IRS steps up war on captive insurance tax dodges
By establishing 12 new examination teams to go after taxpayers using 831(b) captive insurance vehicles to avoid paying taxes, the Internal Revenue Service (IRS) has significantly ramped up the pressure that has grown up around these shelters.
The IRS teams comprise employees from its large business, international and small business and self-employed divisions. It is not clear whether the 12 teams will exclusively pursue captives suspected of tax evasion: they may also look into other cases, such as conservation easement tax shelters. But by naming “abusive micro-captives” specifically, and exclusively, the announcement left no room for doubt about the IRS’s primary target.
“The message is that engaging with the IRS will not be quick or easy, and the IRS will use every enforcement tool it has available.” David Slenn, Shumaker, Loop and Kendrick
Its interest in the captive insurance industry may be unprecedented. One observer said he couldn’t think of another example of the IRS being so aggressive in its pursuit of a particular type of tax abuse.
The IRS has been concerned about abusive micro-captives for several years. It has named these transactions on its Dirty Dozen list of tax scams since 2014. In 2016, the Department of the Treasury and IRS issued Notice 2016-66, identifying certain micro-captive transactions as having the potential for tax avoidance and evasion. Captives were required to report transactions of interest to the Office of Tax Shelter Analysis.
Its position was bolstered by three US Tax Court decisions, each confirming that certain micro-captive arrangements are not eligible for federal tax benefits. All of this increased the pressure on those using their captive as a tax dodge, rather than a means of legitimately insuring their business.
The IRS upped the ante in September 2019 when it sent settlement offer letters to “up to 200” captives that it suspected were not engaged in legitimate insurance activities. According to the IRS, nearly 80 percent of taxpayers who received its settlement offer elected to accept it. This required substantial concession of the income tax benefits claimed by the taxpayer, together with appropriate penalties.
In a statement on January 31, IRS commissioner Chuck Rettig said that this demonstrated the service’s success in fighting abusive micro-captive insurance transactions. At around the same time it was sending out the settlement offers to captives, a representative of the IRS was telling delegates at the National Tax Conference 2019 that it was increasing its headcount. It did not indicate these extra staff would be charged with going after captives, but they do come at a time when captives are very much in the IRS’s crosshairs.
A wider net
The IRS will now move forward in bringing cases against the 20 percent of taxpayers that received its settlement offer but have not taken it up.
Its latest move indicates it will cast its net even wider, going after abusive captive insurance vehicles that have so far escaped its attention. There is no reason to doubt its ability to identify its targets: last year it indicated it would increase its use of data analytics to identify captives that were not being used legitimately.
The tax authority clearly sees a big problem with 831(b)s. It said it will open examinations impacting micro-captive insurance transactions of several thousand taxpayers in the coming months, vowing to “vigorously pursue those involved in these and other similar abusive transactions going forward”.
It will open additional examinations and use all available enforcement tools, including summonses, to obtain the necessary information, the IRS said in its statement.
Potential civil outcomes include full disallowance of claimed captive insurance deductions, inclusion of income by the captive entity and imposition of all applicable penalties.
David Slenn, partner at law firm Shumaker, Loop and Kendrick, says: “Taxpayers need to understand that the risk of loss will not mean a mere loss of deduction; the consequences are potentially disastrous. The IRS will push for all applicable penalties, which could include a 40 percent penalty on the understatement.”
He adds: “The IRS is signalling to non-compliant taxpayers that defending their captive will be a war of attrition. The message is that engaging with the IRS will not be quick or easy, and the IRS will use every enforcement tool it has available.”
Keeping up the pressure on the captive insurance industry makes a lot of sense, given the success the IRS has already enjoyed.
Matthew Queen, general counsel at Venture Captive Management, says: “The IRS has collected huge sums of money in recent months from the settlements it has reached, and has amassed quite a war chest. The more it goes after these captives the more money it makes, so it is only logical that it keeps up the pressure.”
What next for 831(b)s?
How many problematic 831(b)s there are left to find is anyone’s guess. The IRS talked about thousands, and the 80 percent return it achieved in its last batch of settlement offers suggests it has some idea of where the bad actors are.
However, Queen believes, most of the more egregious cases have probably already been dealt with. “I doubt there are many large operations engaged in this tax dodge left,” he says. “The remaining cases are probably smaller, less competent managers.”
More high profile legal battles, such as the cases of Syzygy and Avrahami, are unlikely, says Queen.
“The majority of the IRS litigation is probably over,” he says. “I don’t expect many more of these captives to fight it because they don’t have a leg to stand on. But we may now see captive owners going after their service providers, the managers, auditors and law firms that talked them into using these tax shelters in the first place.”
Queen adds: “The canary in this coal mine died a long time ago. It is one thing to use a tax shelter when few people know about it, but the IRS has been on to this one since 2014, so the smart money will have got out of it back then, or at least by 2017.”
While most within the industry agree that 831(b)s, or micro-captives, are not inherently bad, the situation does leave the industry even more on edge.
Queen notes: “If a client came to me now asking about 831(b)s I would be concerned. If they came with concerns about how to best manage their risk, it may still be that an 831(b) structure would be the right one for them, but the focus has to be on the risk.”
Those who do have legitimate 831(b)s must understand that the spotlight is shining right on them.
As Slenn concludes: “It is vitally imperative that owners of captives that have made an 831(b) election take steps now to review their compliance.”