Understanding How IRS Audits Captive Managers Suspected Of Abusive Tax Practices


Article from Forbes.com


"Not all small captive insurance arrangements are invalid — far from it. The vast majority of small captive insurance companies making the 831(b) election are valid and play by the rules, and are not going to be bothered by any of this. Unfortunately, the captive industry over the last decade has been inundated with promoters who sell small captive insurance companies as the tax shelter du jour, with only a wink and a nod being paid to what should be the true insurance and risk financing purpose of a captive."

"Going after certain managers allows the IRS, limited as it is by scarce resources, to take down many abusive captive arrangements at once. Instead of going after individual captives one-by-one through random audits, by promoter audits the IRS has the opportunity to invalidate several hundred captive arrangements at one time.

Consider the promoter of abusive captives who is managing 200 such captives. If the businesses of the captive owners are paying on average $1 million a year in premiums, that means that in the aggregate they are paying $200 million in premiums — and taking deductions in the aggregate of $200 million dollars. If those companies have been in existence for three years, then $600 million in deductions have been taken."

"If the IRS is able to invalidate all of these captives at once, and deny the deductions, that gives the IRS the opportunity to recapture $600 million in the deductions — not a small sum. Further, the IRS could very well tack on substantial underpayment penalties, and maybe even tax shelter penalties, meaning that the business owners might end up paying 50% or more in non-deductible penalties in addition to losing their deductions."

"You can see that this is a high-stakes game. It is not about a few million dollars in lost taxes, it is about hundreds of millions of dollars in lost taxes and penalties in the aggregate. It is a smart, and frankly quite predictable, strategy that the IRS is following."

"Fortunately, only a relatively small number of captive managers are subject to the promoter audits. By far, the vast majority of captive managers do things the right way, and realistically have no expectation of any such troubles. Their clients need not worry about any of this. But for a few managers, and hundreds of their clients, many sleepless nights are ahead."

"Similarly, it should be caveated that the mere fact that the IRS is conducting promoter audits doesn’t mean that the involved managers will ipso facto see their arrangements invalidated. For all we know, most or all of these managers will go through the audits with flying colors. It is for that very reason that I refuse to name the managers known to be under promoter audits. But I wouldn’t put my money on that bet, since the IRS usually doesn’t even start a promoter audit (a substantial and resource-draining event for the IRS) unless it already has some evidence that something is rotten in Denmark."

"Moreover, the IRS has historically lost most of its court challenges to captive arrangements. These challenges, however, were to predominantly large, corporate captives, which are a different breed entirely. Large corporate captives are able to spread their risk over many subsidiaries, and so they usually have no need for risk pooling arrangements to meet their risk diversification requirements. Plus, the large corporate captives that have prevailed in the court cases had gone to very substantial lengths up-front to really treat their captives as risk-financing vehicles, doing things that would usually be impractical for much smaller captives to even consider."

"So, how should business owners considering a captive protect themselves? The answer here is the same as it has always been: Conduct substantial due diligence of the captive manager, and get advice from independent tax counsel (not tax counsel recommended by a manager) that the particular captive arrangement is valid and meets IRS requirements. Particular care should be taken if the captive will require risk pooling to meet risk diversification requirements, to validate that the risk pooling arrangement will withstand scrutiny."

"Also, some practical advice: If somebody is trying to sell a captive as tax-avoidance tool, as opposed to an insurance and risk-financing tool, run.

The same advice goes to the owners of existing captives: When in doubt, hire independent tax counsel who is experienced with captives to review the arrangement. This advice rings particularly true if you receive a notice that your captive manager is under a promoter audit."

Article From www.forbes.com

Captive insurance plans: How to Avoid Being audited? 
The insurance industry have been conjuring ways to make life insurance premiums tax deductible.  Over the years we have seen many schemes that have failed IRS scrutiny. Welfare benefit plans set up under I.R.C. section 419, 412(e) plans and Producer Owned Reinsurance Companies (PORCs) are all common examples.


Captive Insurance is on the IRS's watch list for 2015 


In abusive structures, however, “unscrupulous promoters” persuade closely held entities to participate in schemes using captives, the IRS said.

They assist the entities to create captives onshore or offshore, draft organizational documents, and prepare initial filings to state insurance authorities and the IRS.

This assistance includes creating and selling to the closely held entities “insurance” binders and policies that the IRS said are often “poorly drafted.” These documents purport to cover ordinary business risks or “esoteric, implausible risks” for “exorbitant ‘premiums,’” while maintaining economical commercial coverage with traditional insurers, the IRS continued. 

Total amounts of annual premiums often equal the amount of deductions the business entities need in order to reduce income for the year, the IRS said. “Or, for a wealthy entity, total premiums amount to $1.2 million annually to take full advantage of the Code provision.”

Meanwhile, underwriting and actuarial substantiation for the insurance premiums paid are “either missing or insufficient.”

The promoters manage the entities’ captives year after year for what the IRS said are “hefty fees.” These firms essentially assist taxpayers who are unsophisticated in insurance to “continue the charade,” it said.

Captive Insurance & Other Abusive Tax Shelters

Captive insurance arrangements that are funded with cash-value life insurance are the hot tax shelter for 2014. But serious questions exist whether they work as the promoter’s promise they will do.

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419,412i, Captive Insurance, Section 79 Problems

Sometimes the IRS might disagree with planning you did with other advisors and you need to find help to ensure that your rights are protected, the facts are interpreted accurately and the law applied correctly.

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This article originally appeared in Accounting Today

Taxpayers who previously adopted 419, 412(i), captive insurance or Section 79 plans are in big trouble. 

In recent years, the IRS has identified many of these arrangements as abusive devices to funnel tax deductible dollars to shareholders and classified these arrangements as "listed transactions." 

These plans were sold by insurance agents, financial planners, accountants, and attorneys seeking large life insurance commissions. 



"Group Captives" Insurance Scam

Just a few years ago, captive insurance companies were a hot news item in the arcane world of abusive tax shelters. Sleazy promoters were signing up small businesses in droves. 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 in 2008 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.

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Captive Insurance Problem