Although most of the nation has been anxiously watching the stock market and daily coronavirus updates from White House officials, some business owners have been sidetracked with captive insurance issues. For many business owners who participate in micro-captive insurance programs, and as highlighted in the March 20th issue of the New York Times, the recent cessation of business has prompted a review of captive coverages to determine whether relief can be provided in the form of a claim for business interruption.
However, news coverage of micro-captives was almost immediately followed by the receipt of IRS Letter 6336 (the Micro-Captive Soft Letter) by many captive owners and their insureds. Similar to the up and down of the stock market, micro-captive owners and insureds are now wondering whether they can seek monetary relief for business interruption through their micro-captives, but are at the same time confused as to their exposure for federal and state income tax liabilities. The current environment for micro-captive owners requires examining micro-captive policies to not only determine whether relief is available, but also to avoid losing sight of any potential tax issues, including reporting requirements.
Potential for Abuse. Tax law generally allows businesses to create “captive” insurance companies to cover certain risks that are otherwise unavailable or expensive to cover in the commercial market. The insured company benefits by obtaining the additional coverage and deducting the premiums paid to the captive insurer. Upon making an election under section 831(b) of the Internal Revenue Code, the captive insurer may exclude the premiums from income.
According to the IRS, in abusive micro-captive insurance structures, the relationship might lack the attributes of genuine insurance. For example, coverages might insure implausible risks, fail to match genuine business needs, or duplicate the taxpayer’s commercial coverages. Premium amounts might be unsupported by actuarial analysis or geared toward a desired deduction amount, and policies might contain vague and ambiguous terms, or otherwise fail to meet industry standards. Further, premiums for policies that do not result in claims, but generate income tax deductions (at ordinary income tax rates to the insured), and are accumulated for future distribution (at capital gain rates) to family members or trusts created for their benefit, entirely sidestepping transfer taxes in the process, have also been identified by the IRS as potentially abusive.
Continuing IRS Pressure. The soft letters recently issued are one tool the IRS uses to obtain information from taxpayers as well as advisors. The IRS has previously indicated that soft letters might be used as a tool for enforcement, and has recently used soft letters as an enforcement tool in its cryptocurrency campaign. Other methods of enforcement utilized in IRS campaigns include issue-based exams as well as practitioner outreach.
Micro-Captive Soft Letter. The Micro-Captive Soft Letter puts the taxpayer on notice that (a) the taxpayer has been identified as participating in a micro-captive; (b) several consecutive tax court rulings have issued in favor of the IRS; and (c) the IRS is increasing enforcement activity, which will entail opening additional examinations. The Micro-Captive Soft Letter then requests that if the taxpayer is “no longer claiming a deduction or other tax benefit for any micro-captive,” the taxpayer “must” sign a statement under the penalties of perjury indicating whether the taxpayer is still “participating” in a captive and the year the taxpayer last took a deduction or other “tax benefit” associated with the captive.
If the taxpayer is continuing to participate in a micro-captive, the Micro-Captive Soft Letter reminds the taxpayer to continue to disclose participation in the transaction on Form 8886. Additionally, it recommends that the taxpayer seek independent, competent counsel prior to filing 2019 tax returns, and to consult on whether the taxpayer should amend prior-year returns for improper deductions or tax benefits.
The IRS informs the taxpayer that complying with the terms of the letter will be considered in any future enforcement action. When filing amended returns, the IRS requests the taxpayer to write “Micro-captive” on the top of the amended tax return. The IRS closes its letter by stating that if prior years are amended, such amendments could be qualified amended returns (QAR). The IRS states that the Micro-Captive Soft Letter does not constitute an examination for purposes of the rule negating a QAR if the taxpayer has already been contacted by the IRS concerning any exam with respect to the tax return. This means the IRS will not seek penalties (under the first-contact exception to the QAR rules) if the IRS subsequently opens such years for exam. This benefit can be incredibly helpful in that the IRS has been seeking a 20-percent penalty and up to a 40-percent (nondisclosure of noneconomic substance) penalty for understatements resulting from denied micro-captive deductions. It is also worth noting that a transaction lacking economic substance carries with it strict liability for such penalties, notwithstanding an advisor’s opinion letter.
