In early November of 2016, the IRS released a notice warning that “micro-captive” and similar transactions were not consistent with best business practices and may be consistent enough with tax evasion practices to be considered tax evasion themselves. These transactions will be closely watched by the IRS to ensure that companies engaging in them are not doing so with the intent of avoiding tax payments, and companies so engaging may be investigated further.
What does all this mean? What are micro-captive transactions anyway? And do you need to worry about an IRS investigation or tax resolution issues because of them?
In regards to the last question, it depends. Like many IRS initiatives and warnings, this one is pretty specific, and it may or may not apply to you depending on what you’re doing. So let’s start with the second question.
A micro-captive transaction works like this. First, a business signs up with an insurance company and deducts its insurance premiums on their taxes (which they can often legally do). But then the insurance company (known as the “captive” company) chooses to be taxed only on its investment income (which they can also legally do, under Section 831(b) of the US Tax Code), allowing them to discount or avoid reporting the insurance payments from the first company as taxable income. The upshot is that both companies get to decrease their taxable income using the same money, which really shouldn’t happen.
Is this illegal? Not yet. The IRS has not yet confirmed that these practices are tantamount to tax evasion, but they are definitely concerned about them and will be watching out for them in the near future. In the meantime, these types of transactions do appear to be a bit on the shady side. So if you’re doing anything like this, or your insurance company is doing it, you might want to stop. And if you’re deducting your insurance premiums at all, you might want to make sure your insurance company isn’t discounting them as well.