Recent IRS actions with respect to "micro-captive" insurance companies warrant heightened tax scrutiny of "self-insured" businesses in the mid-market M&A space.

Last decade saw "self-insurance," as a business practice, break out of the large-cap space and into the mid-cap space. Often, "self-insured" has meant forming an insurance company as a wholly owned subsidiary or as an affiliate owned by the owners of the business. These insurers provide insurance policies that cater to the needs of the insured's businesses. Such an insurer, commonly known as a "captive," can help a business to manage insurance costs and to insure against unique or rare risks for which there may not be a readily available commercial insurance market.

Another magnet for this captive breakout has been the income tax deferral for the owners on income from the insured's business. This is achieved by creating a current deduction (for the insured's business) and deferred income (for the captive) for the same insurance premium. Since 1986, this income tax deferral has been available to insurance companies that (i) have net premiums of less than $1.2 million per year (rising to $2.2 million in 2017 and adjusted for inflation thereafter) and (ii) make an election to pay tax only on investment income. These so-called micro-captives (also known as "mini-captives"), because of the small size of the permissible annual net premium ceiling, rarely pay dividends, and their shareholders do not pay tax on any net earnings of the captives' insurance business until their liquidation.

An entire cottage industry has sprung up that has promoted micro-captives as a tax-deferred wealth transfer tool for the mid-cap business owners, creating insurance policies for risks too remote from or insignificant to the insured's operations to justify the amount of premiums, and with terms too informal and vague to be respected as a true insurance policy. The captives' shareholders would make use of the cash hoarded by the captives on a tax-free basis, by borrowing it from the captives or by pledging their captive stock, or receiving guarantees from the captives for third-party loans.

The IRS has rapidly escalated its scrutiny of the micro-captives. For several years, the IRS has been investigating the promoter cottage industry, as well as auditing and litigating a number of micro-captives. In 2015, the IRS included captives on its "Dirty Dozen" list of abusive tax scams. In November 2016, the IRS designated certain micro-captives fitting the "abusive" mold above, formed after November 1, 2006, as "transactions of interest," the participants (including the insureds and the captives) of which must file certain disclosures with the IRS not later than May 1, 2017. And, most recently, on February 1, 2017, the IRS announced the audit "campaign" of micro-captives as one of its "13 campaigns" where it will concentrate its compliance resources.

These IRS actions show that the tax stake is high and sharp for businesses that either own micro-captives or have insurance policies with micro-captives. The potential consequences range from the denial of the tax deduction for premiums paid on the insurance, net premium income that the micro-captives should have paid taxes on, and accuracy and timing-related penalties, all going back years, as well as penalties associated with the failure to file required disclosures with the IRS in a timely manner. These could represent a disproportionately large percentage of the value of a mid-cap business that enters into this arrangement.

Prospective investors looking at potential M&A targets in the mid-cap market should carefully review the potential targets' insurance practices and strengthen tax representations and warranties to adequately protect against any potential fallout from the current IRS efforts to stamp out "abusive" micro-captives.