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IRC 831(b) Micro-Captives: Avoiding IRS Scrutiny, Diversification Requirements, Effective Transaction Structures

Today’s faculty features:

1pm Eastern | 12pm Central | 11am Mountain | 10am Pacific

THURSDAY, FEBRUARY 25, 2021

Presenting a live 90-minute webinar with interactive Q&A

Alan J. Fine, CPA, JD, Tax Partner and Insurance Industry Group Leader, Brown Smith Wallace LLP,St. Louis, MO

David E. Foate, Attorney, Certified Specialist, Taxation Law, Gresham|Savage, San Bernardino, CA

David J. Warner, Tax Attorney, Holtz, Slavett & Drabkin, APLC, Newport Beach & Beverly Hills, CA

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February 25, 2021

Recent Captive Insurance Company Case Law

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Test for Insurance

1. Insuring insurance risks

2. Risks appropriately shifted

3. Risk distribution

4. Commonly accepted notions of insurance

8© 2020 All Rights Reserved Brown Smith Wallace LLP

Avrahami (a/k/a “How NOT to do a captive”)

Court held not valid insurance transactions- Lacked risk distribution – TRIP pooling arrangement not valid

- Suspiciously like “circular flow of funds”- Terrorism premiums “grossly excessive” and Court questioned “one size

fits all”- Pool compensated by fixed fee rather than percentage of premiums- Insured ineligible TRIP claims (areas > 1 million people – lived in

Phoenix)

- Not “Insurance in its commonly accepted sense”- Investments only “an unthinking insurance company would make” – 65% of

assets in form of long-term loans to related parties- Failed to seek regulatory approval for related party loans- No claims until IRS exam began- Claims dealt with on “ad hoc basis”- Late claims approved

9© 2020 All Rights Reserved Brown Smith Wallace LLP

Reserve Mechanical

Court determined risk sharing pool not a bona fide insurance company - Significant number of references to Avrahami- Lack of nontax business purpose without tie to commercial policies – without

prior incident taxpayer failed to demonstrate need for additional insurance- Circular flow of cash- Policies “cookie cutter” language

- Other factors- Low claims incidence- Pricing- Inactive businesses paying premiums

- Appeal pending in 10th Circuit Court of Appeals

10© 2020 All Rights Reserved Brown Smith Wallace LLP

Syzygy

- Court held fronting carriers not bona fide insurance companies; as a result, captive lacked risk distribution

- Court also held not insurance in commonly accepted sense citing:- No evidence to support premium calculation- Premium rate-on-line significantly exceeded those from commercial policies- Flow of funds “suspiciously close” to circular flow of funds - Policy language ambiguous and failed to provide refunds if cancelled- Claims required to be filed the earlier of 30 days after loss incurred or 7 days

after policy expired – not consistent with arms’ length policies- Taxpayer arguably entered into transaction to manage deductibles but failed

to submit in excess of $100,000 eligible claims- Captive invested heavily in split-dollar life insurance policies without ability to

access cash surrender values

11© 2020 All Rights Reserved Brown Smith Wallace LLP

CIC

- Primarily an administrative law question re: Notice 2016-66

- Supreme Court accept cert in July; Oral arguments took place in December

- At issue – CIC challenged whether Notice requiring Reportable Transaction disclosure was properly issued

- Lower courts agreed with the IRS that the Anti-Injunction Act prevented challenge until tax bill actually sent

- CIC victory would remand to District Court to hear merits of the case

12© 2020 All Rights Reserved Brown Smith Wallace LLP

Rent-A-Center

Tax Court valid insurance arrangement – main issue risk distribution

- No impermissible circular flow of funds

- Parental guaranty of DTA’s did not violate risk shifting

- Risk distribution achieved – view risk distribution from insurer not insured. During years in question insured:

- Between 2,600 and 3,100 stores- Between 14,300 and 19,750 employees- Between 7,140 and 8,000 vehicles

