IRS At Supreme Court Over Captive Insurance

The Supreme Court rarely hears tax cases which makes the recent oral arguments in CIC Services v IRS exciting. That is about all that makes them exciting to ordinary mortals as what was going on at the Supreme Court was an argument about whether they could have an argument.

In 2017, CIC Services and Ryan LLC brought an action in the United States District Court for the Eastern District of Tennessee asking to set aside IRS Notice 2016-66 as modified by IRS Notice 2017-08. Both the District Court and the Sixth Circuit ruled that the action was barred by the Anti Injunction Act. The notices concern micro-captive transactions.

Micro-captive has a science fiction sound to it, Makes me think of Kandor – the Kryptonian city in a bottle that Superman kept in his Fortress of Solitude. That’s not it, though. It is about insurance, sort of. Simplistically, a captive is an insurance company that is owned by the insured or related parties. Micro means it takes in less than $2.3 million in premiums. (I’m simplifying. The threshold has been changing.).

So You Want To Own An Insurance Company

Warren Buffett famously likes to own insurance companies. He explained it in the 2019 Berkshire Hathaway Annual Report:

One reason we were attracted to the P/C business was the industry’s business model: P/C insurers receive premiums upfront and pay claims later. In extreme cases, such as claims arising from exposure to asbestos, or severe workplace accidents, payments can stretch over many decades.

This collect-now, pay-later model leaves P/C companies holding large sums – money we call “float” – that will eventually go to others. Meanwhile, insurers get to invest this float for their own benefit. Though individual policies and claims come and go, the amount of float an insurer holds usually remains fairly stable in relation to premium volume. Consequently, as our business grows, so does our float.

The Tax Leverage Of Insurance

So running an insurance company you can make or lose money from paying out more or less in claims than you collect in premiums – the underwriting income – and from your investments while you hold onto the money,

Back in the day, it was even better as insurance companies could deduct all those amounts that they expected to pay in the future. The Tax Reform of 1986 cut into that a bit, by forcing them to discount the expected payouts to present value. That was a much bigger deal back in the eighties when money earned interest. It was very complicated.

TRA 1986 carved out a break for smaller insurance companies. A small company, based on premiums written, can elect to only pay taxes on its investment income. The underwriting profit or loss is not considered in determining taxable income.

When you view all this in the aggregate considering both the insurance companies and their customers, there is some tax leverage at play. When people are insuring business risks they can deduct the premiums as ordinary and necessary business expenses immediately. The insurance companies ultimately will recognize income to the extent they don’t pay claims, but that will be over time unless they are one of the electing small companies.

If the customers decided to self-insure, they would not get a deduction for money they put aside to be prepared for whatever eventuality they were insuring against. At a very basic level, that is the tax incentive for a captive insurance company. There is a lot more to it than that. Your captive insurance company can go into the reinsurance market allowing you to lay off some of the risks in a more flexible way than you can with commercial insurance. So there can be business reasons independent of tax incentives for setting up a captive insurance company.

The Shenanigans

If you don’t see the potential for shenanigans in all this, you have not thought much about it.  If the customers get to deduct and the company does not have to pick up income there is one of those rifts in the space-time continuum when that big balance sheet in the sky does not balance. That’s the part of the universe where abusive tax shelters spawn.

The way CIC promotes almost implies that.

CIC Services is a captive manager and strategist. Since 2005, we’ve been helping small & mid-sized business owners turn their risk into wealth by owning their own insurance company. 

“Turn their risks into wealth” ?? If the wheels that spin straw into gold are not working, you have to do the best you can.

I spoke with a tax executive for a major life insurance company. Promoters had been trying to get the company’s sales force to recommend captive insurance deals. When he examined them he concluded that there was not actually much in the way of insurance going on. It looked more like alchemy.

If you can pay your own insurance company deductible dollars that the insurance company does not have to recognize as income, the more you pay them the better. That’s the essence of the potential shenanigans. We can see them illustrated in the Tax Court decision in the case of Benyamin Avrahami & Orna Avrahami by Judge Holmes.

