Recent moves by both the IRS and the U.S. Senate Finance Captive Regulatory Series Committee (“SFC”) have made it clear that there is some level of coordinated focus on the § 831(b) captive industry.
The IRS action underscored its position that it deems certain practices are problematic, and perhaps criminal. The SFC action began as a legislative proposal, then (at least temporarily) shifted to a factfinding mission. However, the potential qualitative difference between an IRS enforcement action and Congressional legislation is very significant.
First we provide an overview of the IRS and SFC actions, much of which we posted online shortly after the SFC hearing. Second, we provide context to the difference between these responses if taken to their logical conclusion.
The IRS and SFC Actions
The Dirty Dozen Listing
On February 3, 2015 the IRS placed certain abusive § 831(b) captive insurance companies on their “Dirty Dozen” list of questionable tax transactions. Given the use of words like “prosecute” and “scams” in the Dirty Dozen listing notice, inclusion of a transaction on the Dirty Dozen is not something to be taken lightly by advisors or clients involved in a transaction that makes the list. This is, after all, the list that also contains identity theft, pervasive telephone scams, publishing, false promises of “free money” from inflated refunds, return preparer fraud, hiding income offshore, impersonation of chartable organizations, and falsely claiming zero wages or using false form 1099.
Of course, the Dirty Dozen listing does not cover all § 831(b) captive insurance companies. In fact, the listing notice makes it clear that a general § 831(b) captive insurance company, done correctly, is a perfectly viable transaction. The Dirty Dozen § 831(b) transaction appears to take the § 831(b) captive chassis and add one or more of the below-described four negative attributes.
1. Coverage Issues. The listing notice describes § 831(b) transactions that have poorly drafted insurance documents to cover ordinary business risks or esoteric, implausible risks for exorbitant premiums, while maintaining their economical commercial coverage with traditional insurers. The IRS is clearly concerned by the use of
§ 831(b) captives to cover risks that either could be covered inexpensively by traditional First printed in the April 2015 issue of Captive Visions.
carriers, or risks that are very unlikely to occur — either or both — for what it deems very high premiums. It is tempting to see this as solely a pricing issue. However, the IRS appears to be setting the table to argue that the intent of the insurance coverage is not to insure risks, but rather to generate high deductions without claims
2. Structured Premiums. The listing notice describes a transaction where total amounts of annual premiums often equal the amount of deductions business entities need to reduce income for the year, or (for a wealthy entity) total premiums amount to $1.2 million annually to take full advantage of § 831(b). Thus, the IRS is concerned that promoters are structuring premiums to fit client tax deduction needs, rather than reflecting the price for needed insurance coverage.
3. Poor Actuarial Substantiation. Another factor described in the listing notice takes place when underwriting and actuarial substantiation for the insurance premiums paid are either missing or insufficient. While at first it may seem that this factor may be more of a symptom of the bigger diseases listed above, it is entirely possible that the IRS could determine that poor actuarial substantiation completely undercuts the taxpayers’ good faith in taking the premium deduction. Without a professional assessment of the connection between premium amount and risk potential, the entire premium deduction becomes suspect. Even where a taxpayer may not be sophisticated enough to understand that the actuary’s work is not sufficient, the taxpayer’s advisors could very well be charged with this knowledge. Also, if the actuary’s assessment seems sloppy or overtly aggressive, the taxpayer may be charged with the knowledge that a review of it should have elicited a more investigatory response prior to
signing a tax return that relied on it.
“Thus, the IRS is concerned that promoters are structuring premiums to fit client tax deduction needs, rather than reflecting the price for needed insurance coverage.”
4. Excessive Fees Charged to Unsophisticated Taxpayers. The listed notice also alleges that promoters manage the entities’ captive insurance companies year after year for “hefty” fees, assisting taxpayers unsophisticated in insurance to continue the “charade.” This factor is clearly aimed at promoters. The IRS wants to warn unsophisticated taxpayers from working with promoters on § 831(b) captive insurance companies that have one of the above negative aspects. This factor is also a warning to promoters that the IRS considers them to be conducting a fraud (“charade”) in exchange for large fees. Whenever the IRS uses language like this, promoters should not disregard it as bluster.
How could the Presence of These Factors Result in a Criminal Action?
The first three factors above provide a good framework for bringing a civil or criminal case, depending on the intent of the parties involved. For example, if a taxpayer is filing a return with a stated deduction that deprives the IRS of owed taxes, the IRS can argue that the deducted premium is a fraud against the United States should the promoter and taxpayer know the premium is actually driven by the need for a specific tax deduction rather than the insurance need that generated the deduction. The fourth factor alone is unlikely to be enough to make the IRS challenge a transaction, but in combination with any of the above three other factors, could result in a significant escalation of the IRS’ response.
