California FTB Begins looking at Captive Insurance Companies

While states often lag behind the IRS in enforcement of IRS priority issues, the California Franchise Tax Board (FTB) has begun to show an interest in looking deeper into captives owned by California residents.

While the FTB has made no formal pronouncements about its intention (unlike the IRS, which has classified certain microcaptive transactions as Reportable Transactions), it has begun examining captives, their owners, and their California insureds. While these audits seem to have begun in the past year or so, there appears to be a noticeable increase in FTB audit activity as of late. These audits contain similarities to IRS audits, in that they involve voluminous document requests and FTB interviews of taxpayers, which seek to get at the heart of the taxpayers’ intent in using a captive.

The IRS has sought to impose in a rote manner the much maligned 40 percent (non) economic substance penalty, even on some of those who use their captive properly and have acted in good faith. The FTB has the authority to go farther – not just in captive audits but with all audits. In addition to a 40 percent penalty, the FTB may stack an additional accuracy related penalty, interest based penalty, and potentially even a failure to disclose a reportable transaction penalty for years prior to 2017 (when microcaptives became Reportable Transactions), which is an incredibly aggressive position for the state to take. When the smoke clears, taxpayers could face (after almost any FTB audit) a 90 percent penalty. Application of such a penalty seems outlandish in the captive context, considering the IRS hasn’t in litigation been able to have even a 20 percent penalty stick.

Although the FTB likely does not have the resources to audit every captive insuring a California business, taxpayers should take a look at their own captives and take proactive measures in the unfortunate event the FTB comes knocking. Counsel can assist in reviewing the captive program and suggest items to address and clean-up to ensure a taxpayer’s captive can at the very least pass the smell test. A tax adviser who is experienced with FTB examination procedures can help a taxpayer know what to expect, and prepare accordingly.
If you have questions about captive insurance or any other tax matter, please contact ZMFF&J at 713-350-3529.

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