IRS Audits Captive Owners – Know the Red Flags!

The IRS is currently auditing owners of captive insurance companies who are customers of promoters who are under scrutiny by the IRS. For more information on Promoter audits, see http://www.forbes.com/sites/jayadkisson/2014/09/19/irs-launches-promoter-audits-of-captive-managers-suspected-of-abusive-practices/

The IRS practice is to identify Promoters who may be improperly selling captive insurance companies and to open audits of the Promoters. From those audits, the IRS obtains customer lists and opens individual audits of some percentage of the customers. Although the IRS recognizes that captive insurance companies can be compliant with tax laws, captive owners should take note of the following red flags which may be scrutinized by the IRS:

  •  Purpose of the Captive. If the Captive is marketed as a tax deduction instead of a manner of addressing necessary insurance, the IRS will perceive that insurance is not the primary purpose. Also, the IRS looks for signs that the real purpose of the Captive is to meet some estate or retirement planning objective of the Captive owner.   Unfortunately, if the intent of the Captive owner is not well documented, the IRS will likely refer to the marketing materials from the Promoter as evidence of what is intended.
  •  Spike in Insurance Cost. If the business has a substantial spike in insurance cost because of premiums paid to the Captive with no explanation as to why there is a need for additional insurance, the IRS will perceive that the insurance was not needed before the Captive and is probably not needed after the Captive.  It is far better if the Captive can be replacing some commercially purchased insurance, or that there are specific events that relate to the need for new types of insurance.
  • Cart Before the Horse. In normal business practices, consumers negotiate for the lowest cost of their insurance. If the cost for insurance provided by the Captive is determined after the employer’s desired deduction is identified, the IRS may question whether the insurance was bargained at arm’s length.
  • Life Insurance. If the captive is investing in life insurance on the life of the owner, the IRS will consider the purpose of the captive to be providing tax deductible life insurance instead of business insurance. See Beckett G. Cantley, Repeat as Necessary: Historical IRS Policy Weapons to Combat Conduit Captive Insurance Company Deductible Purchases of Life Insurance. (copy can be found at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2315868).
  • Types of Insurance Provided. The IRS considers whether the risk insured is real and also whether the premium cost is appropriate. Also, the IRS is concerned that some insurance not insurance as commonly provided in business. Thus, the IRS may challenge remote risks that have unrealistic premium charges and risks that are not normally covered by insurance. In a series of recent IRS Rulings, the Service questioned “whether some or all of the purported insurance contracts were insurance for federal tax purposes, as opposed to, for example, contracts covering investment or business risks.”   See CCA 201350008 (copy can be found at http://www.irs.gov/pub/irs-wd/1350008.pdf).
  • Risk Pools. For small captives, they qualify only if more than 50% of their premiums are from third parties. In this way, they satisfy the requirement of risk distribution. See IRS Revenue Ruling 2002-89 (copy can be found at http://wiki.captiveinsurance101.com/index.php/Rev._Rul._2002-89). The IRS is concerned about risk pools where the risk is not really being shared. There are a few ways this can happen. One is by requiring some indemnification or payback by an insured in the event the insured incurs a claim. Another is by providing retrospective premium increases to pay for a large claim. The bottom line is that if the risk pool actually operates in a manner that insulates the risk such that captive owners are not really sharing the risk of others, the IRS will likely disqualify the risk pool and thus disqualify every Captive using the risk pool. Another important area to review with risk pools is the occurrence of claims. If there is an unusually low occurrence of claims, the IRS will perceive that there is not a sharing of risk.

If you would like more information about captive insurance companies and the IRS red flags, call Mike Lloyd at (412) 454-0225 or email mlloyd@williamscoulson.com.

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