus outbreak). So, the Service naturally wants to take a “targeted” approach to these audits, focusing on those taxpayers it deems most susceptible to its intimidation. They represent the low hanging fruit for the Service.

Even better, and before starting these audits, 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 that).

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 couple of years the IRS has managed to win three cases in a row against smaller 831(b) electing captive insurance companies by targeting comparatively weak captive insurance structures. This has 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. These favorable (to taxpayers) court precedents will no doubt clear up some of the FUD that the IRS has spread (making it more clear what is legitimate and what is not) and, more importantly, will deprive the IRS of psychological leverage over those taxpayers still operating legitimate arrangements.

Consequently, the IRS wants to wind up/down as many of the presently-existing 831(b) arrangements as it can before this favorable precedent is handed down and its leverage is lost. The latest letter comes at the point of the IRS’s maximum psychological leverage and is just its latest in a series of attempts to dissuade business from engaging in even legitimate captive insurance arrangements.

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 anyway, 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.

Should I Reply to the Letter?

Again, each taxpayer should consult his/her 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’ 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 already under audit.
• Taxpayers who have NOT taken any captive insurance related tax deductions for any year that remains open under the statute of limitations (which for most taxpayers would be after 2015).
• 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

• Lack access to capital and credit markets
• Have geographically concentrated revenue streams that are dependent upon a few key suppliers, customers or contracts
• Aren’t generally 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.

A great many of our clients are far, far 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

This 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 moot. The letter comes at the IRS’ point of maximum psychological leverage and is intended to induce taxpayers into voluntarily surrender 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 tiny bit of additional protection. But, if you’ve been operating a real insurance company that insures real risks and pays real claims (including those of unrelated third parties), then the IRS’ latest letter is just more of the same.

Interestingly, the letter from the IRS comes on the heels of a New York Times article praising small captives.

CLICK HERE to read the article in the New York Times.