13© 2020 All Rights Reserved Brown Smith Wallace LLP

Securitas

Tax Court Memorandum Opinion – Further supports Rent-A-Center

- Followed 4-part test outlined above

- Primary issue risk distribution – during years in question one entity accounted for between 37% and 88% of the risks insured – IRS argued this violated concept of adequate risk distribution

- Risk distribution is viewed from perspective of the insurer not the insureds –“who owns the exposures is not critical”

- Insuring in excess of 123,000 employees- Significant number of vehicles being insured as well

© 2020 All Rights Reserved Brown Smith Wallace LLP14

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ANTI-AVOIDANCE PRINCIPLES

David E. Foate, Esq.Gresham|SavageDavid.Foate@greshamsavage.com909.723.1816

David E. Foate, Esq. 909.723.1816 David.Foate@greshamsavage.com 17

Anti-Avoidance Principles

Overview

“Any one may so arrange his [or her]affairs that his [or her] taxes shall be aslow as possible; he [or she] is not boundto choose that pattern which will bestpay the Treasury.” – Gregory v. Helvering294 U.S. 465 (1935)

That said, all transactions must pass thecommon-law doctrines used by thecourts and IRS to determine if atransaction is legitimate or a tax shelter.

Substance Over Form Business Purpose Economic Substance

David E. Foate, Esq. 909.723.1816 David.Foate@greshamsavage.com 18

Substance Over Form

Formally stated by U.S. Supreme Court in 1935

“as a general rule, the incident of taxation dependson the substance rather than form of thetransaction.” – Gregory v. Helvering, 293 U.S. 465(1935)

Although the tax payer followed the letter of thelaw governing corporate reorganizations, the Courtheld that the code section in question was notintended to allow reorganizations merely for thepurpose of tax avoidance.

“It is quite true that if a reorganization inreality was effected within the meaning of [thestatute], the ulterior purpose mentioned will bedisregarded. The legal right of a taxpayer todecrease the amount of what otherwise would behis [or her] taxes, or altogether avoid them, bymeans which the law permits, cannot be doubted.... But the question for determination is whetherwhat was done, apart from the tax motive, was thething which the statute intended.”

David E. Foate, Esq. 909.723.1816 David.Foate@greshamsavage.com 19

Substance Over Form

6th Circuit provides rare rebuke in 2017

“…[But] [i]f the government can undotransactions that the terms of the Codeexpressly authorize, it’s fair to ask what the pointof making these terms accessible to the taxpayerand binding on the tax collector is. ‘Form’ is‘substance’ when it comes to law. The words oflaw (its form) determine content (its substance).How odd, then, to permit the tax collector toreverse the sequence—to allow him todetermine the substance of a law and to make itgovern ‘over’ the written form of the law—and tocall it a ‘doctrine’ no less.” –Summa Holdings, Inc.v. Comm’r, 848 F.3d 779 (6th Cir. 2017).

“the substance-over-form doctrine does not givethe Commissioner a warrant to search throughthe Internal Revenue Code and correct whateveroversights Congress happens to make or redoany policy missteps the legislature happens totake.”

David E. Foate, Esq. 909.723.1816 David.Foate@greshamsavage.com 20

SubstanceOver Form

The form will berespected if there isa valid businesspurpose and realeconomic substance

Tax Court’s 105 page decision (on Lexis) ruled in favor ofthe IRS based on the assignment-of-income doctrineestablished by U.S. v. Basye, 410 U.S. 441 (1973) meant toinsure that income is attributed to the person who earnedit regardless of efforts to shift the income elsewhere.

11th Circuit’s 7 page decision reversed, stating: “The transaction under challenge here simply altered theform of an existing, bona fide business, and this casetherefore falls in with those that find an adequate businesspurpose to neutralize any tax-avoidance motive. True,UPS's restructuring was more sophisticated and complexthan the usual tax-influenced form-of-business election ora choice of debt over equity financing. But itssophistication does not change the fact that there was areal business that served the genuine need for customersto enjoy loss coverage and for UPS to lower its liabilityexposure.”