Benyamin and Orna Avrahami own three shopping centers and three thriving jewelry stores. In 2006 they spent a little more than

$150,000 insuring them. In 2009 this insurance bill soared to more than $1.1 million and it flew even higher, to more than $1.3 million, in 2010. The Avrahamis were paying the overwhelming share of these big bills to a new insurance company called Feedback that was wholly owned by Mrs. Avrahami. Yet there were no claims made on any of the Feedback policies until the IRS began an audit of the Avrahamis’ and their various entities’ returns. With money flooding in and none going back out to pay claims, Feedback accumulated a surplus of more than $3.8 million by the end of 2010, $1.7 million of which ended up back in the Avrahamis’ bank account—as loans and loan repayments, say the Avrahamis; as distributions, says the Commissioner.

The Practical Effect Of The Notices

In the contested notices, the IRS declared that certain captive insurance transactions were “transactions of interest”. This is not quite as bad as being a “listed transaction”, but bad enough. What the designation does is trigger substantial reporting requirements that are backed by really nasty penalties. There is also collateral damage in that when something becomes identified this way people get nervous about it, which is bad for business. Ryan and CIC mentioned this in the original complaint filed in 2017.

As a result of the IRS audit program, the §831(b) market has, of course, been substantially constricted, negatively affecting captive managers, their employees, and many others who rely on the captive industry for employment, including residents of the State of Tennessee, which, at least for the moment, enjoys a robust captive insurance marketplace.

Reilly’s Fourteenth Law of Tax Planning – If something is a listed transaction, just don’t do it. I think I should revise that with a corollary rule – If somebody suggests a transaction of interest, tell them you are not interested.

I had a long talk with someone who is responsible for the tax practice of a firm that focuses on professional practices. He has fielded quite a few attempts to get his firm’s client’s interested in doing captive deals. When he first learned of the concept, the deals that were presented did not pass the smell test. There did not seem to be any business rationale for what they were doing. Once the notices came out he felt vindicated.

My outreach via #TaxTwitter did not yield much more in the way of anecdotal information. One respondent suggested that captive insurance tends to work well for auto dealers. It is important to remember that there are legitimate reasons for setting up a captive. That is why it is a “transaction of interest” rather than a listed transaction.

An example of the latter is in Notice 2017-10. That notice takes on syndicated conservation easements. Don’t get me started. That is an industry based on nonsense. Partnership For Conservation, the industry trade association, filed an amicus brief in the CIC case.

“IRS statements made around the time and subsequent to issuance of the Notice indicate the real purpose of the Notice was to put an end to the conservation easement donations so described. Comments from IRS Comm’r Charles Rettig include: “Putting an end to these abusive schemes is a high priority for the IRS.” and “[e]nding these abusive schemes remains a top priority for the IRS.“

Lance Wallach

Lance Wallach made a name for himself exposing 419(a) employee welfare benefit plans, a scheme that seems to share a lot with captive insurance in the type of market that it went after. He is very concerned with the possible bad effect that CIC winning this suit might have on tax compliance. He wrote:

In my experience of lecturing, writing, and acting as an expert witness in tax shelter cases, the IRS needs every tool available to it in order to combat the proliferation of the abusive tax shelters. I have watched IRS’s programs grow from the “SON OF BOSS” to 419 welfare benefit plans, 412i plans, section 79 plans, syndicated conservation easements, and section 231b small captive insurance arrangements. These “schemes” are a way for taxpayers to cheat the government out of large sums of money. They are also a way for promoters and others involved in the scams to earn large incomes. Many of these arrangements involve the sale of huge amounts of high commissioned life insurance policies by agents representing life insurance companies, which make huge amounts of money on the sale of these “shelter” policies.

As an expert witness against these life insurance companies, whose products fund many of the abusive tax shelters, I have never lost a case. Almost all the lawsuits have been settled privately. Profitable business owners and professionals are approached by insurance agents or accountants and sometimes attorneys, enticing them to get involved in tax shelters that are usually abusive. The end result for the taxpayer is usually, aggravation, payment of taxes, huge penalties, and interest to the IRS simply as the result of purchasing a product that they really never needed.

I have received thousands of phone calls about these “abusive” tax shelters.

It is my opinion, that the IRS needs every tool available to fight the growth of these abusive tax shelters. The insurance companies and promoters have vast resources to fight the IRS. While most of us dislike and/or are afraid of the IRS, their resources are, in fact, limited.

