The IRS and Captive Insurance Arrangements

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Jason B. Freeman

Jason B. Freeman

Managing Member

214.984.3410
jason@freemanlaw.com

Mr. Freeman is the founding member of Freeman Law, PLLC. He is a dual-credentialed attorney-CPA, author, law professor, and trial attorney.

Mr. Freeman has been named by Chambers & Partners as among the leading tax and litigation attorneys in the United States and to U.S. News and World Report’s Best Lawyers in America list. He is a former recipient of the American Bar Association’s “On the Rise – Top 40 Young Lawyers” in America award. Mr. Freeman was named the “Leading Tax Controversy Litigation Attorney of the Year” for the State of Texas for 2019 and 2020 by AI.

Mr. Freeman has been recognized multiple times by D Magazine , a D Magazine Partner service, as one of the Best Lawyers in Dallas, and as a Super Lawyer by Super Lawyers, a Thomson Reuters service. He has previously been recognized by Super Lawyers as a Top 100 Up-And-Coming Attorney in Texas.

Mr. Freeman currently serves as the chairman of the Texas Society of CPAs (TXCPA). He is a former chairman of the Dallas Society of CPAs (TXCPA-Dallas). Mr. Freeman also served multiple terms as the President of the North Texas chapter of the American Academy of Attorney-CPAs. He has been previously recognized as the Young CPA of the Year in the State of Texas (an award given to only one CPA in the state of Texas under 40).

For years now, the IRS has been targeting abusive captive insurance arrangements.  Since 2015, captives have adorned the IRS’s annual “Dirty Dozen” list of tax scams.  The IRS’s Large Business and International Division’s (LB&I) tax compliance campaign has made captives a priority.  And last year, the Service issued Notice 2016-66, describing certain related-party captive insurance transactions as “transactions of interest,” a further indication that it will continue its attack on captives.

The Service recently notched a significant victory in a micro-captive case.  See The Tax Court Deals a Blow to “Micro-Captive” Insurance Company.  The case involved an IRS challenge to deductions taken by the taxpayer for premiums paid to a “micro-captive” insurance company.   The Tax Court, siding with the IRS, denied the deductions at issue.  And while the case was a victory for the IRS, there is a history of back-and-forth case law trends in this area, some cases going the IRS’s way and some the way of the taxpayer.  See, e.g., Rent-A-Center, Inc., v. Comm’r 142 TC No. 1; Securitas Holdings, Inc. v. Comm’r, T.C. Memo 2014-225.

As a general matter, the typical captive insurance case presents a fundamental issue: Whether the premium payments made by the taxpayer are deductible.  This issue often turns on, among other things, whether the captive provides “insurance.”  Notably, “insurance” is not defined in the Code or regulations—its meaning in this context has largely been developed by case law, going back to the Supreme Court’s seminal case in Helvering v. Le Gierse, 312 U.S. 531 (1941).  The IRS has been aggressive in challenging the use of (what it views as) abusive captives, often arguing that they do not provide “insurance” and that premium payments made to the captive are, therefore, not deductible for federal tax purposes.

But the recent decision in Avrahami v. Commissioner demonstrates that taxpayers often face other tax risks as well.  In that case, the Tax Court invalidated the captive insurance company’s section 953(d) election—an election by a foreign entity to be taxed as a domestic corporation.  (Section 953(d) elections are common in this area.)  As a result, the captive would be treated as a foreign corporation, and this would have triggered an obligation on the part of the taxpayer to file a Form 5471.  A failure to file a form 5471 carries a potential monetary penalty of $10,000 (and additional continuation penalties can reach up to $50,000 per failure to file), as well as potential losses of foreign tax credits.  Taxpayers can also face penalties under Section 6662(j) for undisclosed foreign financial asset understatements related to the entity.  And to add insult to injury, where a Form 5471 is not filed, the statute of limitations on the taxpayer’s entire tax return can potentially remain open—indefinitely.

While I have seen little commentary on these types of collateral consequences in this context, they demonstrate some of the hidden risks that taxpayers may face in the wake of the IRS’s continued effort to crack down on abusive captive insurance arrangements.

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