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Recent Microcaptive Letters are an IRS Gift in Disguise

By Anthony P. Daddino, P.C. on April 2, 2020

I recently blogged on the IRS’ mass mailing of soft-contact letters to microcaptive participants. Although perceived as a nuisance, it is an early Christmas present from the IRS – the gift of time to assess the planning, shore up defenses, and in some  instances, to remediate.

In my prior blog linked here, I outlined the contents of the IRS microcaptive letter and its instructions.  Since that time I have called the number on the letter and was surprised to receive a call back the same day.  The IRS official spoke in no-uncertain terms about the goal of the letters:  to manage workload.  If it were up to the IRS, it would audit every microcaptive participant.  But even in the best of times, which these are obviously not, the IRS lacks the resources to do so.  How the IRS will use the letter responses, or lack of responses from taxpayers, to accomplish its goal of managing “workload” is anyone’s guess.  

Meanwhile, captive managers have been vocal and consistent in their response to the microcaptive letter.  They label the microcaptive letters as aBig Brother tactic and are bending over backwards to reassure their clients of the strength and merits of their planning and how the captive managers are ready to defend the planning should the IRS seek to scrutinize the insurance transactions.

Without question, some of the captive managers have the  “goods” in their planning to back up these statements.  But the problem is all captive managers are making such statements.  And in my experience, not all of them have the “goods.”

This brings me back to my opening statement:  The IRS has given taxpayers the gift of time to test the statements of their captive managers and size-up their insurance transactions.  Even prior to the microcaptive letter, I’ve helped clients conduct an IRS-risk-assessment review of their planning.  This often involved the use of an outside insurance consultant, as many of the tax issues rest upon insurance industry concepts such as risk transfer and risk distribution.  And in reviewing the IRS’ recent wins, the Tax Court paid much attention to the issue of whether the insurance and reinsurance transactions were insurance in the commonly accepted sense, essentially looking at commercial reasonableness and industry norms, which a good insurance consultant should be able to help a taxpayer vet. 

Is it easier and less expensive to rely on the statements of the captive manager and take a wait and see approach rather than conduct an independent review?  In the short run yes.  But the long-term potential cost is sizeable, given that the IRS is routinely proposing in audit a 40% accuracy related penalty based on the IRS’ finding that the planning lacked economic substance.   

Ultimately the taxpayer’s planning may pass the review with flying colors.  If so, the taxpayer has paid a small price for a better night’s sleep.  And undoubtedly, such testing will help the taxpayer fill in gaps and shore-up soft spots in the planning in anticipation of an IRS audit that might later come.  Should the news be not so rosy, there is time to remediate.  The IRS was careful to point out that the microcaptive letter did not constitute as an IRS contact for purposes of  the rules on qualified amended returns (which help mitigate penalty exposure).  Even for those taxpayers wanting to leave the past untouched,  a risk-assessment review provides a roadmap for future tax years and the opportunity to visit with the captive manager about improvements and fortifications to the planning to reduce overall IRS risk.

While the cost of these reviews varies depending on size and scope, for some taxpayers any additional cost may seem too expensive in these uncertain times.  For those taxpayers, I encourage you, at a minimum, to undertake an internal, do-it-yourself review.  In a prior blog post, I identified 18 tips for assessing captive planning:  (https://www.meadowscollier.com/weathering-the-storm-18-tips-for-assessing-your-clients-section-831b-microcaptive-insurance-planning-following-the-avrahami-decision).

In the end, time is your friend; use it wisely.  And whatever you do, don’t look this IRS gift horse in the mouth.

If you have any questions about this blog post or any other tax-related matter, please do not hesitate to contact me at (214) 749-2464 or adaddino@meadowscollier.com.