IRS expands enforcement focus on abusive micro-captive insurance schemes.
WASHINGTON — With the October 15 filing deadline quickly approaching, the Internal Revenue Service today encouraged taxpayers to consult an independent tax advisor if they participated in a micro-captive insurance transaction.
The IRS encourages any taxpayer who has continued to engage in an abusive micro-captive insurance transaction to not anticipate being able to settle its transaction with the IRS or Chief Counsel on terms more favorable than previously announced. Any potential future settlement initiative that the IRS may consider will require additional concessions by the taxpayer.
A lawsuit arguing that taxpayers are permitted to challenge a Treasury Department reporting requirement without first violating it defies a measure Congress took to protect tax collection, the U.S. Solicitor General’s Office told the U.S. Supreme Court.
The office made that argument in a Wednesday court filing urging the justices against taking up a case testing the reach of the Anti-Injunction Act. The act blocks lawsuits aimed at restraining officials from assessing or collecting taxes, which some interpret as shielding the department from early legal challenges to regulatory actions.
In the new filing, the government insisted that the reporting requirement is directly tied to tax collection.
“Requiring taxpayers and tax professionals to report information (and tax professionals to keep records) about such transactions enables the IRS to ensure that taxes applicable to them are not evaded but are properly assessed and collected”, the Solicitor General’s Office said.
CIC Services LLC, a Tennessee-based company, has argued that the law doesn’t block its challenge to a reporting requirement backed by a penalty in IRS Notice 2016-66 because it’s challenging the burdens of reporting rather than the penalty itself and, in any event, the penalty isn’t a tax.
The case strongly divided judges at the U.S. Court of Appeals for the Sixth Circuit, with a three-judge panel ruling 2-1 in favor of the government and multiple judges weighing in separately when the full circuit declined to rehear that decision.
CIC Services has said the notice containing the reporting requirement isn’t legally valid because the IRS didn’t notify the public of its plans for the requirement and respond to comments in advance, which the company says was required by the Administrative Procedure Act.
An attorney for CIC Services LLC didn’t immediately return a request for comment.
The case is CIC Services, LLC v. Internal Revenue Service, U.S., No. 19-930, response brief filed 3/25/20
Taxpayers engaged in micro-captive insurance arrangements (and re-insurance arrangements) have started receiving correspondence directly from the Large Business and International (LB&I) division of the IRS. The correspondence asks taxpayers to certify whether they have terminated their participation in the arrangement and, if so, to disclose the last tax year they claimed a tax benefit from the arrangement.
For taxpayers still engaged in micro-captive insurance arrangements as a means to self-insure against business risk, the IRS letter may be an occasion to review the captive insurance arrangement.
In Notice 2016-66, the IRS described micro-captive insurance arrangements as “transactions of interest.” Although many taxpayers engage in captive insurance arrangements to legitimately self-insure against business risk, the IRS expressed concern that some arrangements may result in tax abuse. The notice requires taxpayers participating in such arrangements to disclose the transaction on Form 8886—Reportable Transaction Disclosure Statement—and file the form with their current tax return and with the Office of Tax Shelter Analysis.
The notice provided examples of abusive micro-captive insurance arrangements. The IRS describes the potential abusive transaction as one that starts with a taxpayer who deducts premiums paid to a micro-captive insurance company, with the insurance company electing (under section 831(b)) to be taxed only on its investment income (premium income is not directly taxed). The mismatching of the deductible insurance premiums and the insurance company’s election not to be taxed on premium income may lead to potential abuse. This abuse may exist where the micro-captive insurance company insures against implausible risks, the micro-captive insurance company is used as an investment vehicle for its owners, or where there are loans between the micro-captive and related parties.
Notice 2016-66 lists a number of factors used to determine whether a micro-captive arrangement is an abusive tax structure. However, captive insurance arrangements are also widely used to legitimately self-insure against business risk, and micro-captive insurance companies (defined as having annual premiums of less than $2,200,000) are used by many taxpayers in the middle market. The notice recognizes this fact and specifically states:
However, the Treasury Department and the IRS lack sufficient information to identify which § 831(b) arrangements should be identified specifically as a tax avoidance transaction and may lack sufficient information to define the characteristics that distinguish the tax avoidance transactions from other § 831(b) related-party transactions.