“We therefore conclude that UPS's restructuring of itsexcess-value business had both real economic effectsand a business purpose, and it therefore under ourprecedent had sufficient economic substance to meritrespect in taxation.” – United Parcel Service of America,Inc. v. Comm’r, 254 F.3d 1014 (11th Cir. 2001).

David E. Foate, Esq. 909.723.1816 David.Foate@greshamsavage.com 21

Business Purpose

Gregory v. Helvering revisited

“When [the statute] speaks of a transfer ofassets by one corporation to another, it means atransfer made 'in pursuance of a plan ofreorganization' ... of corporate business; and nota transfer of assets by one corporation toanother in pursuance of a plan having no relationto the business of either, as plainly is the casehere. Putting aside, then, the question of motivein respect of taxation altogether, and fixing thecharacter of the proceeding by what actuallyoccurred, what do we find? Simply an operationhaving no business or corporate purpose-amere device…nothing more than a contrivanceto the end last described. It was brought intoexistence for no other purpose; it performed,as it was intended from the beginning it shouldperform, no other function. When that limitedfunction had been exercised, it immediately wasput to death.” – Gregory v. Helvering, 293 U.S.465 (1935).

David E. Foate, Esq. 909.723.1816 David.Foate@greshamsavage.com 22

Business Purpose

Testing for Business Purpose

To be respected the transaction musthave a true business purpose other thanthe tax benefits.

Although not codified, the doctrine canbe found in the Regulations governingCorporate Reorganization:

Required by the exigencies of business; An ordinary and necessary incident to the

conduct of the business; and Not a device for tax avoidance

-See Reg. § 1.368-1(b), (c)

David E. Foate, Esq. 909.723.1816 David.Foate@greshamsavage.com 23

Business Purpose

Particularly Relevant for Risk Shifting and Distribution Analysis

Risk Shifting Must Involve Insurable Risks and Companies Should Show Evidence of Quotes From 3rd Party Insurance Companies

Syzygy Insurance Co., Inc. v. Comm’r, T.C. memo 2019-34

Avrahami v. Comm’r, 149 T.C. 7 (2017)

Risk Distribution Rev Rul. 2002-89 & 2002-90 Clougherty Packing Co. v. Comm’r, 811 F.2d 1297 (9th

Cir. 1987). Avoidance of Risk Pools

Aldon Homes Inc. v. Comm’r, 33 T. C. 582 (1959)-16 corporations created by the parent company to develop one residential neighborhood had no business purposes and were shams Shaw Construction Co. v. Comm’r, 323 F.2d 316 (9th

Cir. 1963).-88 separate corporations constructing residential housing owned by one husband and wife were formed primarily for tax benefits because they did not perform the business activities which created the income.

David E. Foate, Esq. 909.723.1816 David.Foate@greshamsavage.com 24

Economic Substance

The Legacy of Gregory v. Helvering

Since Gregory v. Helvering courts have sought todifferentiate legitimate tax planning (i.e., thatwhich has substance) from tax abusive structures,which are compliant with the letter of the law butcontrary to its spirit. The principle has been invokedin different iterations and has evolved over theyears:

The incidence of taxation depends upon the substance of thetransaction and not mere formalism. – Comm’r v. Court HoldingCo., 324 U.S. 331 (1945).

A mere transfer in form, without substance, may be disregardedfor tax purposes. –Comm’r. v. P. G. Lake, Inc., supra; Comm’r. v.Court Holding Co., supra; Comm’r. v. Sunnen, 333 U.S. 591 (1948)Helvering v. Clifford, supra; Corliss v. Bowers, supra; Richardson v.Smith, 102 F. 2d 697 (2nd Cir. 1939); Howard Cook v. Comm’r, 5 T.C.908 (1945); J. L. McInerney v. Comm’r., 29 B.T.A. 1 (1933), affd. 82 F.2d 665 (6th Cir. 1936).

