Captive Insurance – Buyers Beware!

lance wallachHerol Graham has turned defensive boxing into a poetic art. Trouble is, nobody ever got knocked out by a poem. — Eddie Shaw


Every accountant knows that increased cash flow and cost savings are critical for businesses in 2009. What is uncertain is the best path to recommend to garner these benefits.

     Over the past decade business owners have been overwhelmed by a plethora of choices designed to reduce the cost of providing employee benefits while increasing their own retirement savings. The solutions range from traditional pension and profit sharing plans to more advanced strategies.

     Some strategies, such as IRS section 419 and 412(i) plans, used life insurance as vehicles to bring about benefits. Unfortunately, the high life insurance commissions (often 90 percent of the contribution, or more) fostered an environment that led to aggressive and noncompliant plans.

     The result has been thousands of audits and an IRS task force seeking out tax shelter promotion. For unknowing clients, the tax consequences are enormous. For their accountant advisors, the liability may be equally extreme.

     Recently, there has been an explosion in the marketing of a financial product called Captive Insurance. Small companies have been copying a method to control insurance costs and reduce taxes that used to be the domain of large businesses: setting up their own insurance companies to provide coverage when they think that outside insurers are charging too much. A captive insurance company would be an insurance subsidiary that is owned by its parent business(es). There are now nearly 5,000 captive insurers worldwide. More than 80 percent of Fortune 500 companies take advantage of some sort of captive insurance company arrangement. Now small companies can, too.

Click here to continue reading this article

IRS Audits of Section 79, Captive Insurance, 412i and 419 Scams

lance wallach  If an IRS audit disallows the § 419 plan or the § 412(i) plan, not only does the taxpayer lose the deduction and pay interest and penalties, but then the IRS comes back under IRC 6707A and imposes large fines for not properly filing.

Insurance agents, financial planners and even accountants sold many of these plans. The main motivations for buying into one were large tax deductions. The motivation for the sellers of the plans was the very large life insurance premiums generated. These plans, which were vetted by the insurance companies, put lots of insurance on the books. Some of these plans continue to be sold, even after IRS disallowances and lawsuits against insurance agents, plan promoters and insurance companies.

As the IRS started going after 419 and 412i plans people started selling captive insurance and section 79 plans.

The primary use of a captive must be for bona fide risk management purposes, and not to save taxes. Unfortunately, many of the same promoters of tax shelters who a few years ago were selling Son of Boss, CARDS, BLIPS, and other flavor-of-the-day tax shelters, are now selling captives as a way to save taxes, with only the barest lip-service being paid to the risk management function.

Click here to continue reading this article

419, 412i, Captive Insurance and Section 79 Problems

lance wallachSometimes 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.

Lance Wallach is among the few in this country who fully understand the mechanics and legal issues surrounding what has become known as “419 Plans,” 412i plans, captive insurance and section 79 programs. He wrote the book, that others read for CPE on these subjects. For that reason taxpayers throughout the country seek his services in dealing with the Internal Revenue Service in audits, appeals and in the Tax Court with his associates. As an expert witness Lance Wallach’s side has never lost a case. Sometimes it is easy to get your money back with a letter.

Click here to continue reading

Captive Insurance Tricks to Avoid

captive penaltiesThere are many people and advisors who try to form their own captives and end up with a pretty big mess. In such cases they expose themselves and their businesses to unnecessary tax liability.

There still seem to be a number of people who have not yet received the news that the 501(c)(15) captive is effectively no more. While Congress did not abolish 501(c)(15) insurance companies, they instead created a $600,000 maximum limit for gross receipts of both the insurance company and other companies held by the same control group. Which means, if both the insurance company’s income and the income of the owners exceeds $600,000 in a year, then the 501(c)(15) limit has been busted and the exception no longer applies. Since no business would even consider a captive that would have less than $600,000 in income by itself, the effect of Congress’ change is to have effectively eliminated 501(c)(15) in all but the rarest of circumstances.