Last year, the IRS successfully litigated several cases where the micro-captive insurance arrangement was clearly tax abusive. Based on these cases, the IRS sent out the above-mentioned letters to those taxpayers who had previously filed a Form 8886. The letter instructs taxpayers who are no longer claiming deductions or other tax benefits for any of the captive transactions described in Notice 2016-66 to notify the IRS. The notification must be signed under penalty of perjury, and include the date the taxpayer ended participation in the micro-captive arrangement, and the last tax year the taxpayer claimed any tax benefit from the arrangement.
Noticeably confusing in the IRS letter is whether taxpayers still engaged in micro-captive insurance arrangements need to respond at all to the IRS letter. Many taxpayers have established micro-captive insurance companies to insure against legitimate business risk; the captive insurance company manages reserves and pays claims that come due. Under the terms of the IRS letter, these taxpayers may not need to specifically respond to the IRS.
The IRS correspondence received by taxpayers has caused confusion as to how to respond and whether a taxpayer’s micro-captive insurance arrangement will be respected. Taxpayers still engaged in a micro-captive insurance arrangement should consider whether and how to respond to the IRS. Based on concerns raised in IRS Notice 2016-66, questions to determine if the captive insurance arrangement is acceptable may include the following:
Does the micro-captive insurance coverage match a business need or risk to the insured?
Does the coverage duplicate other insurance coverage already in place?
Are premium payments calculated to cover risk based on an analysis consistent with industry standards?
Are premium payments consistent with premiums required under commercially available insurance contracts?
Is there documentation of insurance coverage?
Has the captive insurance company registered as an insurance company with the applicable government agency?
If the captive insurance company is an offshore entity, has it elected under section 953(d) to be taxed as a U.S. insurance company?
Does the captive insurance company have procedures for the handling of claims?
Does the captive insurance company have adequate reserves to cover claims?
Does the captive insurance company have assets that significantly exceed the necessary reserves?
Does the captive insurance company invest in illiquid or speculative assets?
Does the captive insurance company provide loans to related parties?
Although no one factor is dispositive of a bona fide captive insurance arrangement, these questions should be considered by taxpayers to gain an understanding of the micro-captive insurance arrangement and to evaluate their own arrangements. In addition, there is a real concern that the IRS may begin examining taxpayers who are still engaged in micro-captive insurance transactions.
The U.S. Department Of Justice Files Suit To Enforce An IRS Summons Against The Delaware Department Of Insurance For Artex Transactions tax shelters.
tax shelters. On June 19, 2020, the Tax Division of the U.S. Department of Justice filed a Petition To Enforce Summons against the Delaware Department Of Insurance, which seeks testimony and certain documents relating to Artex Risk Solutions, Inc. and Tribeca Strategic Advisors, LLC in connection with its promoter audits of those companies. Concurrently with the Petition, the DOJ also filed the Declaration of IRS Revenue Agent Bradley Keltner and the Summons that it is attempting to enforce. Artex/Tribeca is affiliated with publicly-traded Arthur J. Gallagher.
According to the Petition, the IRS is conducting a promoter audit, known as a “6700 audit” from § 6700 of the U.S. Tax Code that creates penalties for the promoters of tax shelters. In this case, says the Petition the IRS is investigating whether Artex and Tribeca marketed and sold so-called “micro captives”, i.e., captive insurance companies qualifying under IRC § 831(b), as tax shelters — which for both Artex and Tribeca is like wading out into the ocean to look for water. The Petition also notes that a class action (Shivkov v. Artex), which I have written about previously, had been brought against Artex and others for not telling their clients that they were entering into an abusive tax transaction.