Where a taxpayer embarks on a series of transactions that are insubstance a single, unitary, or indivisible transaction, the courtshave disregarded the intermediary steps and have givencredence only to the completed transaction. -Redwing Carriers,Inc. v. Tomlinson, 399 F. 2d 652, 654 (5th Cir. 1968); MayBroadcasting Co. v. U.S., 200 F. 2d 852 (8th Cir. 1953); WhitneyCorporation v. Comm’r., 105 F. 2d 438 (8th Cir. 1939), affirming 38B.T.A. 224 (1938); Comm’r. v. Ashland Oil & R. Co., 99 F. 2d 588 (6thCir. 1938), reversing sub nom. Swiss Oil Corporation v. Commr., 32B.T.A. 777 (1935), certiorari denied 306 U.S. 661 (1939); Kuper v.Comm’r., 61 T.C. 624 (1974); Kimbell-Diamond Milling Co. v.Comm’r., 14 T.C. 74 (1950), affirmed per curiam 187 F. 2d 718 (5th Cir.1951), certiorari denied 342 U.S. 827 (1951).

David E. Foate, Esq. 909.723.1816 David.Foate@greshamsavage.com 25

Economic Substance

Legacy of Gregory v. Helvering cont.

Whether we respect a taxpayer’s characterization of a transactiondepends upon whether the characterization represents and is supportedby a bona fide transaction with economic substance, compelled orencouraged by business or regulatory realities, and not shaped solely orprimarily by tax avoidance features that have meaningless labelsattached. - Frank Lyon Co. v. U.S., supra at 583-584; Winn-Dixie Stores, Inc.v. Comm’r., supra; Nicole Rose Corp. v. Comm’r., 117 T.C. 328 (2001), affd320 F3d 282 (2nd Cir. 2002).

Taxation is not so much concerned with refinements of title as it is withactual command over the property. - Corliss v. Bowers, 281 U.S. 376, 378(1930); see also Comm’r. v. P. G. Lake, Inc., 356 U.S. 260 (1958); Helvering v.Clifford, 309 U.S. 331 (1940); Griffiths v. Comm’r., 308 U.S. 355 (1939); Sachsv. Comm’r., 277 F. 2d 879, 882-883 (8th Cir. 1960), affirming 32 T.C. 815(1959).

A given result at the end of a straight path is not made a different resultbecause reached by following a devious path. - Minnesota Tea Co. v.Helvering, 302 U.S. 609, 613 (1938).

Transactions that are challenged as intermediary steps of an integratedtransaction are disregarded when found to be so interdependent thatthe legal relations created by one transaction would have been fruitlesswithout the completion of the series. - American Bantam Car Co. v.Comm’r., 11 T.C. 397, 405 (1948), affd 177 F. 2d 513 (3rd Cir, 1949), certioraridenied 339 U.S. 920 (1950); see Scientific Instrument Co. v. Comm’r., 17 T.C.1253 (1952), affd per curiam 202 F. 2d 155 (6th Cir., 1953).

David E. Foate, Esq. 909.723.1816 David.Foate@greshamsavage.com 26

Economic Substance

Codification IRC § 7701(o)

Test

Elements of IRC § 7701(o):

The standards by which the economic substancedoctrine is applied were clarified by theenactment of IRC § 7701(o).

In determining whether a transaction meets theeconomic substance doctrine, the followingpoints must be considered:

The economic substance doctrine must berelevant to the transaction.

Additionally, the following conjunctive two-prong test must be met:

The transaction changes the taxpayer’s economicposition in a meaningful way (apart from Federalincome tax effects) (the “economic substancetest”).

The taxpayer has a substantial purpose (apartrom Federal income tax effects) for entering intothe transaction (the “business purpose test”).

David E. Foate, Esq. 909.723.1816 David.Foate@greshamsavage.com 27

Economic Substance

Codification

Application

I.R.S. Application of Code § 7701(o).

Rely on relevant case law to analyze whenthe economic substance doctrine will apply.– Notice 2010-62.

