The never-ending “Whack-a-Mole” game that the IRS plays with legitimate (and not-so-legitimate) tax planners follows a predictable pattern: planners use tax strategies in ever-more-aggressive ways, shysters push planning into abusive or even criminal territory, and if the Treasury Department is losing enough money from a tax strategy then the IRS will focus civil and criminal resources on promoters who sell it and taxpayers who use it.
Today’s target? Captive insurance. In the past year, the IRS has issued two notices about abusive captive insurance schemes, with the second notice warning that using a captive could be a crime. That’s no surprise to me, as I worked on a criminal case involving a captive insurance company while I was a federal prosecutor, but it could come as a shock to a client who thought she’d found a clever way to avoid taxes.
For those in the know, a properly set up and operated captive insurance company – an insurance company designed to allow a business to self-insure in a tax-advantaged way – can save on current-year taxes by deducting the premiums. Small captives only pay income tax on investment income, not underwriting income, under Tax Code Section 831(b). According to promoters, if you do it right, and much to the IRS’s chagrin, you can pay little or no income tax on up to $2.2 million of premiums per year and, at death, pass those untaxed funds to your heirs. Insurance is generally treated well under the tax code, but the estate tax benefits appear particularly galling to the IRS and they have decided to clamp down on captives.
One way Congress has recently clamped down on captives was to require small captives to act more like real insurance companies, such as by spreading risk amongst more insured entities, to retain the tax exemption for underwriting income. However, the IRS is also attacking captives through aggressive audits, and the Agency doesn’t like what it’s seen. It just sent a shot across the bow in the form of Notice 2016-66, available at https://www.irs.gov/pub/irs-drop/n-16-66.pdf, which warns that the IRS considers certain captives “transactions of interest” meriting close scrutiny. Most troublingly, the IRS notes that it can’t determine which transactions are abusive or even criminal, leaving clients unsure of which way to turn.
The bottom line is, as usual, to seek out competent advice, never engage in a transaction just for tax benefits, and get experienced help if the IRS comes knocking.
EVAN DAVIS – For more information please contact Evan Davis – firstname.lastname@example.org or 310.281.3200. Mr. Davis is a principal at Hochman, Salkin, Rettig, Toscher & Perez, P.C., a former AUSA of the Tax Division of the Office of the U.S. Attorney (C.D. Cal) handling civil and criminal tax cases and, subsequently, of the Major Frauds Section of the Criminal Division of the Office of the U.S. Attorney (C.D. Cal) handling white-collar, tax and other fraud cases through jury trial and appeal. He has served as the Bankruptcy Fraud coordinator, Financial Institution Fraud Coordinator, and Securities Fraud coordinator for the Criminal Division.
Mr. Davis represents individuals and closely held entities in criminal tax investigations and prosecutions, civil tax controversy and litigation, sensitive issue or complex civil tax examinations and administrative tax appeals, federal and state white collar criminal investigations. He is significantly involved in the representation of taxpayers throughout the world in matters involving the ongoing, extensive efforts of the U.S. government to identify undeclared interests in foreign financial accounts and assets and the coordination of effective and efficient voluntary disclosures (OVDP, Streamlined Procedures and otherwise).