In a move that some might consider tone-deaf, the IRS has done a mass mailing to microcaptive participants, boasting of its wins in Tax Court, and inviting taxpayers to amend prior year returns to remove the Federal tax benefits claimed relative to their captive insurance planning. Do taxpayers accept this invite and if not, how should they respond to this IRS letter?
A little history lesson: in Notice 2016-66, the IRS officially declared war on small captive insurance arrangements that rely on I.R.C. Section 831(b) and the ability of the captive to exclude from income a certain amount of premiums earned each year. The IRS identified these microcaptives, as they are commonly known as, “transactions of interest” for federal income tax purposes. This identification triggers an obligation by taxpayers and material advisors to formally disclose the details of their insurance transactions to the IRS or otherwise face potential penalties.
Presumably from these disclosures, which are required to be filed annually, the IRS recently mass mailed letters to microcaptive participants. In the introductory paragraphs, the IRS highlights that several U.S. Tax Court decisions “have confirmed that certain micro-captive arrangements are not eligible for claimed Federal tax benefits” and that the IRS is seeking to help the taxpayer “make informed decisions about claiming tax deductions for micro-captive insurance premiums.” The IRS further states that it has “increased enforcement activity” and that IRS examinations “may result in full disallowance of claimed micro-captive insurance deductions, inclusion of income by the captive entity, and the imposition of penalties.”
The IRS is not simply making veiled threats, however. In its letter, the IRS goes on to instruct taxpayers on what to do. If the taxpayer is no longer participating in the captive insurance arrangement, the IRS advises the taxpayer to sign under penalties of perjury (ouch) a statement attesting to their cessation of the planning and certain details surrounding the termination. For those that are still participating, the IRS reminds taxpayers of its annual disclosure obligation and invites taxpayers to amend prior year returns. In what this author can only describe as humorous, the IRS instructs taxpayers to mail the amended returns to a specific address and to write “Microcaptive” at the top of the first page. Interestingly, the IRS notes that this letter does not constitute an examination or contact that might make the amended returns ineligible as a “qualified amended return” which helps reduce the risk of penalties. And finally, for those taxpayers that choose not to respond to the IRS’ letter, the IRS has a warning: “We may refer your return for examination. Please be aware that underpayments of tax are subject to interest and penalties.”
Generally, the IRS is giving taxpayers approximately six weeks to respond. Whether or how they should respond will depend on each taxpayer’s particular facts and circumstances. If you or your client received a letter from the IRS and have questions about how to respond, please do not hesitate to contact me at (214) 749-2464 or firstname.lastname@example.org.