Micro-Captive Soft Letter Side Effects. The recent developments described above could have various impacts on the micro-captive industry. First, the soft letters might have a psychological effect making micro-captives and the associated management fees that go along with it seem decidedly less attractive. This in turn might impact revenue for those that rely primarily on the tax election as a source of business. See Endeavor Partners Fund, LLC v. Comm’r of Internal Revenue, 115 T.C.M. (CCH) 1540 (T.C. 2018), aff’d, 943 F.3d 464 (D.C. Cir. 2019) (“Recognizing that the IRS notices accurately described POPS and PICO, Bricolage advised its clients that the notices were only a statement of the IRS’ position, not a change in law. But the notices effectively eliminated demand for Bricolage products, forcing it to abandon many planned transactions. Bricolage accordingly began to wind down its activities.”). Second, some taxpayers might follow the IRS’s advice and seek independent counsel, who might suggest filing amended returns. This advice could be completely at odds with the advice that might be provided by a captive management company, thereby creating a quandary for the taxpayer as to who to trust. Further, conflicted advisors who are contacted by taxpayers might assist in procuring “independent” counsel, subject to the conflicted advisor’s “vetting process.” However, these advisors may not be viewed by the court as being truly independent, weakening the taxpayer’s defense against penalties. Consequently, it is likely that the industry will be divided into camps, where some will advise taxpayers to seek independent advice, and others, such as some promoters, will advise taxpayers that the latest IRS letter is a nothing more than the same IRS bullying. Their advice may be to ignore the letter and “wait it out,” given that the IRS has limited resources. Notwithstanding limited resources, LBI memo 4 14 2020 provided the campaign against micro-captives will continue, including opening new audits, despite the general postponement of new returns examinations until July 15, 2020.
Signing under Penalty of Perjury. This particular signature carries with it important ramifications. In addition to perjury statutes of general applicability, an IRS-specific perjury statute, 26 U.S.C. § 7206(1), subjects false sworn statements to the IRS to fines of up to $100,000 ($500,000 in the case of a corporation) and imprisonment for up to three years. Consequently, any prevarication concerning continued participation in or tax benefits received from a micro-captive program could subject a taxpayer to criminal penalties, even if the program is otherwise defensible.
Parallel Investigations. The potential for criminal exposure provides further reason to heed the IRS’s advice and consult knowledgeable and experienced independent counsel. Indeed, unbeknownst to soft letter recipients, if the IRS suspects fraud, a criminal investigation could be proceeding in the background. The IRS routinely conducts such simultaneous civil and criminal investigations. Such parallel investigations are conducted separately, but whereas IRS policy forbids criminal investigators from directing actions in the civil investigation, the civil and criminal functions conduct regular “coordination meetings” to “facilitate sharing important case developments.” IRS policy dictates that “[s]haring information between revenue officers and government attorneys assigned to the case is a key ingredient in developing civil and criminal cases simultaneously and efficiently.” Therefore, in deciding whether and how to respond to the soft letter, counsel should consider the potential for criminal exposure, and in particular, whether to inquire about the existence of a criminal investigation, given that IRS policy forbids revenue officers from misleading taxpayers in this regard—though, a word to the wise, it also essentially directs revenue officers to avoid giving a straight answer to such an inquiry.
Next Steps. Micro-captive owners should engage in a cost-benefit analysis with respect to the execution of the Micro-Captive Soft Letter. Although the response date is May 4th, the IRS recently informed the press that the response date has been automatically extended to June 4th, an extension that has also been confirmed by revenue agents working the Micro-Captive Soft Letter hotline. (According to hotline agents, this extension should be posted to the IRS website soon.) The micro-captive owner must consider whether to respond because submitting the letter technically is not required. Additionally, the micro-captive owners should consider their exposure if audited and penalties are imposed, in addition to exposure to criminal penalties. All of this should be considered in light of the micro-captive owner’s particular facts and circumstances and the established precedent of the recent tax court opinions that found in favor of the IRS. Although one tax court opinion is currently being appealed, holding out hope for a favorable appeal does not help now, nor does it guarantee that a favorable ruling will be applicable to every micro-captive’s unique facts and circumstances.
 The New York Times, March 20, 2020.
 The United States Supreme Court accepted review of the Sixth Circuit’s divided decision in favor of the IRS and its reporting requirements under Notice 2016-66. See CIC Services, LLC v. Internal Revenue Service, et.al., 19-930.
 I.R.S. Info. Rel. 2019-47, Mar. 19, 2019.
 Memo from LB&I Commissioner to all LB&I employees regarding “LB&I Compliance Priorities During the COVID-19 Pandemic” dated April 14, 2020.
 IRM §§ 220.127.116.11 (Parallel Investigations) (12-16-2014), 18.104.22.168 (Coordination Meetings) (08-03-2009).
 IRM § 22.214.171.124 (Information Sharing) (08-03-2009).
 IRM § 126.96.36.199(3) (Interviews) (08-03-2009).