The Petition goes on to say that the Delaware Department Of Insurance (DDOI) issued 191 insurance certificates to companies associated with Artex, and that the information sought by the IRS might indicate whether Artex made false or misleading statements in organizing those captives. For instance, according to the Petition, there are instances where the DDOI was apparently complicit in backdating Delaware certificates of authority (basically, insurance licenses), such as one was where the certificate was backdated almost two months from February 25, 2013 back to December 31, 2012 — after which Artex then rewarded six
According to the Petition, the DDOI has failed to fully comply with the IRS Summons directed to it, such as failing to produce all the e-mails between the DDOI and Artex (and its predecessor Tribeca).
More juicy facts are found in the sworn Declaration of IRS Revenue Agent Bradley Keltner, including that the DDOI has so far turned over to the IRS over 18,331 pages of documents related to 16 Delaware captives.
As shocking as the allegations of backdating and complicity in tax shelter schemes might be to the reader who is unfamiliar with the area of captive insurance tax shelters, this is simply what has gone on for the last decade with the insurance departments of several states that have served as mass outlets for risk-pooled 831(b) captive insurance companies. While the Delaware Department of Insurance may be the first to be caught in backdating documents, I can assure you that they are not the only such department to have done it.
The hard truth is that the so-called micro captive tax shelter industry utilizes a lot of — well, let’s just call them what they are — corrupt co-conspirators. The industry requires actuaries who anticipate huge losses from year to year even though those losses have never actually materialized in any year, underwriters who intentionally draft policies so that nobody can figure out what is actually being covered, accountants who turn a blind eye to numerous red flags, lawyers who write opinion letters of dubious validity, and at the center of it all the captive managers who market, sell and keep the clients writing checks to everybody.
There is one more necessary piece to this puzzle, one more group of corrupt co-conspirators for which the entire scheme would fail in the absence of their misdeeds: The state “captive commissioners” and the unit within the state’s insurance department that oversees captive insurance companies. For each and every captive tax shelter relies very heavily on that one sheet of paper — the captive’s license or certificate or authority — without which the shelter would be stillborn. And corruptly conspire they do.
The captive deputies have a powerful incentive to sell as many captives as they can, without regard to the quality of any individual captive. Bigger numbers means more revenue generated by their sections, which leads to bigger staff, greater prestige, and sometimes higher salaries. The departments are themselves frequently willing to turn a blind eye towards what their captive sections are doing, because the department can report to the state legislature a larger number of licenses issued, and thus seek a bigger budget. But between states, the captive insurance marketplace is very competitive: Most of the states have more-or-less the same captive statutes, and if one enacts something better then the rest follow quickly, and most of the states charge about the same for their insurance licenses.
What that leaves is something known as the captive industry as “flexibility”, which means that while most insurance departments are restrained by doing things by the book, have rigorous internal controls, and no backdating a document. A few other insurance departments don’t quite have the same scruples. Instead, some of the captive jurisdictions have earned reputations as being “flexible”. That means that they will bend, break or simply ignore the rules to facilitate the licensure of a new tax sheltered captive. The captives they are licensing don’t make any economic sense but are simply formed for the purpose of cheating Uncle Sam out of a few bucks in taxes. The regulators go along with it because they benefit too. Thus, ignoring or twisting their own rules in the name of “flexibility” as to what constitutes a legitimate captive. These regulators indeed became corrupt co-conspirators too.
Note that “flexibility” is not just in allowing the formation of the captive, but how the captive continues to be regulated in the following years. Here is where the captive deputies really show their complicity in running tax shelters, since they see the same captive managers and same actuaries submitting reporters over and over which predict that losses will be X in the coming year, but it turns out very consistently that the actual losses were actually less than 5% of X. In the real insurance world, consistently missing predicted losses by such a huge margin would be pretty good evidence that false actuarial studies were being submitted, but it is here that the captive deputies know that if they required accurate reporting, then the captives couldn’t charge as much premiums as their clients want for their tax deductions, and everybody would lose business — so the captive deputies simply ignore it all.
