Though in the midst of a stifling budget and personnel reduction, the United States Internal Revenue Service (“IRS”) recently announced an increased effort to curb what it sees as widespread abusive applications of so-called “micro” captives—those that elect under Section 831(b) of the Tax Code to be taxed solely on their investment rather than premium income. Focusing on micro captives is a frugal application of its diminishing resources because the IRS can generate deficiencies against multiple captives and related persons through a single audit of a suspected promoter of abusive schemes. Once the IRS learns how a particular promoter structures its transactions, it can apply that blueprint against all those linked to that promoter. The industry, therefore, should expect and prepare for heightened IRS scrutiny of micro captives over the coming years.

Most perceived “abuses” of micro captives nevertheless comply with the strict letter of the tax rules governing those entities. Thus, rather than search for technical failures, the IRS will assess the substance of the transaction and tax it accordingly. It is insufficient, therefore, merely to “check the boxes” of compliance. Careful planners must take heed of what troubles the IRS and be sure to avoid those attributes in new captive arrangements. What follows is a brief overview of the relevant tax rules, followed by a description of the sorts of uses of micro captives that the IRS considers abusive despite their objective compliance with legal standards.