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IRS Sends Second Wave Of Soft Letter Warnings To Certain Captive Owners For Abusive Microcaptive Transactions

On July 31, 2020, the IRS sent out a second wave of so-called “Soft Warning Letters” to the owners certain risk-pooled captive insurance companies that qualify under Tax Code § 831(b). This follows the initial March 20, 2020 release of such letters for so-called “microcaptive” transactions. You can read about these letter in my article then.

What has happened is that, even with the ongoing COVID-19 pandemic, the has IRS continued to devote very substantial resources to chasing down what it considers (not without substantial basis) “abusive microcaptive transactions”. Sifting through information they received from a variety of sources, the IRS has identified additional microcaptives that are now marked for increased scrutiny, and the IRS is trying to get these particular captive owners to “come clean” — if, indeed, they have done anything wrong — and thus save everybody a lot of time and trouble.

But that’s the thing: The IRS has only seen red flags indicating trouble, and it doesn’t know whether a particular microcaptive transaction is abusive or not at this stage. Thus, it is encouraging taxpayers to themselves go get a “second opinion” (or maybe just a first) from independent and qualified tax counsel to determine whether their particular 831(b) captive is in harm’s way or not. In this sense, “independent” means tax counsel who has nothing to do with the captive manager or other professionals who sold the captive owner into the deal in the first place.

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The captive managers who have been involved with abusive microcaptive transactions absolutely hate these “soft warning letters” for the very reason that some percentage of their clients will in fact seek out such an independent second opinion, and then will begin the steps to shut down their captives. That means both lost management business for the captive manager, and that the captive manager’s risk pool now has less captives participating in it, and thus less risk distribution for tax purposes. It also means that a taxpayer who decides to exit the arrangement might try to cut a deal with the IRS if later audited, with the deal being to turn over e-mails and other information that would not paint the captive manager in a particularly good light. With 40% penalties being the norm, taxpayers have substantial incentives to bail quickly and sell their captive manager down the river in the hopes of a good deal.

Again, these are “soft warning letters”, not hard ones. A captive owner has gotten one of these letters because a red flag has been triggered somewhere, not because the IRS has already determined that their particular captive is a bad one. The red flag might have arisen from something that is unusual but explainable. But the red flag might also be that the particular captive has participated in a risk pool that the IRS has already determined (at least within the Service) doesn’t work, or the captive is being managed by a captive manager that the IRS has determined (again, at least within the Service) to be a promoter of an abusive tax transaction. The latter recalls that there is somewhere being a half-dozen to a dozen captive managers who are currently undergoing promoter audits — if your captive is being managed by one of these outfits, well, that’s probably not good news.

For captive owners, the appropriate response to these “soft warning letters” is to follow the IRS’s advice: Have the captive arrangement reviewed by independent tax counsel. If it is kosher, then it is kosher and the captive owner should not worry unduly about penalties. But if it is not kosher, then it is probably past time to wind it up and start thinking about turning “state’s evidence” to get a better deal. Because that 40% penalty can hurt, a lot, in addition to paying literally hundreds-of-thousands of dollars to “controversy counsel”, e.g., tax law litigators, to take the matter into the U.S. Tax Court.

And that’s no soft warning from me.

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