IRS scrutiny of captive insurance companies is increasing with most of it is aimed at small captives using the 831(b) tax election. Large or small, captives must be formed for the correct reasons. Their premiums must be appropriate and their business plans must involve genuine insurance.

But some mini captive or micro captive formations under Section 831(b) of the Internal Revenue Code lack a genuine insurance purpose and instead provide tax shelters for their owners. IRS scrutiny drawn by improper use of captives threatens to cast a bad light on the entire captive industry.

The word is out of the general counsel’s office that the IRS has taken an increased interest in captives, said Jay Adkisson, a chairman of the American Bar Association’s committee on captive insurance. “There are more cases against captives than ever before.”

“Some people have their own motivations for getting clients into captives that don’t necessarily involve risk management,” Mr. Adkisson said. “Let’s just call them what they are, they’re tax shelters.”

“If the IRS wanted to make a lot of money, they could go out and audit every one of the 831(b) captives that’s doing terrorism coverage,” he said. Terrorism coverage “tends to be a hallmark of the tax shelter captives. They’re coming up with these terrorism covers and the pricing bears utterly no relationship to any kind of reality.”

Under Section 831(b), property/casualty captives earning less than $1.2 million in annual premium may elect to pay U.S. taxes only on their investment income.

The provision, part of the Tax Reform Act of 1986, was meant to encourage formation of insurance companies and simplify business for small companies. The rapid growth of small captives taking advantage of the 831(b) election has driven similar rapid growth of several newer captive domiciles such as Utah, Montana and Kentucky as it has added to many captive managers’ rosters of captive clients.

“The 831(b) election has its purpose”, said Thomas P. Stokes, U.S. consulting practice leader at JLT Towner Group L.L.C. in New York. “It also has the potential for abuse.”

Brady Young, president and CEO of Strategic Risk Solutions Inc. in Concord, Mass., said, given the number of 831(b) captive formations, it’s probably natural that they would draw IRS attention. “I just think there are some aggressive captive promoters out there and some aggressive structures that some people have used that have caught the eye of the IRS and they’re going after those,” he said.

Several experts cite the “Salty Brine” case in which two Texans involved in an elaborate arrangement of corporations and partnerships — including 831(b) captives — sought unsuccessfully in U.S. District Court for the Northern District of Texas to overturn penalties the IRS levied against them for what the federal agency said was an improper effort to avoid taxes.

“Salty Brine, the judge thought it was just a complete sham,” said Charles J. Lavelle, a partner at Bingham Greenebaum Doll L.L.P. in Louisville, Ky. “He said this wasn’t even a captive.”

Mr. Lavelle agreed that the IRS appears to be scrutinizing captives more closely, but said that attention is aimed at large captives as well as smaller ones. “There’s a lot more activity of IRS audits of captive companies, but that includes public companies as well as closely held. I think the IRS is just more active in the captive area now than they have been in the past,” he said.

It’s possible the IRS is looking to the courts to fill in the gaps between previous rulings establishing what captive insurance activities are sufficient to merit favorable tax treatment, Mr. Lavelle said.

According to Mr. Adkisson, the IRS position on captives may become clearer in September at a meeting of the ABA’s Section of Taxation in San Francisco at which John Glover, senior counsel in the office of the associate chief counsel, financial institutions and products of the IRS, is scheduled to participate in a panel on captive insurance.

Thomas M. Jones, a partner at McDermott Will & Emery L.L.P. in Chicago, said the increased focus from the IRS on captives isn’t a recent phenomenon.

“For the last two-and-a-half or three years, the IRS has certainly been more aware of captives and therefore more likely to do a tax audit,” Mr. Jones said.

He cited two recent cases, one brought against the government by Rent-A-Center Inc. that was heard in 2011 and another in which he was involved in recent weeks involving Securitas Holdings Inc.

“Both of the cases involve trying to further define the meaning of risk distribution,” Mr. Jones said.

“I think both the IRS and the taxpayers want a clearer definition,” he said. “It’s not like the IRS is doing the audits to define the term. The IRS is doing audits to raise revenue.”

While saying he has no first-hand knowledge of increased IRS scrutiny of captives, David F. Provost, deputy commissioner of the Captive Insurance Division in the Vermont Department of Financial Regulation, said IRS actions against captives can cast the entire captive industry in an unwanted light.

“Anytime you have a captive tax case, that just sort of perpetrates the idea that captives are just a tax dodge,” he said. “It kind of perpetuates the myth around captives.”