The IRS has rapidly increased audits of tax returns that report micro captive transactions.  Specifically, since November 1, 2016, the IRS has deemed the micro captive insurance transactions to be listed transactions.  In 2018, the IRS included the micro captive insurance transactions as one of its dirty dozen tax scams.  The inclusion of the captive insurance transactions within this listing signaled these transactions as one of the IRS’s top audit priorities.  This has not changed.  Rather, due to successes that the IRS has had in challenging these captive insurance transactions, including two recent U.S. Tax Court cases, the IRS is aggressively increasing the selection of these returns for audit and assessment.

The IRS has been very successful in attacking these micro captive transactions.  In the most recently reported Tax Court case, Averami v. Comm’r, the IRS successfully challenged a micro captive arrangement based on an argument that the arrangement was not “insurance” under normal legal principles.  This case involved taxpayers who owned a very successful jewelry business.  As a result of their participation in the captive insurance transaction, the jewelers increased their insurance deductions from $150,000/year to $1,100,000.  The substantial increase in their insurance coverage was the item of scrutiny in the case.  The Tax Court examined the risk distribution and types of risks insured by the taxpayers.  The Tax Court agreed with the IRS and concluded that the micro captive transaction in that case failed to distribute risk and that the captive insurance company was not a bona fide insurance company.

More recently, in June 2018, in Reserve Mech. Corp., v. Comm’r., the Tax Court also sustained the IRS’s challenge of a captive insurance transaction on similar grounds.  In this case, the Tax Court held that the insurance policies at issue were not bona fide insurance agreements because (1) they involved the circular flow of funds, (2) policies were not negotiated at arm’s length, (3) all the insured’s were obligated to pay the same percentage of premiums, (4) and the premiums were not based upon a proper risk assessment and actuarial determination.

The Reserve Mech Corp case is unique in that it involved the foreign captive insurance company as the Petitioner.  The captive insurance plan at issue in this case was designed and managed by Capstone.

We represented a number of taxpayers in IRS audits that include a review of captive insurance transactions.  In these recent audits, the IRS asserted both the insurance argument that was sustained in the Averami and Reserve Mech. Corp. decisions, as well as more recently asserting an economic substance argument under I.R.C. §7701(i).  Under the economic substance argument, the IRS is essentially arguing that the micro captive transaction does not serve any economic substance and that it is created solely for purposes of generating tax deductions and savings.

Importantly, in the recent audit examinations, the IRS has also proposed the substantial 40% penalty, on top of the tax assessments.  This 40% penalty is authorized under I.R.C. §6662(b)(6) if the transaction at issue is deemed to lack economic substance.

The IRS is vigorously looking for and initiating audit examinations of captive insurance transactions.  Now that these transactions are required to be disclosed on the returns, it is easy for the IRS to select and audit these returns.  If you participated in a captive insurance transaction, we recommend getting an independent review of the policy and premiums to ensure that you are in compliance with the law and can withstand IRS scrutiny.  Unfortunately, there are many captive insurance transactions that were set up in an abusive manner.  Due to this, all captive insurance transaction will face intense scrutiny by the IRS.  Please contact the tax attorneys at Terrence A. Grady & Associates, to discuss your plan and any tax exposure you might have related to the transactions.

One of the most common questions I am asked when I tell people that I am tax attorney is whether the filing of an extension to extend the due date of their income tax return increases the risk that their tax return will be audited.  The IRS allows taxpayers to file an extension request by filing an IRS Form 4868 by the April 15^th deadline.  The filing of this form automatically extends the due date for the tax return for an additional six months.  This form is extremely easy to complete and does not even require the taxpayer’s signature.  Thus, the lure of the filing an extension is substantial.

Some practitioners believe that filing an extension increases a taxpayer’s audit risk.  I disagree.  While it is likely that there is a greater probability of an audit for returns filed on an extended due date, I do not believe it has anything to do with the actual extension.  Rather, the IRS uses several different methods to select a tax return for audit.  Most commonly, taxpayers’ returns are selected for audit through the IRS’s computer screening programs.  Nowadays, the IRS does not have the budget to expend resources and time auditing returns that do not result in a tax assessment.  Accordingly, very high tech computer scoring and selection programs have been developed to identify the returns that are most likely to result in additional tax being owed.  The IRS’s computer screening programs look at two simple formulas and scores to determine whether to select a tax return for audit.  These two scores are computed under the IRS’s Discriminate Inventory Function System (“DIF”) score and Unreported Income Discriminate Index Formula (“UI DIF”).

The DIF score is a numeric score computed by the IRS’s Discriminate Inventory Function System for each individual and some corporate tax returns.  This computer program identifies and selects tax returns for examination by utilizing a scoring system.  A higher DIF score increases the potential for an IRS audit examination.  Essentially, this scoring system compares the income tax return against the “norms,” for other similarly situated taxpayers.  These “norms” are developed by the IRS based upon audit history and statistically valid sampling of returns.  A taxpayer’s return will receive a higher DIF for larger deviations from the norms.  For example, if the taxpayer has a large family size and lives in a high-end residential area but reports a very low (and below normal for the area) income, the return will score a higher DIF and will have a higher likelihood of being selected for audit.

In addition to the DIF score, the IRS also uses the Unreported Income Discriminate Index Formula (UI DIF) to rate the probability of inaccurate information on an income tax return or the probability of omitted income on the tax return.  This audit selection program generally targets four types of returns/taxpayers for audit selection: (1) high income high risk taxpayers, (2) high income non-filing taxpayers, (3) high itemized deduction taxpayers, and (4) self-employed taxpayers (taxpayers filing a Schedule C).

While many practitioners believe that filing an extension increases the audit risk, I do not agree.  Rather, I believe that taxpayers who tend to file extensions are naturally within the groups that are typically subject to a higher audit risk.  Specifically, taxpayers who are with self-employed, high income, and high itemized deductions are generally the type of taxpayers that require additional time to complete their complex tax return.  In contrast, W-2 employees with the normal standard deduction are less likely to need to file an extension and are automatically at a much lower audit risk.