Yet some tax professionals ignore the news about this change and continue to advise their clients that the 501(c)(15) is a great investment. Even worse, some of these professionals have misconstrued the Determination Letter provided by the IRS to allow in some way an “exception” to the gross receipts test, which is absolutely not true. To the contrary, such letters say that the captive is exempt only so long as it complies with 501(c)(15), which is no longer practically feasible. These clients are about to wake up to a horrific tax nightmare.

Another common captive insurance error is when the person setting up the insurance company only uses it to underwrite the risks of his own company. Being that there is no risk-spreading, there is little to no chance that the IRS will consider the insurance company’s activities to be that of insurance, and no chance that the IRS will consider the insurance company to be an insurance company for tax purposes.

The problem begins when people have received bad advice from their Property-Casualty broker, and set up a captive insurance to underwrite their business needs. By thinking that due to the fact that they have 11 or more single-member LLCs as subsidiaries, they meet the test for risk-sharing. But the IRS recently announced in Rev.Ruling 2005-40 that the IRS simply disregards the single-member LLCs and so there is just one policyholder and no risk-sharing.

There is a major Property-Casualty insurance broker who has been advising his clients to set up these arrangements and I would not be surprised to see significant litigation against this broker and his advisors who thought they understood the federal tax treatment of insurance companies.

A captive insurance strategy being sold to doctors, where they act like they are making payments of medical malpractice premiums or disability income premiums to an offshore segregated-cell insurance company. After some time, that insurance company ends up paying out those premiums as profits to an offshore trust or a similar arrangement that is directly or indirectly controlled by the doctor himself. These arrangements are designed to appear as offshore deferred compensation arrangements.

What happens is the same in all these cases. The doctor makes his premium payment to the segregated-cell captive, takes a deduction for it, and then gets his money back tax-free offshore. This is a criminal tax evasion, and the doctor who doesn’t fess up before being caught by the IRS will definitely spend time at a federal prison. In addition to prison time, the doctor will have to pay huge fines and penalties and back taxes and interest.

Captive insurance company taxation is complex and constantly changing. It is too easy to mess up leading to the entire captive arrangement to be disregarded. While captive insurance is a powerful tool, it must be overseen by a quality tax advisor and counsel. If an arrangement sounds too good to be true, it probably is.

The IRS and Captive Insurance Companies

captive keyThe use of captive insurance companies have been used to manage costs and risks and realize tax benefits has been legitimate for years. The IRS has recently focused audit resources on small and mid-market companies that are forming small captive insurance companies. These companies seek to benefit from Section 831(b) of the tax code, which allows insurance companies with less than $1.2 million in premiums to be taxed on their investment earnings rather than on their gross income.

We are seeing this first-hand while we are representing small and medium size companies who have captive insurance companies in audit with the IRS. At its core, the main concern for the IRS is that some of these small and medium companies forming captive insurance companies are not engaged in true insurance. In response to this situation, the IRS recently added captive insurance to its annual “Dirty Dozen” list of tax scams for the 2015 filing season. This means that the IRS is taking a hard look at captive insurance companies and the people who manage these companies. The language from the IRS announcement is: “In the abusive structure, unscrupulous promoters persuade closely held entities to participate in this scheme by assisting entities to create captive insurance companies onshore or offshore, drafting organizational documents and preparing initial filings to state insurance authorities and the IRS. The promoters assist with creating and ‘selling’ to the entities oftentimes poorly drafted ‘insurance’ binders and policies to cover ordinary business risks or esoteric, implausible risks for exorbitant ‘premiums,’ while maintaining their economical commercial coverage with traditional insurers.”

Based on our experience, we have learned that the IRS repeatedly focuses on these main questions:

  1. Why was the captive insurance company created?
  2. How did the captive insurance manager market his product to the captive owner?
  3. Do annual premiums vary in tandem with the business’s taxable income for the year, or conversely, do premiums hover at or near the $1.2 million mark year in and year out?
  4. Were there any claims made against these policies?
  5. Were there claims made against the risk pool that is often a part of the small captive setup?
  6. Do coverages appear warranted and do premiums appear correctly calculated?
  7. Do the premiums vary by reason of underwriting on an annual basis?
  8. Who owns the captive?
  9. Is the captive insurance held in trust for the benefit of others or future generations?
  10. What kinds of investments are present?
  11. Has life insurance been purchased?

