While micro-captive insurance policies may be about as clear as mud to many people, what is crystal clear is that a U.S. Court of Appeals affirmed the IRS’ position that abusive micro-captive insurance transactions are sham transactions resulting in a disallowance of the preferred tax treatment, at a minimum. The key is to know whether your policy, or one you are considering, is a sham, or legitimate.
A captive insurance company writes polices for its owners and affiliates. They deduct the amounts paid to third parties for insurance policies but set aside a form of self-insurance that is not deducted. A micro–captive policy makes an Internal Revenue Code Section 831(b) election to be taxed only on its investment income, and not the income it receives underwriting the policies. The amount must be under $2.2 million per year and underwriting losses are not deductible.
For several years, this has been a hotly debated issue with business and the IRS both having some success. Since 2015, the IRS has treated micro-captive polices as those included on the IRS’ annual Dirty Dozen listing of abusive tax transactions.
The problem became that by making the IRC 831(b) election, smaller businesses could deduct large amounts of premiums paid at ordinary income tax rates, and when the money was eventually distributed to the owners or affiliates, they would only pay capital gain rates on the distribution. The policies began being advertised as asset protection tools which unfortunately drew attention for the tax abuse potential.
Most recently, the IRS’s position that abusive micro-captive insurance transactions are scams was upheld by the U.S. Court of Appeals for the Tenth Circuit in Reserve Mechanical Corp. v. Commissioner. For more, click here.