“Transaction” includes all the factualelements relevant to the expected taxtreatment of any investment, entity, plan,or arrangement. It also includes any or all ofthe steps that are carried out as part of theplan – Notice 2014-58 & Reg. § 1.6011-4(b)(1).

David E. Foate, Esq. 909.723.1816 David.Foate@greshamsavage.com 28

Economic Substance

Codification

Penalties

Penalty if the transaction reduces tax: Portion attributable to the reduction is subject to

a 40% penalty. If, however, the transaction is disclosed in a tax

return on Form 8275, Disclosure Statement, thepenalty is reduced to 20%. – IRC § 6662(b)(6).

Penalty is strict liability (i.e. no reasonable causeexception). – IRC § 6664(c)(2).

Although not binding on the I.R.S., the LargeBusiness and International Division has issuedinternal guidelines for determining when it isappropriate to apply the economic substancedoctrine and request the penalty – LB&ICodification of Economic Substance Doctrine andRelated Penalties, LMSB-20-0910-024, Sept 14,2010.

This guidance contains numerous examples oftransactions that are not appropriate for theapplication of the economic substance doctrine.

David E. Foate, Esq. 909.723.1816 David.Foate@greshamsavage.com 29

I.R.C. § 831(b) Micro-CaptivesIRS ENFORCEMENT

DAVID J. WARNERTax Attorney

dwarner@hsdtaxlaw.com

DAVID J. WARNER, ESQ.Holtz, Slavett & Drabkin, APLC

4695 MacArthur Court, Suite 200, Newport Beach, CA 92660T: 949 999-6606|F: 949-544-0440|dwarner@hsdtaxlaw.com

www.hsdtaxlaw.com

⮚ Tax attorney and managing attorney of the firm’s Orange County office.⮚ Practices exclusively in civil and criminal tax controversy

including tax audits, litigation, and collection defense.

⮚ Represents individuals and businesses in IRS and state tax audits, as well as litigation in U.S. Tax Court, U.S. district court, and the Court of Federal Claims.

⮚ Former Senior Trial Attorney with IRS Office of Chief Counsel for 9 years.⮚ Litigated over 500 cases in U.S. Tax Court.

⮚ Advised IRS revenue agents on complex audits, including micro-captive, offshore matters, and flow-through entities.

⮚ Served as a DOJ Special Assistant U.S. Attorney.

⮚ Former Adjunct Professor of Law at UC Irvine School of Law, Loyola Law School, and Chapman University Fowler School of Law.

⮚ Tax LL.M. from NYU School of Law

32

Topics Discussed Today

IRS Past Enforcement Historical Background

IRS Positions on:

Income Taxes & Penalties

Other Penalties & Statute of Limitations

Promoter & Criminal Investigations

IRS Present Enforcement Settlement Programs

Soft Letters

IRS Future Enforcement

33

IRS Past Enforcement: Background

34

History of Enforcement Against Micro-Captives IRS has litigated whether contracts are “insurance” for decades.

Helvering v. Le Gierse, 312 U.S. 531, 539 (1941)

Whether policy was “insurance” and excluded from decedent’s estate.

AMERCO v. Commissioner, 96 T.C. 18 (1991), aff'd, 979 F.2d 162 (9th Cir. 1992); Harper Grp. v. Commissioner, 96 T.C. 45 (1991), aff’d, 979 F.2d 1341 (9th Cir. 1992); Sears, Roebuck & Co. v. Commissioner, 96 T.C. 63 (1991), aff'd in part and rev'd in part, 972 F.2d 858 (7th Cir. 1992).

Cases all involved captive insurance companies and whether a captive could provide “insurance.”

Rent-a-Center, Inc. v. Commissioner, 142 T.C. 1 (2014).

35

IRS Increased Enforcement of Micro-Captives Micro-Captive Project

About 10 years ago, IRS formed project teams with IRS Counsel attorneys and revenue agents—originally based in Phoenix.

For example, the taxpayer in Avrahami involved the 2009 and 2010 tax years and was audited during 2011 – 2013.