Note: The fact that the captive insurance company may have been Ok’d by the state insurance commissioner will get you halfway with the IRS. It is important for CPAs to understand these two things:

  1. While the IRS may first contact your client in the context of a promoter audit, you need to treat the contact with the IRS with utmost seriousness, even if it was initially just a third-party contact.
  2. Even if your client is doing things properly, if the client is part of a larger risk pool of insured—and if one of the other members of that pool is not squared away—the entire pool is potentially in jeopardy, including your client. Bear in mind that the stakes are high. If the IRS finds that the captive insurance company doesn’t pass muster, it means losing not only the premium deduction, but also incurring a 20 percent penalty, along with interest on top of that. The IRS is also considering imposing economic substance penalties and the 20% goes up to 40%.

The best practice for CPA firms with clients who own captive insurance companies is to have a review conducted to ensure that the captive is conforming to tax law requirements both in form and substance with a deep look at the insurance provided and the overall insurance pool. This is best done before the IRS comes knocking at your door. The risks of adverse IRS action can be managed if done proactively on a voluntary basis. If your client has already heard from the IRS, be aware that this is a highly technical area of tax law which involves a detailed understanding and knowledge of insurance questions from a tax law perspective.

The mere fact that captive insurance is on the “Dirty Dozen” list means you can anticipate a thorough audit that is closely managed by technicians and senior officials at the IRS.

Lance Wallach’s success with his clients has come from having a good understanding of the IRS’s concerns and priorities and also from what he has experienced with his clients in past cases. The key is knowing what the IRS is willing to accept, when the IRS is willing to let the taxpayer correct and what it takes to resolve an examination or an audit. CPAs do play a vital role as the most trusted financial advisor for most small and medium companies. For those CPAs who do have clients with captive insurance companies, now is the time to explain to them that they are in trouble and assist them in safely getting out of this mess.

It’s Tax Time Again

CaptiveInsuranceIt’s tax time again, which means many people will be writing checks to the IRS. But not a lawyer in Los Angeles, who last year put all of his earnings, $840,000, into a tax shelter and plans to put $1 million in this year. He doesn’t have to pay any income tax. In fact, he was able to borrow back some of the money to live on and write off the interest on the loan.

The attorney accomplished this feat by putting his earnings into a captive insurance company, a vehicle that allows companies to insure themselves against risks that are too expensive to buy coverage for in the regular insurance market or to cover events that are unlikely to happen but would be costly if they actually did.

Until a decade or so ago, most captive insurances were set up by large companies. Captives have gained popularity among small-business owners who see another benefit. They can be designed so that the risks they insure are so unlikely that the captives will never pay out a claim and all those premiums will go back to the business owners or their heirs with little or no tax.

The question is whether these small captives have gone too far. This year, the IRS placed them on its annual “Dirty Dozen list of tax scams.” Small captives now share space with phishing, identity theft and offshore tax avoidance. In its commentary, the IRS criticized wealthy individuals who canceled or greatly reduced their income by putting money into small captives. The agency took particular exception to promoters who drafted policies to cover ordinary business risks or implausible risks for exorbitant premiums, while maintaining their economical commercial coverage with traditional insurers. Yet promoters of captives persist, seemingly undaunted.

“They said a couple of things that are extremely general — one about unscrupulous promoters,” said Celia Clark, a lawyer in New York who wrote an article in Trusts and Estate Magazine last year about the asset protection and estate planning benefits of small captive insurance companies. “But when you’re dealing with that level of generality, I don’t get anything out of that that would be useful. We’re waiting to hear how it plays out in court.”

