The Internal Revenue Service (“the Service”) annually publishes its Dirty Dozen list. The Dirty Dozen list compiles a variety of scams along with a list of transactions that have the potential for tax abuse. The purpose of the Dirty Dozen list is to remind taxpayers to protect themselves against a wide range of abuses that the Service encounters in its tax revenue collection and enforcement function for the U.S. Treasury. The Service has now released its Dirty Dozen list for 2015.
The 2015 Dirty Dozen list reflects phone scams, phishing, identity theft, return preparer fraud, improper offshore tax avoidance, fake charities, hiding income with fake documents, falsifying income to claim credits, excessive claims for fuel tax credits, frivolous tax arguments, and abusive tax shelters as tax scams which taxpayers may encounter. Most of these 2015 Dirty Dozen items have made their appearances in prior years. Accordingly, the 2015 Dirty Dozen list is friendly reminder of tax scams that taxpayers need to especially vigilant for during tax filing season.
However, the Service generally sanctioned smaller captive insurance companies as tax planning tools. According to the Service, smaller captives are “… a legitimate tax structure”. The Service goes on later to discuss a limited group of promoters of captive insurance companies that have the potential to abuse both the tax laws and to scam taxpayers that unknowingly engage with these promoters and are a concern to the Service. The potentially abusive situation that the Service is concerned with will be discussed further within this alert.
Hence, the Service, while rightfully desiring to raise awareness towards certain potentially abusive situations that may involve smaller insurance companies has also explicitly recognized the validity of these smaller insurance companies in the language of their information release. In doing so, it also recognized that these smaller insurance companies are in part tax-motivated structures that can be implemented for legitimate purposes. Previously, most insurance practitioners with a tax background thought the Service took a neutral positon on the use of captive insurance companies. This is a significant positive change of position for taxpayers who are seeking to currently set aside reserves on a tax-deductible basis to cover anticipated future losses within their captive as the Service has now publically endorsed the use of these structures as “legitimate tax structures.”
In general, captive insurance companies are closely-held insurance companies primarily insuring or reinsuring insurance risks for commonly controlled or affiliated businesses. Insurance companies are taxed as corporations and therefore are required to pay their own income tax when generating taxable income. Congress wanted to encourage the formation of small insurance companies and hence provide a significant income tax benefit to encourage the formation and continued operation of small insurance companies.
Certain smaller captive insurance companies are only taxed on their investment income, if any, and not their underwriting income (i.e. net income from solely their insurance operations), provided an election under Internal Revenue Code section 831(b) is properly made. This is the significant income tax benefit that Congress has provided to small insurance companies through the Internal Revenue Code, as genuine insurance companies derive the majority of their income from underwriting instead of investment activities. Accordingly, a small electing insurance company will generally pay little income tax.
Congress clearly defined a small insurance company in drafting Internal Revenue Code section 831(b). If the captive insurance company’s net written premiums (or direct written premiums if larger) do not exceed a $1,200,000 threshold, then the insurance company qualifies as a small insurance company per the Internal Revenue Code. It is interesting to note that this limit is 1) an annual limit (i.e. each year up to $1,200,000 of premiums could be paid to the insurance company) and 2) the limit is pegged solely to the revenue side of the insurance company and has nothing to do with its balance sheet (i.e., an insurance company with $40,000,000 of net assets can still qualify as a small insurance company).
The insured business entity should receive a deduction for the premiums paid to the captive insurance company. Accordingly, in the instance that the captive insurance company and the insured entity are commonly owned, the result is potential income tax deferral and arbitrage. Tax is deferred when an ordinary deduction for the insured business entity is taken for the premiums paid and yet no commensurate underwriting income for the captive insurance company is recognized as currently taxable income. Tax rates are arbitraged when this income is eventually paid out as the payment of this deferred income is generally subject to lower capital gains rates since the payment will either be in form of qualified dividends or liquidating distributions.
So what is the difference between an abusive tax structure and a legitimate tax structure involving a captive insurance company? The short and correct answer: the captive insurance company must be an insurance company in operation and substance.
The Service highlights and solely singles out captive insurance companies with unscrupulous promoters as having the potential for abuse. Specifically:
“…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 often times 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.”
“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 the Code provision. Underwriting and actuarial substantiation for the insurance premiums paid are either missing or insufficient. The promoters manage the entities’ captive insurance companies year after year for hefty fees, assisting taxpayers unsophisticated in insurance to continue the charade.”
In our experience, some unsophisticated and oftentimes conflicted (frequently multiple conflict of interests are present and usually not disclosed to their clients) promoters sell the idea of captive insurance companies as a turn-key product that focuses primarily, and frequently solely, on the income tax benefit outlined above. These promoters have handled many, if not all, aspects of the insurance company’s existence and operation. The formation documents are typically inadequately drafted and regulatory requirements are often not met. The insurance binders and policies are poorly created to cover uninsurable risks (such as a group of farmers without passports forming a captive that covers terrorism insurance). Premiums are set to meet the Internal Revenue Code’s 831(b) limit rather than being determined by a third-party actuary according to the risks assumed by the insurance company. Lastly, a promoter, with little or no knowledge of the overall insurance process, may manage the captive insurance company, but with little or no oversight.
Unfortunately, we have seen multiple taxpayers misguided by such promoters. Most of the time unscrupulous promoters are gone by the time trouble arises or will point the finger back by pointing to documents that were signed which oftentimes contain boilerplate language warning the person to seek independent advice. The defense of improper structures before both tax authorities and insurance regulators is almost always at least two to three times what a proper structure would have initially cost. Moreover, “significant penalties and interest and possible criminal prosecution” are all possible outcomes when you are associated with an improper insurance structure.
David M. Henderson, CPA, JD, LLM, CFP(R)