IRS Chief Counsel Advice 201250020: Advice from IRS Counsel’s National Office in 2012 about whether promoter information from one audit could be shared with taxpayers in another audit.

In 2015, micro-captives added to IRS’s list of the “Dirty Dozen.” See IR-2015-19 (Feb. 3, 2015); IR-2015-26 (Feb. 9, 2015).

36

IRS Notices 2016-66 & 2017-8 Certain micro-captives identified as a “transaction of

interest” (note: NOT a “listed transaction”).

For IRS Notice 2016-66 to apply, 3 elements:

Captive makes an I.R.C. § 831(b) election;

At least 20% of the stock of captive is owned by (1) insured party, (2) owners of insured, or (3) persons related to insured or owners of insured; and

Either (or both):

For the 5 more recent years, captive’s liabilities for insured losses and claim admin. expenses < 70% of (premiums earned by captive – policyholder dividends paid); OR

In 5 most recent years, captive provided loans or otherwise conveyed funds to insured, insured’s owners, or related parties in a transaction that did not result in taxable income or gain.

37

IRS Notices 2016-66 & 2017-8 (continued)

If these three elements apply, then micro-captive is a “transaction of interest.” See Treas. Reg. § 1.6011-4(b)(6).

If entered into transaction after November 2016, then must file Form 8886 with return and send copy to IRS Office of Tax Shelter Analysis (OTSA).

If taxpayer entered into transaction before November 2016, taxpayer has 90 days to file Form 8886 with OTSA.

90 days = January 30, 2017.

IRS Notice 2017-8: Extended 90-day period to May 1, 2017.

CIC Services, LLC v. IRS, case no. 19-930 (U.S. Supreme Court)

Challenged validity of these IRS notices

Asked court for injunction to prohibit application of IRS Notice 2016-66.

Argument mainly that IRS notices did not follow Administrative Procedure Act because there was no “notice and comment.”

Supreme Court oral arguments held on December 1, 2020.

38

Other IRS Enforcement Efforts

IRS Large Business & International (LB&I) Division

In 2017, added micro-captives as a compliance campaign.

IRS Office of Chief Counsel

Originally, project team based entirely in Phoenix office.

Expanded to micro-captive project teams in all areas of the country.

Nationwide training for all attorneys on micro-captive issues.

Reviews ALL notices of deficiency with micro-captive issues, including notices issued by IRS Appeals. See Internal Revenue Manual 8.17.4.31.

Tax Court cases labeled as “micro-captive” in the caption.

Highly Coordinated Issue

National office teams and extra review for Exam, IRS Appeals, and IRS Counsel

Income tax returns, including amended returns, flagged as “microcaptive,” scanned in, and identified with SPCO category code.

39

IRS Past Enforcement: IRS Positions

40

IRS Positions: Taxes

Abusive Micro-Captives are NOT insurance.

Courts focus on the elements and factors (risk distribution, etc.)

For IRS, it’s primarily about the cash flow:

Premiums before micro-captive v. premiums after micro-captive.

Types of coverage and actuarial issues

Where did the premiums go?

Pay claims?

“Loans” back to owners?

Estate planning for owners’ kids?

41

IRS Positions: Taxes (continued)

Insured cannot deduct insurance premiums paid because not “ordinary and necessary” under I.R.C. § 162.

Effect on Micro-Captive’s elections:

I.R.C. § 831(b) not valid = Micro-captive has income equal to premiums received.

I.R.C. § 953(d) not valid = Shareholders of micro-captive that is a foreign corporation have Subpart F income.

Any “loans” from micro-captive are dividend distributions from micro-captive to owners (might be a qualified dividend).

Insurance premiums are NOT re-classified as capital contributions. Thus, owners could get taxed again on liquidation.

If owners of insured ≠ owners of captive, might have gift tax consequences.

42

IRS Positions: Income Tax Penalties IRS primarily asserting I.R.C. § 6662 accuracy-related penalty

Instead of 20% default penalty, IRS usually asserting 40% penalty under I.R.C. § 6662(i).