The Stakes In The Supreme Court

It might not be quite that dramatic. This is the sort of case that only legal nerds really like. The reason the IRS won at that district and circuit is because of the Anti-Injunction Act. Basically, you can’t sue to prevent the IRS from assessing a tax. The penalty for not complying with the notice is defined by Congress as a tax. You will find plenty of coverage on those nuances. The purpose of this post is to look at the broader picture.

Nonetheless, I turned to one of my legal experts who prefers to remain off the record about the stakes.

Peter the key is that CIC has a process for pre-enforcement challenge of whether a regulation is needed. Historically, taxes and penalties that the Code says are taxes (like the one involved in CIC) have permitted only post-enforcement challenge and the AIA (§ 7421(a)) is designed to preclude pre-enforcement challenges in most cases. There are some exceptions though, and I think that is were the Supreme Court will divide – as to whether there can be a pre-enforcement challenge (not whether the challenge has merit).

If CIC convinces the Court that it can mount its challenge (the challenge that a notice and comment regulation is required rather than a Notice), then the Court (probably lower court on remand) will determine whether that challenge has merit.

So the argument at the Supreme Court is about whether an argument can be held lower down.

The Ultimate Stakes

At the end of the day making something a listed transaction or a transaction of interest helps tax enforcement in two ways. All the extra filing identifies deals for the IRS to look at. The extra filing requirements discourage people from engaging in sketchy transactions and make mainstream advisers very wary of them. The ultimate stakes in this litigation are that it would be harder for the IRS to declare that something is a listed transaction or transaction of interest.

In Supreme Court Hears Arguments in Captive Insurer Case, Allison Bell discusses the problem IRS could ultimately face if it loses.

Supporters of the IRS position say that rejecting its ability to impose new reporting requirements through notices, without going through notice-and-comment periods, would gut the agency’s ability to respond quickly to scams and abusive tax shelters.

I am skeptical that that will actually affect tax compliance all that much. The IRS already knows about a lot of noncompliance that it never looks into. My favorite example is alimony. This is from a story I wrote in 2014 about a TIGTA (Inspector General) report.

According to the TIGTA report, there were 567,887 Forms 1040 for 2010 that had alimony deductions. The total claimed was $10 Billion. When they compared the corresponding returns that should have recorded the income, there were discrepancies on 266,190 returns including 122,870 returns that had no alimony income at all reported. 

The IRS examined 10,870 of those returns. They simply don’t have the resources. Getting serious about tax compliance requires more audits, which requires more people.

When it lists transactions, the IRS is to a significant extent bluffing. And shelter promoters are calling that bluff. Forcing the IRS to jump through more hoops to get the transactions listed will probably not be a real game-changer. Bringing IRS staffing back to where it was 20 years ago with an emphasis on sharp enforcement people is what would make a real difference.

Other Coverage

The North Carolina Captive Insurance Association has Long Awaited Oral Arguments In CIC Services v. IRS Before The Supreme Court Of The United States 12/1/2020. Before a rundown on how the arguments went, they give some interesting background on how the case came to be filed.

Beginning in 2017 NCCIA brought the case to the attention of the membership leading some association members to instigate the Captive Insurance Defense Group (“CIDC”) that privately raised monies to file an injunction/declaratory judgment action against the IRS for violation of the Administrative Procedures Act (“APA”). Sean King of CIC Services, LLC was a participant in the CIDC effort. The CIDC needed a plaintiff for that lawsuit. King bravely stepped up as plaintiff (even though his attorney feared possible IRS retaliation). NCCIA was the ONLY captive trade group to file an Amicus Curiae (friend of the court) brief (“AB”) in the initial District Court action. 

Captive Insurance Times expressed optimism for the industry’s prospects with IRS counsel faces tough questions from Supreme Court in CIC Services case.

Richard Rubin had Supreme Court Justices Question IRS Shield in Tax-Shelter Case in the Wall Street Journal.

Jack Townsend on Federal Tax Crimes has Discussion of Criminal Tax Issues in Oral Argument in CIC Services (12/5/20). He also covered the oral arguments more generally of Federal Tax Procedure with CIC Services Supreme Court Oral Argument (12/3/20).

As with any Supreme Court decision, I am grateful to the coverage on SCOTUSblog which allows me to keep my PACER bill from going through the roof.