May 31, 2018
By Emily L. Foster
The IRS could resolve captive insurance transaction disputes with a global settlement, as it did for abusive transactions in the 2000s, but tax professionals say the trick is to root out the bad actors.
Microcaptive insurance cases are seeing high volume in three areas — examination, appeals, and litigation — and could be ripe for a global settlement initiative, according to several tax professionals. Their estimates range from hundreds of outstanding cases involving captive insurers — companies wholly owned and controlled by their insureds — to potentially thousands of them. The IRS had no immediate comment on how many cases it is dealing with.
But the tax professionals warned that the solution won’t be as simple as offering settlement programs to captive insurance abusers, because the agency’s first and largest hurdle is determining which operations are legitimate and which are misusing the tax code.
Global settlement offers are most appropriate when there is a clear pattern of abuse, said Mark Everson, vice chair of Alliantgroup LP, who served as IRS Commissioner from 2003 to 2007. That makes captive insurance “much trickier for the Service” to deal with than other programs because many legitimate captives have been operating for decades, Everson told Tax Analysts.
Under Everson’s leadership, the IRS implemented several global settlement initiatives to curtail abusive tax shelters, beginning with the son-of-BOSS transaction (Announcement 2004-46, 2004-1 C.B. 964), which Everson said was one of the most egregious tax shelters.
The son-of-BOSS transactions generally inflated the basis in the partnership interest to diminish the gain that would otherwise be recognized on transfer of a partnership asset — a method that the IRS said was unsupported by any reasonable interpretation of the tax laws. The global settlement offer yielded about $4 billion in taxes, interest, and penalties from 1,200 individual taxpayers.
For abusive captive insurance transactions, Everson said the IRS must be “very sure-footed in where it draws the line.” If the scope of the transactions is “too harsh” and fails to recognize legitimate structures, that will jeopardize the entire settlement initiative and lead to more litigation, he said. Attorneys will either challenge the IRS’s settlement terms in court or recommend that their clients wait until the issues are clarified and the IRS comes back with more reasonable terms, he added.
Steven T. Miller, a former acting IRS commissioner who is now with Alliantgroup, said captive insurance arrangements differ from son-of-BOSS and other transactions with settlement initiatives, including lease-in, lease-out and sale-in, lease-out (LILO/SILO) transactions, because the IRS declared those types of transactions abusive. By contrast, the captive insurance area is colored in shades of gray, he said.
Rachel L. Partain of Caplin & Drysdale Chtd. also emphasized the binary nature of a son-of- BOSS transaction: either basis increased or it didn’t. Although the settlement covered different versions of the transaction, the issue primarily involved a legal interpretation of the statute concerning liability for purposes of determining basis, she said.
In contrast, whether a microcaptive insurance arrangement is considered abusive tax avoidance turns on the particular facts and circumstances of each transaction and how the IRS and the courts view them. Although the Tax Court’s seminal microcaptive decision in Avrahami v. Commissioner, 149 T.C. No. 7 (2017), shed some light on what might constitute insurance for a microcaptive arrangement, it didn’t settle some long-standing issues that IRS officials and practitioners have struggled with.
Under section 831(b), captive insurers that qualify as small insurance companies can elect to exclude some of their annual net premiums from income so that the captive pays tax only on its investment income. Captives receiving up to $2.2 million in premiums qualify for that treatment.
In abusive microcaptive structures, promoters, accountants, or wealth planners persuade owners of closely held entities to participate in schemes that lack many of the attributes of genuine insurance. The potential for abuse arises because the insured typically deducts the premiums paid to the microcaptive as ordinary and necessary business expenses, and the captive doesn’t recognize the income.
Small captive insurance company transactions have been on the IRS’s radar for a while, and on the annual “Dirty Dozen” list of tax scams for four consecutive years. Although not all microcaptive insurance company transactions are abusive, the IRS and the courts often view them skeptically.
In 2016 the IRS identified microcaptive transactions as transactions of interest (Notice 2016-66, 2016-47 IRB 745, modified by IRS Notice 2017-8, 2017-3 I.R.B. 423), meaning the government believes these transactions have the potential for tax avoidance or evasion, but it lacks sufficient information to identify which section 831(b) arrangements it considers tax avoidance transactions. The IRS requires anyone entering into microcaptive transactions or advising on them to disclose information that might assist the agency in defining the characteristics that distinguish tax avoidance transactions from other section 831(b) related-party transactions.
The microcaptive insurance campaign — one of the initial 13 compliance initiatives rolled out by the IRS’s Large Business and International Division in 2017 — focuses on the transactions described in the notice. The IRS said it intends to use issue-based examinations to improve microcaptive insurance compliance.
An IRS official said in March that a global settlement initiative is one way to resolve the many microcaptive cases under audit, but noted that no decision had yet been made.
Partain said a global settlement is inevitable given the volume of cases in exam, appeals, and litigation, along with the IRS’s resource constraints, but said the predicament is in defining which section 831(b) transactions would be part of the agreement. She pointed out that the 2016 notice was far-reaching and “swept in a lot of ‘good’ captives” that lack the concerns the IRS listed in the announcement. Any global settlement will need a much narrower focus to avoid that issue, which makes setting the parameters more difficult, Partain added.
Identifying factors or distinguishing ‘good’ insurance from ‘bad’ requires guidance and “a level of detail that’s going to be hard for [the IRS] to get into,” according to Miller. After defining what transactions fall within the scope of a settlement agreement, the next challenge will be providing inducements to entice a substantial number of taxpayers to come forward, he said, noting that those will drive the program’s success.