This is exactly where the “flexible” insurance departments engage in what cannot be characterized as anything short of tax fraud, i.e., issuing insurance certificates based on actuarial studies that are obviously inaccurate just so that the ultimate taxpayers can generate a false deduction through the vehicle of falsely-inflated premiums. While a tax shelter promoter taking a half-dozen employees of the DDOI to breakfast isn’t exactly the most corrupt quid pro quo, it does illustrate the fundamental coziness between the insurance departments who rely upon the promoters to bring licensure business in, and the promoters who rely upon the insurance departments to issue captive licenses no matter how obviously the application indicates a tax shelter captive.
Delaware was one of the first “flexible” jurisdictions, and at captive conferences for years the folks of the Delaware Department of Insurance went out of its way to express to the industry that Delaware was open for “pure tax” captives, so long as application fee checks cleared. Thus, in just a few years, Delaware went from being a state with few captives to being one of the most prolific issuers of captive licenses; 191 to Artex alone as the Petition here states.
Shortly thereafter, two other states, Tennessee and North Carolina, also exploded in the number of their captive licenses issues also because they were holding themselves out as “flexible” — it would frankly surprise me to find out that of each of Tennessee and North Carolina’s hundreds of captive licenses issued, either one has more than a handful of micro captives that are not just tax shelters. Because Delaware is a corporate hub, it probably has a goodly number of legitimate captives, but I would similarly be surprised if less than 90% of its micro captives are not of the tax shelter varietal.
Where Delaware really kicked the sales of tax shelter micro captives into overdrive was in the area of so-called “cell captives” which are organized as Delaware Series LLCs. The idea here was that a tax shelter promoter could form just one parent captive, and then have a bunch of children captives of that parent in which their clients could participate. These cell captives were sold by the bushel to folks who could not afford sufficient premiums to make their own standalone captives worthwhile, such as doctors and other small businesspersons who had high incomes who were looking to shelter income.
Interestingly, the insurance departments of other states quickly replicated this model so that they could also get their piece of the cell captive tax shelter pie by licensing individual cells of Delaware Series LLC in their own states. Tennessee, for instance, licensed a lot of these. The percentage of legitimate captives in these Series LLC programs is very low, probably less than 5%. If a state regulator cross-indexed those captives organized as Delaware Series LLCs against those whose losses were less than 20% of premiums for two consecutive years, the resulting list of captives could safe be put into the “terminate immediately” pile.
One would think that when the IRS issued Notice 2016-66 and listed captives as a “transaction of interest” that such would have put the kibosh on the states aggressively competing for tax sheltered captive sales, but in fact the last several years have seen the rise of a new regulatory player in this sector, albeit not quite a state: Puerto Rico. The captive programs coming out of Puerto Rico take abusive to an entirely new level, and office of the Puerto Rico insurance commissioner seems to welcome that business with open arms.
Meanwhile, captive managers in the “flexible” states continue to market and sell abusive micro captive programs, albeit they are working much harder to try to make it appear (falsely) that they are only selling captives for bona fide insurance reasons. Where many other states that offer captive licenses have significantly backed off taking new micro captive business, there are still a few states out there that are hungry for new business no matter how much it smells. These insurance departments still want to go to their legislatures for bigger budgets, bigger staffs, more prestige, etc., and it that takes complicity in tax fraud then that is what it takes. And they’ll keep getting IRS Summons as here too.
Finally, it is hard to figure out why Gallagher continues to hold on to Artex other than maybe blind speculation that Gallagher affirmatively wants to be in the tax shelter business. Otherwise, it makes little sense. Buying Tribeca made little sense to begin with, since it was a notorious tax shelter captive shop that had all the subtlety of a hooker wearing skimpy clothing who waives at cars passing by, and fit nowhere in Gallagher’s traditional business model.
The Artex/Tribeca deal has to go down as one of the singularly worst transactions in Gallagher’s history, and indeed Gallagher now finds itself on the wrong end of a class action suit because of it all. Strange; it seems like maybe Gallagher’s Board of Directors is asleep at the controls on this one. They would be well advised to just totally axe Artex, move its assets and legitimate non-tax business to a new insurance company that doesn’t have any of Tribeca’s taint, and vow never to do anything like this again. But somehow Artex survives. Again, strange.
I have been an expert witness in captive insurance cases. This article is from Jay Adkinson. If you are in a captive you need help NOW.
