Should You Be Worried About The IRS Auditing Your Captive Insurance Company?

Much has been made of the IRS’s recent interest in captive insurance companies (CICs) with some commentators suggesting that the service is engaging in an “audit sweep” of captives.

Whether there is such a sweep is still up in the air, but even if there is, it should be noted that such sweeps are not unusual.  And, clients operating properly formed captives for legitimate risk management reasons should not be overly concerned.  The IRS frequently targets certain industries or types of returns for extra scrutiny in order to obtain a statistically valid sample for measuring overall compliance.  For example, several years ago the IRS launched an audit sweep of 401(k) and 403(b) plans, discovering that 401(k)s were mostly compliant while 403(b)s were not.  This led to new 403(b) plan regulations being issued.

Given the dramatic risk management and tax planning benefits of captive insurance companies, the IRS’ interest is no surprise.  The good news is that captive owners seem to be fairing pretty well so far, at least in our experience.  Just two months ago, the IRS lost a very high-profile tax court case involving Rent-a-Center’s CIC.  Also, we are aware of several audits that have concluded in recent months with no or very little additional tax being owed by virtue of the audit.

Even so, we want to remind owners of captive insurance companies how important it is that ANY inquiries from the IRS (whether via a formal audit or informal telephone call/survey) be handled professionally and accurately.  For this reason, we advise that captive owners not attempt to answer questions from the IRS about their CIC on their own.  Instead, direct all IRS questions to your CPA.  Your CPA should then contact the attorney who oversees your captive in order to gain the necessary background information to accurately respond to any IRS requests.

A few commentators have suggested that clients considering forming a captive insurance company defer that decision until the results of the IRS’ sweep are clearer.  This will help them avoid the cost of defending their captive in a potential audit.  We find this recommendation to be potentially short-sighted for multiple reasons.

First, it assumes that such a sweep is in fact occurring and will be ongoing.

Second, even if that is the case, it assumes that the sweep will end within a reasonable time.

Third, and perhaps most importantly, it ignores the significant opportunity cost of doing nothing.  The benefits of owning and operating a captive insurance company can be dramatic.  Forfeiting those benefits for even a year or two can be extremely costly over time, especially when one considers the lost compound interest on the forgone benefit.  Nobody advocated taking a “wait and see” approach to adopting 401(k) plans when they were being audited at higher rates than usual.  The same logic should probably be applied to captives.

Fourth, even if one’s captive is audited (which is still statistically unlikely even if there is a “sweep”), it is exceedingly unlikely that the cost of defending the transaction in an audit would exceed even one year’s tax savings from engaging in it, unless it goes to court.  And the cost likely would not exceed two year’s tax savings even if it did go to court.

Lastly, the captive itself should have tremendous liquid reserves that can be tapped to cover the cost of defending itself if audited, so cash-flowing a defense should rarely be an issue for owners of a captive.

In short, the decision to establish a captive insurance company is ultimately one of weighing costs and benefits.  The potential of an audit does increase the potential cost, but in almost all cases not enough to exceed the benefits.