Attributable to “nondisclosed noneconomic substance transactions”

No reasonable cause exception to this penalty. I.R.C. § 6664(c)(2).

IRS could assert I.R.C. § 6663 civil fraud penalty in particularly egregious cases.

For all penalties, watch for I.R.C. § 6751(b)(1) compliance!

Requires IRS managerial approval of penalty BEFORE first assertion of penalty (usually before issuance of 30-day letter).

Oropeza v. Commissioner, 155 T.C. No. 9 (Oct. 13, 2020).

BUT, qualified amended return. Treas. Reg. § 1.6664-2(c)(3).

43

IRS Positions: Other Penalties – Form 8886

If micro-captive is reportable transaction under IRS Notice 2016-66, then must file Form 8886.

Attach Form 8886 to tax return for each year captive is active.

In the initial year (or within 90 days of IRS Notice 2016-66), also must send a copy of Form 8886 to IRS Office of Tax Shelter Analysis at: Internal Revenue Service, OTSA Mail Stop 4915, 1973 Rulon White Blvd., Ogden, UT 84201.

I.R.C. § 6707A penalty = applies if Form 8886 is not attached to return OR if not timely provided to OTSA.

I.R.C. § 6707A penalty range (for a “transaction of interest”):

For an individual: between $5,000 and $10,000

For an entity: between $10,000 and $50,000

Penalty only abated if IRS determines, in its sole authority, that rescission would promote compliance.

44

IRS Positions: Other Penalties – Form 5471 If micro-captive is a foreign corporation, then most likely the

micro-captive is a controlled foreign corporation (CFC).

CFC owners must attach Form 5471 to their income tax return to report interest in CFC.

Filing Obligation = I.R.C. § 6038(a)

Penalty = I.R.C. § 6038(b)

$10,000 initial penalty

IRS then issues a “pattern letter” stating that there’s an obligation to file Form 5471.

If still don’t file Form 5471, then after 90 days, $10,000 continuation penalty for each month

Maximum Penalty = $60,000 per year, per corporation (1 initial + 5 continuation penalties)

45

IRS Positions: AssessmentStatute of Limitations

In general, IRS has 3 years from date return filed to assess a tax. I.R.C. § 6501(a).

Many exceptions in § 6501.

I.R.C. § 6501(c)(10) would not apply because this provision only applies to “listed transactions” and micro-captives are not listed transactions. Instead, micro-captives are “reportable transactions” and “transactions of interest”

If micro-captive is a foreign corporation, then potential Form 5471 filing obligation and I.R.C. § 6501(c)(8).

If required to file Form 5471 and do not, then assessment statute on income tax return open until 3 years after Form 5471 filed.

From tax year 2006 to present, § 6501(c)(8) keeps the ENTIRE income tax return’s statute open.

If reasonable cause for not timely filing Form 5471, then statute of limitations only open for items related to matters on Form 5471.

46

IRS Positions: Investigations –Promoters and Criminal

IRS is actively investigating promoters of micro-captives—for penalties and injunctions.

Artex Risk Solutions, Inc.

Currently under an IRS investigation for I.R.C. § 6700 penalties.

IRS summoned certain records from the Delaware Department of Insurance and then petitioned the district court to enforce that summons. See United States v. Del. Dept. of Ins., case no. 1:20-cv-00829-UNA (D. Del. Jun. 19, 2020).

I.R.C. § 6700 penalties = 50% of gross income derived from the activity by the promoter.

Criminal charges?

In November 2019, IRS Commissioner for Small Business Self-Employment said micro-captives are another area where we might make some referrals to Criminal Investigations.

No announcements yet for micro-captive, but yes in a similar context for conservation easements.

47

IRS Present Enforcement

48

September 2019 Settlement Program Settlement offer mailed to some (but not all) taxpayers under audit for

micro-captive issues.

All partners / members must agree to the settlement.

Terms:

Disallow 90% of insurance premium deductions and 100% of captive-related expenses

Captive does NOT need to recognize income for premiums received.