Anyone who has received an IRS offer to settle a micro-captive insurance audit should immediately consult an experienced tax lawyer to understand the pros and cons of the offer before any deadline expires. micro-captive insurance
audits The IRS announced its plan to mail settlement offers to a maximum of 200 taxpayers under audit for their participation in micro-captive insurance arrangements which the IRS considers “abusive” and in violation of tax laws. Only those who receive settlement offer letters are eligible for the current initiative. The IRS says that the offer could be offered to others later.
The agency will continue to audit those that reject the offers, subject to tax assessment and available penalties. These taxpayers will not be included in “future settlement initiatives.”
The IRS elected to make the current offers after it was successful in three cases in U.S. Tax Court plans to continue to “vigorously pursue” suspicious micro-captive transactions, which have been on the “Dirty Dozen” list of tax scams since 2014.
What is a micro-captive insurance arrangement?
A business may establish a small micro-captive insurer (or reinsurer) designed to cover certain risks and losses the business may suffer. The insured business normally can deduct insurance premiums as a business expense. Under certain circumstances, the eligible captive insurer can elect to only pay taxes on income from investments and not on income from premium collection.
The structure of these arrangements is subject to abuse of tax benefits when the small insurer is treated as a micro-captive but does not really function as an insurance company. In other words, tax avoidance can happen when the insured business gets deductions for premiums and the captive insurer pays taxes only on investments, but the insurer is more like a sham entity not functioning as a real insurance company would.
In addition, the arrangements may come under IRS scrutiny when the business that pays insurance premiums to the micro-captive insurer turns around and takes loans or other financial benefits from the captive entity. Another red flag can be premiums that are much higher than the market dictates. Sometimes the IRS looks more closely when a third party like an accountant or financial planner makes the arrangements.
Another area of potential IRS interest is when the involved parties fail to report certain related transactions as required by law. Failure to accurately report can bring large financial penalties.
Proceed with caution
The use of micro-captive insurance arrangements is common with many large companies using at least one currently and participation increasing among smaller businesses, reports the Insurance Journal.
According to the IRS, there are about 500 cases in the court system dealing with micro-captive insurance issues. Anyone with this kind of arrangement or considering one should get advice from an attorney to be sure that it is compliant with tax law and for advice about how to report transactions and handle related income tax issues.
Anyone already embroiled in an audit or dispute with the IRS over a captive insurer issue should also seek experienced legal advice. A tax lawyer may be able to negotiate an acceptable arrangement with the agency or have other proposed legal resolutions.
Just a few years ago, captive insurance companies were a hot news item in the arcane world of abusive tax shelters.. Group Captives
If you created a cell captive as a property and casualty loss management tool, it’s probably legitimate. If you “bought” an off the shelf captive from a promoter who promised tax savings, there is a good chance you own an abusive tax shelter.
After the initial wave of fraud and audits, many of the bad promoters went away. New reports suggest that captives are again making a comeback. And with the next generation of captives will come the inevitable fraudsters looking to catch a free ride on the resurgent popularity of these products.
The new wave of captive insurance companies are sometimes called cell captive insurance companies or “group captives.” We have also seen them called rent-a-captive, segregated account companies, segregated portfolio companies and incorporated protected cell companies. Whatever they are called, if properly set up they can be completely legal and valuable risk management tool.
The IRS issued a bulletin to give guidance on these products including whether premiums can be deductible as insurance costs. The IRS says there must be adequate risk shifting and distribution to be considered “insurance.”
The scam promotions typically offer to shelter a large sum of money by calling it an insurance premium. The premium is usually the same dollar amount as the deduction you seek. The promoter offers “insurance” on a highly improbable risk. Hurricane insurance in Nebraska, anyone? Magically, you get a big deduction and in a few years you are promised the ability to get back your money in the form of a “premium refund” or dividend. Sound familiar? You probably purchased an abusive tax shelter.
If you think that you have one of these products, seek legal help immediately. First, the premiums in bogus captive insurance companies or cell captives are not deductible. That has significant tax implications and likely involves big civil penalties too.