Other lawyers are warning their business-owning clients to be wary of the siren song of captives — or at least to make sure they have a real insurance need and are not blinded by other supposed benefits of captives. David Slenn, a lawyer at Quarles & Brady in Naples, Fla., and the chairman of the American Bar Association’s captive insurance committee, said the push to set up small captives had gotten out of hand. The interest in captives is being driven by lawyers and accountants who are seeking additional fees now that the estate tax exemption has been permanently set and there is not as much annual business, he said. “When you consider insurance and what it’s traditionally used for and you compare that to some of the worst offenders with a captive, you see it was set up to achieve a different role,” Mr. Slenn said.

“We’re starting to see this flood of people from the trusts and estates world using the captive as part of an estate planning structure. It’s becoming absurd. People are marketing captives as a possible substitution for estate planning”. He predicted that the I.R.S. would go after the worst offenders to make an example of them. These include captive insurance companies that are owned by trusts — as opposed to a company — and have accumulated a lot without ever paying out claims. Another is the captives that make loans to the heirs of the business owner who benefits from the trusts or allow the heirs to use their interests as collateral to buy something else. However these captives are set up, Mr. Slenn said, they have distorted the original purpose of captives and also sidestepped the gift tax laws.

Under IRC guidelines, business owners can put up to $1.2 million a year into a captive as an insurance premium with just an actuary signing off on the risk being insured. Anything above that number, more justification for the premiums is required. When business owners take a distribution from the captive, it will be taxed at the lower rate for qualified dividends.

The costs to set up a small captive is about $100,000, and then about $50,000 yearly maintenance. But they can be deducted as business expenses. At the outer limits, captives are being promoted as a way around gift and estate taxes and as a vehicle to retain employees in a private company. If a captive were found by the IRS to be abusing the law, the deductions would be denied and back taxes and penalties would be owed, but the burden of proof is high.

Beckett Cantley, an associate professor at John Marshall Law School, recently stated that the IRS had started to question whether someone would have bought insurance for a certain risk without the tax benefits of a captive. The agency is also looking at loans made immediately back to the person who set up the captive. “If you needed the funds so badly for the business, why did you take out such a large insurance policy?” Mr. Cantley said.

There is also the estate planning component for people who don’t need the money in their lifetime. Ms. Clark, whose clients are almost entirely family-held businesses said using captives to pass wealth to children or grandchildren free of estate and gift taxes is appealing to her clients. As she explained it, the captive could be set up and owned by children and grandchildren except for the money paid to establish the captive as an insurance company and the rest of the money put into the shelter would be free of gift tax.

“The really huge advantage that I didn’t spell out in the Trusts and Estates article because I don’t want the wrath of an enormous agency coming down on my head is that the only gift that is considered a gift is the initial contribution being paid into the trust,” Ms. Clark said. “That capital contribution is going to range between $50,000 and $300,000. Any other future potential appreciation in value of those shares is not coming from gifts but from business transactions.”

The IRS is not alone in its campaign against small captives. At a Senate Finance Committee meeting in February, Charles E. Grassley, Republican of Iowa, asked Mark Mazur, the assistant secretary for tax policy at the Treasury Department to look into ways to narrow the uses of captives. There is a right way to set up these captive insurances, but it does take longer and requires bringing in independent actuaries and accountants.Mr. Slenn said. “What captive managers like to do is turnkey and save on cost.” But those shortcuts just might bring on the IRS scrutiny that we try to avoid.

IRS Scrutiny of Captive Insurance Companies

captive insurance2IRS scrutiny of captive insurance companies is increasing with most of it is aimed at small captives using the 831(b) tax election. Large or small, captives must be formed for the correct reasons. Their premiums must be appropriate and their business plans must involve genuine insurance.

But some mini captive or micro captive formations under Section 831(b) of the Internal Revenue Code lack a genuine insurance purpose and instead provide tax shelters for their owners. IRS scrutiny drawn by improper use of captives threatens to cast a bad light on the entire captive industry.