Sweetening the Deal
Typically, the deal sweetener for global settlements targeting abusive tax shelters has been a reduced penalty. Under section 6662, the IRS can impose a 20 percent penalty on underpayment of tax for any disallowance of claimed tax benefits for transactions lacking economic substance, and that amount increases to 40 percent if a taxpayer failed to disclose the relevant facts affecting the tax treatment of those transactions in their return.
For the 2004 son-of-BOSS settlement, taxpayers that came forward within the designated time had to concede 100 percent of the claimed artificial tax losses and, in some cases, pay a penalty. However, taxpayers were allowed to treat as a loss their out-of-pocket transaction costs, which were typically promoter and professional fees.
That initiative established a three-tiered structure for penalties with none imposed for taxpayers who voluntarily disclosed their transactions under an IRS announcement issued two years earlier. A 10 percent penalty was imposed if the taxpayer’s investment reflected the first and only abusive tax shelter investment, otherwise a 20 percent penalty applied if the taxpayer participated in other abusive listed transactions.
In one of the 2005 settlements (Announcement 2005-80, 2005-2 C.B. 967), the IRS took a different approach when it introduced a sweeping program that covered 21 different transactions with more than 4,000 taxpayers identified by the IRS that had been involved in the arrangements. Taxpayers that came forward could settle with the IRS if they paid 100 percent of taxes owed, interest, and — depending on the transaction — either a quarter or half of the penalty the IRS otherwise would have sought.
If the IRS does seek a global settlement, perhaps it will offer some version of the son-of-BOSS deal by reducing the statutory penalties and setting tiered penalty levels, Partain said.
Miller noted that the IRS has been seeking 40-percent penalties in microcaptive cases to no avail, but that the agency could consider 20 percent or no penalties at all for specified situations.
Another possible enticement would be to allow captives to retain some of the tax benefits — a portion of the deductions allowed under section 831(b), Partain suggested. She noted that IRS Appeals had been allowing taxpayers to retain 20 percent of their deductions in some cases, which is better than the 10 percent or none of the deductions allowed in recent years.
Another taxpayer concern the agency could address in the settlement terms is the double taxation issue, Miller said, noting that IRS Appeals has been considering only a single level of tax in resolving microcaptive tax controversies. That issue arises if the IRS taxes the premiums received by the captive and taxes those amounts again as nondeductible premiums of the captive owners, he explained.
The Ultimate but Unlikely Dealmaker
Without a “meaningful carrot,” it’s going to be difficult for the IRS to design a program that will draw many taxpayers, Miller said, especially if the agency is intent on shutting down not just transactions but entire operations without providing a mechanism for the captives to continue operating.
If the IRS allowed captives to continue under specified circumstances, that could be “a very clever way to get people in and through the system,” Miller suggested. However, that could prove limiting to the agency down the road because it would affirm what’s allowable, albeit still subject to audit, he said.
Partain agreed that the IRS would have to decide whether captives must terminate and liquidate the business as part of the settlement terms, which she noted would be different from prior initiatives that involved one-time transactions. That could be the deciding point for captives considering whether to participate in a settlement, Partain said, adding that she wouldn’t be surprised if the IRS required them to shut down.
Miller said it would be nice if the IRS created a safe harbor describing permissible captive actions for several aspects of the insurance arrangements, but added that he doesn’t see that happening. The agency would much rather be out of the microcaptive insurance business, he said.
Miller said he believes that the IRS, working with industry practitioners, could develop the ultimate dealmaker — allowing captives to continue on set terms — which could attract many captive managers to sign up for the settlement offer.
Waiting for the Court
Several hundred captive insurance cases are docketed in the Tax Court, with two or three cases that could be decided soon, according to practitioners. The IRS and tax professionals are hoping that those rulings provide more guidance on what constitutes insurance for federal tax purposes beyond the issues addressed in Avrahami.
With Avrahami, the IRS has one win under its belt that gives the agency a relatively strong position if it moves forward with a settlement agreement, Miller said. He said he suspects the IRS will wait for some of the impending decisions, and that if the government wins, “they are going to continue to have a very strong position.”
Miller noted that recently the IRS has been opening more exams of captives and disqualifying their section 831(b) deductions. At the same time, IRS Appeals is “taking a pretty hard line,” and because these cases are coordinated, there might be only a couple of technical advisors who can review them, and therefore they control what happens, he said.
How the IRS will proceed in settling large numbers of cases is uncertain, but they’re going to have to do something, Miller said, noting that settlement guidelines could be an interesting alternative to a global settlement initiative.
Steven T. Miller served as former IRS Acting Commissioner in 2012, but prior to that he served for several years as the Deputy Commissioner for Services and Enforcement, leading all IRS enforcement and service activity. Steven also served as the Commissioner of the Large and Mid-Size Business Division, overseeing IRS audits of large taxpayers and the IRS programs relating to offshore tax compliance and international tax law enforcement. As the Commissioner of the Tax Exempt and Government Entities Division, he supervised the IRS oversight of governments, tax exempt entities and retirement programs.
The Honorable Mark W. Everson served as Commissioner of Internal Revenue from 2003 until 2007. Prior to joining the IRS, Everson held Bush administration posts as Deputy Director for Management for the Office of Management and Budget (OMB) and Controller of the Office of Federal Financial Management. Everson also served in the Reagan administration, holding several positions at the United States Information Agency and the Department of Justice. In the private sector, Everson served as Group Vice President of Finance at SC International Services, Inc., a $2 billion food services company, and as an executive with the Pechiney Group, one of France’s largest industrial groups.
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