Because the IRS views many of these schemes as abusive tax shelters, there are special penalties that apply. If the IRS finds that your captive insurance resembles an illegal welfare benefit scheme (sometimes called 419 or 412 plans), your plan might be considered a listed transaction subject to penalties of $100,000 or more per year.
Abusive tax shelters can also be criminally prosecuted.
Another danger is that in many of the cell captive frauds, the money is simply not there when you go to cancel the policy and seek a refund of premiums.
It’s not always promoters who sell the bad plans. We know of otherwise honest insurance agents and even accountants who were roped into selling these products. Many promoters lure agents into their scheme by offering legitimate looking “legal” opinion letters and slick marketing materials.
If an agent or accountant sold or recommended the plan, you may still be able to recover your damages if the promoter – and your money – is long gone. (Insurance agents love these plans because they usually pay above average commissions – another red flag.)
Micro-Captive Audits Shortly after the Internal Revenue Service again warned taxpayers to steer clear of unscrupulous promoters who sell abusive micro-captive insurance which is on the IRS Dirty Dozen list. It is also targeted by the IRS Large Business and International Division touted the success of its partnership with the Small Business/Self-Employed Division in carrying out the micro-captive campaign, the US Tax Court handed the IRS its third straight victory involving a small captive structure in Syzygy v. Commissioner.
1 Six days after the Syzygy opinion was issued, LB&I announced the initiation of a “Captive Services Provider Campaign” aimed at ensuring US multinational companies pay their captives no more than arm’s-length prices.
2 The IRS is clearly moving quickly to address tax compliance issues in the captive world.
The IRS has now obtained victories in cases involving both forms of small captives under the Internal Revenue Code: captives electing tax-exempt status under § 501(c)(15) and captives electing to be taxed only on investment income under § 831(b). With each victory in court, the IRS has succeeded in highlighting problematic program design features and implementation missteps. Going forward, IRS revenue agents and appeals officers will likely look to the deficiencies identified in the case law in resolving captive controversies.
Understanding the current state of the law regarding captives in the US Tax Court is important not only for pending IRS controversies but also for current micro-captive owners as they consider what approach to take going forward. While each case stands on its own, a thorough review of the captive program can help establish an informed basis for decision-making both before and during an audit.
To carry out this review, it is important to understand the key issues that will be addressed during a captive audit. Some of the core substantive issues, involving risk distribution and whether a captive program reflects insurance in the commonly accepted sense, are discussed below.
Super Factor: Arm’s-Length Transaction. One of the most important questions in determining whether a captive can survive IRS scrutiny is a simple one: Do the coverages make economic sense? Whether the coverages are “arm’s-length transactions” is important in determining whether there is real risk distribution, as well as whether the arrangement constitutes “insurance in its commonly accepted sense”.
While to date no court has addressed whether this factor might also play a role in resolving whether the arrangement should be set aside under judicial anti-avoidance doctrines, it is certainly possible that the courts could rely on the lack of arm’s-length arrangements as a predicate for applying “substance over form” or the economic substance doctrine.4
Regarding risk distribution, all three of the Tax Court micro-captive cases referenced above involved the employment of a risk pool established by the captive manager in order to enable the captive to insure third-party risk and obtain the requisite risk distribution.
In each case, after analyzing the risk pool as part of its risk distribution analysis, the court held that the participation in the risk pool did not result in adequate risk distribution for the captive. If a taxpayer relies on a risk pool, the IRS will request documentation supporting the risk pool structure.
This will include documentation setting forth the rights and responsibilities of the taxpayer vis-à-vis the others who similarly rely on the pool. Given the responsibilities of the pool participants, the IRS will look for evidence of security mechanisms that would traditionally be required. On top of the blueprint for the pooling mechanism, the IRS will want to review how it worked in reality and how it benefited the insured given the insured’s finances and history.
The courts thus far have reviewed captive policies from an objective viewpoint, considering policy metrics (e.g., total cost of risk and rates on line) before and after the implementation of the captive arrangement. After reviewing the various metrics, a court may consider subjective evidence to determine whether there was a rational justification for any expenditures to cover previously unprotected risks through a review of correspondence, marketing materials, etc.