The word is out of the general counsel’s office that the IRS has taken an increased interest in captives, said Jay Adkisson, a chairman of the American Bar Association’s committee on captive insurance. “There are more cases against captives than ever before.”

“Some people have their own motivations for getting clients into captives that don’t necessarily involve risk management,” Mr. Adkisson said. “Let’s just call them what they are, they’re tax shelters.”

“If the IRS wanted to make a lot of money, they could go out and audit every one of the 831(b) captives that’s doing terrorism coverage,” he said. Terrorism coverage “tends to be a hallmark of the tax shelter captives. They’re coming up with these terrorism covers and the pricing bears utterly no relationship to any kind of reality.”

Under Section 831(b), property/casualty captives earning less than $1.2 million in annual premium may elect to pay U.S. taxes only on their investment income.

The provision, part of the Tax Reform Act of 1986, was meant to encourage formation of insurance companies and simplify business for small companies. The rapid growth of small captives taking advantage of the 831(b) election has driven similar rapid growth of several newer captive domiciles such as Utah, Montana and Kentucky as it has added to many captive managers’ rosters of captive clients.

“The 831(b) election has its purpose”, said Thomas P. Stokes, U.S. consulting practice leader at JLT Towner Group L.L.C. in New York. “It also has the potential for abuse.”

Brady Young, president and CEO of Strategic Risk Solutions Inc. in Concord, Mass., said, given the number of 831(b) captive formations, it’s probably natural that they would draw IRS attention. “I just think there are some aggressive captive promoters out there and some aggressive structures that some people have used that have caught the eye of the IRS and they’re going after those,” he said.

Several experts cite the “Salty Brine” case in which two Texans involved in an elaborate arrangement of corporations and partnerships — including 831(b) captives — sought unsuccessfully in U.S. District Court for the Northern District of Texas to overturn penalties the IRS levied against them for what the federal agency said was an improper effort to avoid taxes.

“Salty Brine, the judge thought it was just a complete sham,” said Charles J. Lavelle, a partner at Bingham Greenebaum Doll L.L.P. in Louisville, Ky. “He said this wasn’t even a captive.”

Mr. Lavelle agreed that the IRS appears to be scrutinizing captives more closely, but said that attention is aimed at large captives as well as smaller ones. “There’s a lot more activity of IRS audits of captive companies, but that includes public companies as well as closely held. I think the IRS is just more active in the captive area now than they have been in the past,” he said.

It’s possible the IRS is looking to the courts to fill in the gaps between previous rulings establishing what captive insurance activities are sufficient to merit favorable tax treatment, Mr. Lavelle said.

According to Mr. Adkisson, the IRS position on captives may become clearer in September at a meeting of the ABA’s Section of Taxation in San Francisco at which John Glover, senior counsel in the office of the associate chief counsel, financial institutions and products of the IRS, is scheduled to participate in a panel on captive insurance.

Thomas M. Jones, a partner at McDermott Will & Emery L.L.P. in Chicago, said the increased focus from the IRS on captives isn’t a recent phenomenon.

“For the last two-and-a-half or three years, the IRS has certainly been more aware of captives and therefore more likely to do a tax audit,” Mr. Jones said.

He cited two recent cases, one brought against the government by Rent-A-Center Inc. that was heard in 2011 and another in which he was involved in recent weeks involving Securitas Holdings Inc.

“Both of the cases involve trying to further define the meaning of risk distribution,” Mr. Jones said.

“I think both the IRS and the taxpayers want a clearer definition,” he said. “It’s not like the IRS is doing the audits to define the term. The IRS is doing audits to raise revenue.”

While saying he has no first-hand knowledge of increased IRS scrutiny of captives, David F. Provost, deputy commissioner of the Captive Insurance Division in the Vermont Department of Financial Regulation, said IRS actions against captives can cast the entire captive industry in an unwanted light.

“Anytime you have a captive tax case, that just sort of perpetrates the idea that captives are just a tax dodge,” he said. “It kind of perpetuates the myth around captives.”