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The Internal Revenue Service (IRS) began sending contact letters this week reminding certain taxpayers that it has their information relating to deductions claimed for micro-captive insurance arrangements. The letters also asked taxpayers who stopped claiming deductions to provide certain information under penalty of perjury, including the final year a micro-captive deduction was claimed.  As for those taxpayers continuing to participate in micro-captive insurance transactions, the IRS recommends that the taxpayer consult an independent competent tax advisor on the proper treatment of past and future tax years and consider best options for any improperly claimed deductions, including the filing of amended returns.  The IRS refers to these as Letter 6336 (3-2020) on its web page and provides a hotline number to call for assistance.

Letters similar to these were generally expected after the IRS roll-out of its time-limited settlement offer made to certain taxpayers under examination, followed by its stern warning to the public on January 31, 2020 that the IRS will continue to vigorously pursue those involved in these and other similar abusive micro-captive transactions going forward.

We consider these letters, however, as an opportunity to revisit the legitimacy of the tax benefits claimed with respect to captive transactions.  Moreover, for appropriate taxpayers, these letter may present an opportunity to take proactive, corrective measures that may assist in avoiding onerous examinations and steep penalties that could otherwise be asserted against them.

Why are Micro-Captive Insurance Letters Issued?

The letter explains why the IRS is writing this letter and what steps are requested of the taxpayers.

The IRS states that:

Why we’re writing to you

We have information that you’ve taken a deduction or other tax benefit related to micro-captive insurance on a prior year tax return and disclosed pursuant to Notice 2016-66 and Notice 2017-08.

Several recent U.S. Tax Court decisions have confirmed that certain  micro-captive  arrangements  are not eligible for claimed Federal tax benefits. We’re notifying you regarding IRS compliance activity in this area so you can make informed  decisions  about claiming  tax deductions for micro-captive insurance premiums. The IRS is increasing enforcement activity in this area and has deployed several examination teams to open additional examinations of returns that included micro-captive insurance transactions. Examinations may result in full disallowance of claimed micro-captive insurance deductions, inclusion of income by the captive entity, and imposition of applicable penalties.

What information is the IRS Requesting?

The letter requests that if a taxpayer is no longer claiming deductions or other tax benefits it should notify the IRS in writing  of:   (1) The last tax year in which the taxpayer claimed deductions or other tax benefits for micro-captive insurance premiums, and, if applicable, (2) the date the taxpayer ceased participating in the micro-captive insurance transaction.

If a taxpayer continues to participate in a micro-captive insurance transaction covered under Notice 2016-66, the letter states the taxpayer must continue to disclose participation in the transaction.  The letter also cautions that before filing the 2019 Federal income tax return, the IRS recommends the taxpayer consult an independent, competent tax advisor on the proper treatment for past and future tax years and consider the best options for any improperly claimed deductions or other tax benefit, including filing amended returns.

If there is a need to file amended tax returns for individual filers, the letter states write “Microcaptive”  at the top of the first page of the Form 1040X and mail the amended return to:

Internal Revenue Service
2970 Market Street
Philadelphia, PA 19104

For business filers using paper returns write “Microcaptive” at the top of the amended return and mail to the address listed on the instructions to the amended return.  Business filers filing electronic amended returns should list “Microcaptive” as the reason for filing the amended return.

The letter further  states that “We’ll take your actions in response to this letter into account when considering future compliance activity related to your micro-captive insurance arrangement.” and that it does not consider this letter an examination under the Internal Revenue Code or an audit of a tax return.

The IRS warns that if the IRS does not hear from the taxpayer by the “respond by” date it may refer the returns for examination.

Prior IRS Announcement – IR-2020-26

These letters follow the IRS announcement on January 31, 2020 stating that IRS enforcement activity in this area will be significantly increased.  On that date, the IRS informed  that it will deploy additional resources, which includes starting up 12 new examination teams comprised of employees from the IRS Large Business and International (LBI) and Small Business/Self-Employed (SB/SE) divisions that will address abusive transactions and open additional exams.   The IRS Announcement warned that examinations impacting micro-captive insurance transactions of several thousand taxpayers will be opened by these teams in the coming months.   Potential outcomes can include full disallowance of claimed captive insurance deductions, inclusion of income by the captive entity and imposition of all applicable penalties.

The Letter May Present an Opportunity to Potentially Avoid Protracted Examination and Penalties.

While typically receiving an inquiry from the IRS is never a good thing, the letter does raise the question whether taking proactive steps, such as reversing the transactions  on amended tax returns, could avoid an onerous examination that many individuals and captive entities endured, along with the steep penalties asserted in these examinations.   We are hopeful that it would.

We would like to think that when the IRS invites taxpayers to file amended tax returns and states it will take the taxpayers actions into account when considering future compliance activity, it will consider these corrective actions as good faith gestures warranting the elimination  of penalties.  Moreover, the IRS should  treat amended returns filed in response to these letter as Qualified Amended Returns, warranting penalty mitigation.

On the other hand, ignoring the letter is rarely the correct response.  Even those taxpayers with sound micro-captive transactions positions should fashion a response that addresses the merits of their position, and offers an explanation for the micro-captive benefits claimed.    Many individuals and businesses have legitimate reasons for micro-captive insurance arrangements.  In this COVID-19 new reality we all are facing, one can now plainly see the benefits of additional or gap insurance, such as business interruption insurance or the like.  However, absent a detailed explanation, the IRS may require the taxpayer to expend considerable resources before the legitimacy of the captive insurance plan is known to it.

Moreover, it is possible that for those taxpayers who respond appropriately, the IRS would at a minimum offer terms similar to the time-limited settlement initiative afforded to those under examination, in lieu of opening a full-blown examination against the taxpayer.   Importantly, the time-limited settlement initiative protected the IRS’ interests for years closed by statute, and it is likely that the IRS would want closed years considered as part of any resolution with the taxpayer. As such, amended tax returns alone may not fully address all of the concerns by the IRS.

As the IRS works through these cases, only time will tell how the IRS will respond.   For the time being, taxpayers have 45-days from the date of the letter to sort these issues out and respond accordingly.

For more information regarding this topic please contact Michel Stein – ms@taxlitigator.com   Mr. Stein is a principal at Hochman, Salkin,  Toscher & Perez, P.C. He is a former Attorney-Adviser of the U.S. Tax Court and is a Certified Specialist in Taxation Law by the State Bar of California, Board of Legal Specialization.  Mr. Stein represents clients throughout the United States and elsewhere involving federal and state, civil and criminal tax controversies and tax litigation. He has extensive experience with micro-captive insurance, voluntary disclosures and foreign account and asset reporting, and he frequently lectures throughout the country on these and other tax related topics.  Additional information is available at www.taxlitigator.com .