On March 19, the Serviced announced 2018’s “Dirty Dozen.” This list, compiled annually, warns taxpayers to stay alert and avoid items that the IRS refers to as “common scams.” Micro-captives, included in the Dirty Dozen under IR-2018-62, appear on this list for the fourth consecutive year. The 2018 Dirty Dozen also includes: frivolous tax arguments, falsified income, falsely padding deductions and returns, improper claims for business credits, falsely inflated returns, identity theft, phone scams, phishing, fake charities, and return preparer fraud.

Although an important, and legally recognized, tool for managing the insurable risks of businesses, the tax laws surrounding micro-captives leave them susceptible for abuse. This reality has fueled the Service’s apprehension of micro-captive arrangements. Since their first appearance on the Dirty Dozen in 2015, 831(b) captives have faced ever increasing scrutiny. Since then, a high profile ruling regarding 831(b) captives has been issued in Avrahami v. Commissioner, and micro-captives have been named a transaction of interest under notice 2016-66.

It is the impact of the Avrahami ruling that differentiates IR-2017-31, listing micro-captives as part of the 2017 Dirty Dozen, and the 2018 listing. Both the 2017 and 2018 listings warn taxpayers to beware captive insurance arrangements where the coverages insure implausible risks or fail to meet the taxpayer’s genuine business needs. Both listing also warn of premiums that are not supported by actuarial analysis or underwriting, are geared toward reaching a specific deduction, or are significantly higher than commercially available alternatives. Other items that are addressed in each listing are the tax benefits of micro-captives, potential policy and claims issues, captives investing in illiquid assets, and the use of captives as an estate planning tool.

It is the discussion surrounding Avrahami that sets the 2018 listing apart from previous years. Unlike the 2017 listing, this year’s Dirty Dozen provides additional guidance, through the lens of Avrahami on what might prevent micro-captives from qualifying as genuine insurance in the eyes of the Service. To qualify as insurance an 831(b) captive must “involve risk shifting, risk distribution and insurance risk, and must also meet commonly accepted notions of insurance.”

IR-2018-62 goes on to discuss the findings of the Avrahami Court, noting that there were several problematic facts with the taxpayer’s captive, such as the circular flow of funds, excessive premiums, and a low probability of claims being paid. Additionally, the listing states that the “court also concluded that the arrangement was not insurance in the commonly accepted sense, due in part to haphazard organization and operation, the captive’s investments in illiquid assets, unclear policies, and inflated premiums.”

However, when constructed and managed correctly, captive insurance companies are a valuable and legitimate tool for businesses to insure their risks. It is imperative for taxpayers to ensure that their captive arrangement meets all of the necessary formalities to be considered insurance in the commonly accepted sense. Taxpayers should consult an attorney prior to entering into a captive insurance arrangement. Should you have any questions regarding captive insurance arrangements, 2018’s Dirty Dozen, or any other complex tax issue please contact Steven Miller, alliantgroup, LP’s National Director of Tax, at Steven.Miller@alliantgroup.com.