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18 September 2019Accounting & tax analysis

The IRS’ tough pill


After securing victories in Avrahami, Reserve Mechanical, and Syzygy, defence attorneys are now less focused on whether an 831(b) captive’s coverages qualify as insurance, and more focused on which penalties apply to the taxpayer’s situation.

“Good practices should be continued. Bad practices should be studied and kept at bay.”

This reality underscores a central issue: the Internal Revenue Service (IRS) won. Winners can be choosers, and the purported olive branch offered by the service reflects the agency’s strong position against 831(b) captives under audit.

This week, the IRS issued its Micro-Captive Insurance Resolution Terms. The document outlines the terms and conditions of a voluntary disclosure by taxpayers to effectively settle any tax issues with the IRS prior to the development of costly litigation. However, the deal is lopsided and reflects the IRS’s deep mistrust of captive insurance companies.

Key features of the deal include:

  • Ninety percent of any deductions claimed as captive insurance premiums are disallowed for all open tax years;
  • Any captive expenses are disallowed;
  • The captive must have liquidated or will be forced to liquidate and the taxpayer will pay taxes on dividends (capital distributed) out of the captive;
  • The IRS will impose an accuracy-related penalty under section 6662(a) at a lowered 10 percent rate so long as the taxpayer can demonstrate that it relied on professional guidance to enter into the scheme;
  • Gift taxes must be paid on any transfer of value to the captive;
  • If the captive was not disclosed via the requirements set forth under Notice 2016-66, then a section 6707A penalty for Failure to Include Reportable Transaction Information with Return will be applied at rate of $5,000;
  • Potential additional penalties under sections 6651, 6654, and 6655; and
  • Any 953(d) election for offshore captives will be deemed invalid and controlled foreign corporation issues will be imposed unless the captive reorganises to become a US corporation.

Although this sounds like a terrible deal, the offer provides a solution to a double taxation feature of current IRS litigation. Under the traditional regime, the taxpayer not only has premium payments disallowed and has to pay income taxes on the premiums to the captive, but also had the 831(b) election disallowed and forced the captive itself to pay income taxes. This double penalty is no longer at play for those who enter into the compromise.

Consequences
The deal is a tough pill to swallow. For those who engaged in 831(b) captive insurance solutions with the understanding that their captive was providing difference in conditions coverage, contingent business interruption, or other legitimate coverage, this deal is awful.

That said, there is no record of who has been sent this offer. It is conceivable that only fraudulent captive owners were sent this global settlement offer. This issue brings back the central problem with captive insurance: the IRS hates captive insurance and bad managers have given it good reason.

Captive insurance deserves its spot within the alternative risk financing pantheon. Unfortunately, unscrupulous promoters have poisoned the well and ruined a significant chunk of the market. This global settlement’s tough terms reflect the punishment due to those who used insurance as a sophisticated tax shelter.

The collateral damage here is that scores of legitimate business practitioners use captive insurance solutions to bolster their risk management practices. Those taxpayers deserve their shot to defend their captive insurance practices.

The state of the captive insurance industry is at a historic nadir. The IRS is winning case after case as the majority of the captives prosecuted by the service do not have any legitimate risk within them.

The point of an insurance company is to pay claims. Risk-free captives are a difficult entity to defend. Combined with sloppy policy manuscripting, poor management practices, and sleazy marketing materials, the majority of 831(b) captives under scrutiny will end up paying lots of money to the IRS.

Fortunately, it looks as though most of the bad apples have been shaken from the tree. There is a litany of class action law suits and individual law suits in waiting across the country against every captive manager with a sizable 831(b) risk pool.

Some of these managers and promoters are great people who got caught up in a larger war against captives, but some of them deserve everything that’s coming to them. That’s the cruel nature of war: innocents get caught up in the crossfire.

But wars end. Over time, the IRS litigation will settle and the ensuing litigation will reach a resolution. The captive insurance industry will march on—perhaps the better for it. Any time the dark spectre of fraud creeps into an organisation, it takes time and effort to remove it. Sometimes, it can be very painful.

What is the modern captive manager to do? As it stands today, the whole concept of risk-pooling is not favoured by the IRS. Yet, there is no way to adequately manage 831(b) captives without a risk pool.

This issue will need resolution and the Tax Court has not demonstrated any competence in providing a bright line rule. So, further litigation awaits. That said, risk-pooling is endemic to insurance and captive managers should continue using reinsurance agreements that make sense.

In other words, good practices should be continued. Bad practices should be studied and kept at bay. This is no different from any other time in history.

We can learn a lot from the IRS’s approach to the 831(b) scandal. We now have a better definition as to what constitutes “insurance in the commonly accepted sense”.

We also have a better concept of the IRS’s position on an “insurable interest”. Whether we agree with their positions is less relevant than simply knowing how they will approach various issues.

Matthew Queen is general counsel at Venture Captive Management. He can be contacted at:  mqueen@venturecaptive.com