For example, in Syzygy, the court noted that, generally, it is fair to assume a purchaser of insurance would want the most coverage for the lowest premiums.
After finding that the coverage and associated premium did not make economic sense, the Syzygy court also considered statements made by the taxpayer (which seemed focused on obtaining large tax deductions rather than putting in place a helpful insurance product), which confirmed the court’s conclusion that there was no true distribution of risk.5
Insurance in the Commonly Accepted Sense
In determining whether program transactions constituted “insurance in the commonly accepted sense,” the courts also looked to whether the captive arrangements constituted arm’s-length transactions. The courts focused on whether the premiums were objectively reasonable. It is probably not much of a stretch for one to conclude that if the captive policies do not make sense, the IRS will conclude that the associated captive premiums were likewise unreasonable and thus, not insurance in the commonly accepted sense.
The Syzygy court reached the conclusion that the premiums were unreasonable with only two sentences’ worth of analysis.6 Despite the existence of a claim on the policy by the insured to the captive, adequate capitalization of the captive, and active regulatory oversight, these insurance-like traits were not enough to overcome alleged late-issued policies with ambiguous language and the lack of an arm’s-length transaction.
Thus, as the arm’s-length nature of the arrangement has been considered by the courts when questioning whether the arrangement involved risk distribution as well as whether a captive provided “insurance in the commonly accepted sense,” it is incumbent on the tax advisor to drill deeply into the facts that would bear on whether the arrangement made economic sense.
In an effort to avoid penalties, the taxpayer may produce an opinion letter regarding the deductibility of premiums paid into a captive program. Here, the advisor should review the terms of the opinion as well as all other communications, including marketing materials, that might impact the usefulness of the opinion.8 Further, the advisor must be cognizant of the fact that a written tax opinion will not protect a taxpayer from the accuracy penalty imposed with respect to a transaction lacking economic substance, even if the taxpayer relied on that opinion in good faith.9
The captive audit may start as a result of audit of another issue and then blossom into a captive audit or may be initiated solely due to the captive deduction itself. Over the last 2 years, after the § 831(b) micro-captive transaction was designated as a “transaction of interest,” the IRS has obtained a wealth of information from captive owners and captive managers, both from required filings regarding reportable transactions (Forms 8886, Reportable Transaction Disclosure Statement, and 8918, Material Advisor Disclosure Statement) and section 6112 list maintenance request to captive managers.
Information Document Requests
A captive audit will often involve intense questioning via Information Document Requests10 issued to both the captive and the insureds.11 In some cases, the insured taxpayer may handle responding on behalf of the captive as well as the insured party; in other cases, the captive manager or a third party may respond on behalf of the captive. It is critical to understand potential ethical issues, as well as the degree of control the taxpayer has over the captive for purposes of consistency in providing the IRS the information it is entitled to receive under the Internal Revenue Code.
If the requested information is not provided, not only will this likely result in summons enforcement proceedings (assuming the taxpayer can actually provide the information12), but the taxpayer should also be cognizant that any information not provided (perhaps for strategic reasons) may ultimately have to be produced in subsequent litigation challenging the IRS assessment. If critical or important documents are withheld and only surface later in litigation, then the taxpayer’s good faith may be put in question.
Simultaneous with a tax audit, the advisor must be aware of and address numerous ancillary proceedings, such as issues related to state taxing authorities, civil proceedings involving service providers in particularly weak programs, as well as the exit of a small captive program.13
For example, the taxpayer may be interested in civil remedies, joining a class action, or seeking relief in arbitration.14 Consequently, the advisor will need to carefully review and monitor the flow of information, as it is being requested in different settings, utilized for different purposes, but ultimately for the benefit of the taxpayer client.
As an example, a failure to review and monitor communications may lead to tax counsel making statements to the IRS in a tax audit that are wildly inconsistent with statements made by plaintiff’s counsel in pursuing a claim against a service provider. In sum, a captive tax audit may become an incredibly complex process that involves managing numerous moving parts.