Liquidation or deemed dividend transaction

Estate and gift: Taxpayers must file gift tax returns and pay gift tax / claim credit.

0-10% accuracy-related penalty (depending on declarations submitted)

One $5,000 § 6707A penalty

Full payment when Form 906 signed or agree on installment agreement.

IRS says almost 80% of taxpayers opted to accept the settlement.

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Subsequent U.S. Tax CourtSettlement Program Subsequently, IRS Counsel extended the September 2019

settlement program to docketed cases in U.S. Tax Court.

Only for cases where taxpayers would have received the original settlement offer but did not (for example, micro-captive issue was not identified until after case was docketed).

Same terms as September 2019 settlement offer.

Resolve micro-captive issues with Examinations and enter into Form 906 closing agreement and stipulation of settled issues in Tax Court.

Resolve non-captive issues through the normal procedures (IRS Appeals and then IRS Counsel).

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2020 IRS “Soft Letters”

In March & July 2020, the IRS issued Letters 6336 to taxpayers the IRS identified as involved in micro-captive arrangements who were not under audit for the micro-captive.

Letter makes taxpayer aware of recent Tax Court decisions.

If no longer participating in captive, requests that taxpayer sign statement under penalty of perjury and provide the last tax year and the date that taxpayer stopped participating.

Encourages taxpayers to contact a tax practitioner.

For a Form 1040X individual amended return, directs to write “Microcaptive” across the top and mail to the IRS in Philadelphia. For business returns filed electronically, include “microcaptive” in the explanation for amended returns.

If taxpayer does not respond to letter, then IRS may (likely) refer for audit.

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2020 IRS “Soft Letters”(continued)

Lastly, soft letter states that it is not a contact regarding examination under Treas. Reg. § 1.6664-2(c)(3)(i)(A).

Soft letter allows for filing of qualified amended returns to reduce or eliminate certain penalties.

Qualified amended return (QAR) = Amended return filed BEFORE Date taxpayer first contacted by IRS re examination;

Date person first contacted re I.R.C. § 6700 examination;

Date pass-through entity first contacted re examination;

Date on which IRS serves a John Doe Summons related to an activity for which the taxpayer claimed a tax benefit; OR

Date IRS announced a settlement initiative re a listed transaction.

If QAR, then additional tax on that return is not part of “underpayment.” Thus, tax on QAR is not subject to I.R.C. § 6662. QAR cannot “scrub” an initial fraudulent return.

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October 2020Settlement Program Similar to the September 2019 program

Settlement offer mailed to some (but not all) taxpayers under audit for micro-captive issues.

All partners / members must agree to the settlement.

Change to terms from September 2019 program:

Disallow 100% of insurance premiums (2019 program was 90%)

Penalties: 5-15% accuracy-related penalty (2019 program was 0-10%)

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IRS Future Enforcement

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Future of IRS Enforcement

IRS is not going anywhere. January 2020 – announced 12 new audit teams

dedicated to micro-captive issues.

Similar to offshore issues… Initially, the IRS offers settlements to taxpayers to voluntarily

resolve the matter without the need for substantial resources or litigation.

Then, for those who don’t take the offer or voluntarily come into compliance, follow up with audits.

Expect high level of coordination to continue for years to come.

IRS likely to take position that future audits do not get a better result than taxpayers who took settlement offers or voluntarily filed amended returns.

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What can taxpayers do?

For clients with micro-captives, run a compliance check NOW.

This is true for “abusive” and “legitimate” micro-captive arrangements.

Consider the potential exposure to taxes, penalties, and other enforcement actions in certain situations:

If taxpayer files qualified amended returns; or

If IRS audits and proposes full assortment of taxes and penalties.

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Questions?

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DAVID J. WARNER, ESQ.Holtz, Slavett & Drabkin, APLC

4695 MacArthur Court, Suite 200, Newport Beach, CA 92660T: 949 999-6606|F: 949-544-0440|dwarner@hsdtaxlaw.com

www.hsdtaxlaw.com