Tempering IRS Statements
While the above developments give rise to concerns, we also know from statements made by IRS officials that the Service does not want to “chill” the captive market. This was recently noted in a presentation to the ABA Captive Insurance Committee by Sheryl Flum, IRS Branch Chief, IRS Office of Associate Chief Counsel. Flum noted:
“The government is trying to walk a very thin line here because we are not trying to chill legitimate captive entities. We recognize that in a lot of cases, there are small businesses where it makes a lot more economic business sense to do self-insurance through a captive and then do a pooling arrangement.”
Thus, while it appears that the IRS is very concerned with abusive § 831(b) captive insurance practices, it is still in the investigatory stage, and is not seeking to target § 831(b) captives more broadly.
The U.S. Senate Finance
Committee Hearings On February 11, 2015 the U.S. Senate Finance Committee (“SFC”) discussed proposed legislation that would increase the § 831(b) election to $2.2 million, but would also have added new limitations that would have effectively gutted the § 831(b) election for many small businesses. Thankfully, these provisions were temporarily
removed, in no small part due to the last minute education efforts from several concerned parties, including the Self-Insurance Institute of America, Inc. (“SIIA”), and certain state insurance regulators contacting their state’s U.S. Senator(s).
Unfortunately, the SFC considers the addition of some limitations as a necessary complement to raising the election to $2.2 million. Jeffrey K. Simpson, Chairman of SIIA’s
Alternative Risk Transfer Committee, was and continues to be a part of these discussions. Mr. Simpson advises that the discussion of raising the election is very much alive, but the IRS has advised the SFC that certain perceived estate planning abuses are high on its radar and the SFC plans on formulating offsets to curb them.
U.S. Senator Charles Grassley voiced these concerns at the hearings conclusion, when he specifically asked the IRS to study the abusive use of captives in estate planning. The fall out from the IRS undertaking such an investigation is unclear, but it is entirely possible that the IRS will open a number of audits of promoters and taxpayers believed to
be involved in estate planning with § 831(b) captive insurance companies.
The Qualitative Difference Between IRS and SFC Responses
As briefly described above, an aggressive IRS enforcement response could lead to all sorts of administrative actions that make targeted groups’ professional lives a living hell. The list of IRS potential actions is well known and often ascertainable by taxpayers and advisors who undertake § 831(b) captive transactions.
IRS Administrative Powers:
The IRS has the administrative power to bring taxpayer audits to make life difficult for taxpayers and their advisors. The IRS has the power to bring promoter audits, causing severe disruption to advisors, risk pools, and other professionals associated with the promoter examinations. The IRS has the ability to disallow tax positions and force taxpayers to litigate at great cost in time and money. The IRS has the power to designate certain transactions as abusive such that severe penalties may arise if not disclosed properly. All of these actions are extremely powerful, and can be especially problematic for compliant taxpayers (and advisors) who get caught up in the enforcement wave, and who then must then prove that should not have been targeted.
Having said all that, legislative action is an entirely different level of action.
As discussed above, the SFC was taking legislative action that many commentators believe would have effectively gutted the § 831(b) election for many small businesses in one fell swoop. IRS administrative action permits IRS flexibility as to what types of activities it wants to target, and to provide nuances as to how these activities are defined. Legislative action generally is inflexible and is rarely very nuanced as to what activities it is targeting.
Likewise, IRS enforcement actions inherently permit the IRS to pick and choose who it wants to target, and allow the IRS to make discretionary decisions if it determines a taxpayer or advisor is compliant. Legislative changes are near absolute in their power, leaving very little discretion as to whom is an intended target.
Legislative action brings fundamental change to the underlying IRC provisions that permit § 831(b) captive insurance companies to financially function. Generally, the legislative process is one of long deliberation. However, in this case, the § 831(b) changes were raised in a SFC hearing on non-controversial tax changes. Thus, the sweeping changes to § 831(b) were almost passed out of committee without much input from the existing industry.
Thankfully, there were alert members of the industry who managed to contact various interested states with captive legislation, and that combination of quick action slowed the process down by alerting the SFC that there was another side to the discussion (i.e., it was not non-controversial).
That being said, Sen. Grassley’s comments on abuses make it clear that some legislative action remains on the agenda. Knowing Sen. Grassley’s strong aversion to abusive tax avoidance, nobody should delude himself or herself into believing that a legislative solution is going away. It is entirely possible that the IRS will be the least of the problems of the § 831(b) industry.