Introduction
Taxpayers, like all people, are risk averse for the most part; they want to avoid financial uncertainty to the greatest extent possible. This is difficult to accomplish when the Internal Revenue Service (“IRS”) regularly attacks certain issues, often concluding that taxpayers owe additional taxes, penalties, and interest for several years. It is also a challenge in situations where the IRS either refuses to grant advance approval by issuing a Private Letter Ruling or simply cannot do so in a timely manner. The reality is that many proposed transactions cannot be put on ice for months while the IRS gathers data, conducts its analysis, and goes through a multi-level approval process.
How do taxpayers cope? There are several ways, one of which is to obtain so-called tax insurance. This sounds good in theory, and it might be good in practice. This article offers no opinion on the pros and cons of obtaining tax insurance; its sole purpose is to raise awareness of the types of attacks that the IRS has been making lately.
Two Main Types of Tax Insurance
Tax insurance, for purposes of this article, falls into two main categories. The first addresses fees and expenses linked to tax audits, administrative appeals, and tax litigation (“Tax Defense Insurance”). This type of coverage has no relationship to the ultimate tax liability of the taxpayer, as determined by the IRS or the courts. The second category goes by several names, such as tax gap, tax result, tax protection, or tax indemnity insurance (“Tax Result Insurance”). It has existed for nearly four decades, but its popularity has increased in recent years. Few people seem aware that the IRS has launched various attacks against these products, including the three explored below.
IRS Argues that Insurance Undermines Partner Status
The IRS has argued that Tax Result Insurance eliminates risks associated with investing in certain partnerships. The IRS frequently issues Information Document Requests during audits seeking, among other things, “all agreements, guarantees, representations, or assurances related to the tax benefits of a transaction, including agreements to reimburse or indemnify the taxpayer in the event that the tax benefits are disallowed.” Experience shows that the IRS is attempting to cobble together the following stance: The foundation of a partnership is the existence of downside and upside risk for partners; Tax Result Insurance somehow removes such risk; therefore, the entities involved in the relevant transactions are not “partnerships” for tax purposes and they cannot access any benefits that depend on partnership status.
The IRS faces a couple problems here. For starters, the IRS has published several regulations over the years in connection with “reportable transactions.” These expressly indicate that the IRS has already analyzed Tax Result Insurance and determined that it is not problematic. For instance, in 2002, the IRS created several categories of reportable transactions, including “transactions with contractual protection.” These were defined as those “for which the taxpayer has obtained or has been provided with contractual protection against the possibility that part or all of the intended tax consequences from the transaction will not be sustained.” Commentators urged the IRS to remove contractual protection, including Tax Result Insurance, as an indicator of tax shelter activity because many non-abusive, legitimate business transactions would be improperly burdened. The IRS, after considering public input, eliminated Tax Result Insurance from the concept of contractual protection when it issued final regulations in 2003. It later confirmed this action when it released separate regulations regarding duties of materials advisors. The IRS explained, in 2006, that “the IRS and Treasury Department removed tax result protection from that category of reportable transaction but cautioned that if [they] became aware of abusive transactions utilizing tax result protection the issue would be reconsidered.”
Another problem for the IRS is that it previously approved Tax Result Insurance in written pronouncements. In Historic Boardwalk Hall v. Commissioner, the Court of Appeals held that a member was not a bona fide partner for federal income tax purposes, so the member was not entitled to receive an allocation of credits from the partnership. The primary reason for this decision was that the member enjoyed guaranteed reimbursement of its investment in the partnership if it did not receive the anticipated tax credits. The Court of Appeals concluded that the reimbursement arrangement meant the member did not incur any entrepreneurial risks and did not adequately participate in the financial upside or downside of the partnership’s business, such that it was not a partner. The IRS released Revenue Procedure 2014-12 in the aftermath of Historic Boardwalk Hall v. Commissioner to establish a “safe harbor” for structuring certain tax credit transactions. It described various “impermissible guarantees.” In doing so, the IRS explicitly blessed Tax Result Insurance by saying that the limitations “do not prohibit [a partner] from procuring insurance from persons not involved with the rehabilitation or the partnership.” Likewise, the IRS issued another “safe harbor” a few years later, this time focused on partnerships allocating credits for carbon dioxide sequestration. Revenue Procedure 2020-12 explained that the restriction against guaranteed results “does not prohibit the investor from procuring insurance, including recapture insurance, from persons not related to” the project developer, another partner, the company emitting the carbon dioxide, or the party purchasing qualified carbon dioxide.
IRS Disallows Deductions for Premiums Paid
The IRS has raised another argument focused on tax insurance, which is that taxpayers cannot claim tax deductions for the premiums paid. The IRS’s positions are found in Chief Counsel Advice 202050015 and Chief Counsel Advice 202053010. These two documents plod through various tax provisions, explaining why each supposedly does not contemplate deductions for taxpayers who acquire Tax Result Insurance.
First, Section 162 generally provides that a taxpayer can deduct all ordinary and necessary expenses paid or incurred during a year “in carrying on a trade or business.” The IRS reasoned that, as long as the taxpayer fulfills its limited obligations under the insurance policy, it is entitled to payments equal to the amount of tax deductions disallowed. This result, emphasized the IRS, would occur regardless of whether the taxpayer had expenses related to any trade or business.
Second, Section 212(1) states that individual taxpayers can deduct all ordinary and necessary expenses paid or incurred during a year for the production or collection of income, while Section 212(2) allows deductions for the management, conservation, or maintenance of property held for the production of income. The IRS explained that Tax Result Insurance and its premiums were simply unrelated to any income-producing activity or property of the taxpayer: “Neither the deduction itself, nor any insurance payout for its disallowance, arises as a result of any purported investment activity, or is correlated to the success or failure of such activity.”
Third, Section 212(3) contemplates deductions in connection with the determination, collection, or refund of any tax. The IRS admitted that the standard here is the lowest of all because there is no business or nexus requirement. It further acknowledged that no court has yet ruled on the deductibility of contracts resembling tax insurance under Section 212(3). These two realities did not slow the IRS, though. It indicated that courts have denied deductions under analogous, prior provisions for other types of contractual arrangements on grounds that the expenses were nothing more than “the contractual relabeling of non-deductible tax.”
Finally, Section 275 generally prohibits deductions for federal income taxes paid. The IRS concluded that Tax Result Insurance merely serves to pay taxes for the taxpayer, albeit indirectly through reimbursement.
IRS Claims that Insurance Eradicates Penalty Mitigation
Some penalties, such as those for negligence or for disregarding tax rules and regulations, can be avoided if the taxpayer can prove that there was “reasonable cause” for the violation. In recent cases involving a particular listed transaction, the IRS has acknowledged that the taxpayers hired several legal, accounting, valuation, and other professionals, relied on such professionals, and fully disclosed the relevant transactions to the IRS by filing all required returns. Nevertheless, the IRS has suggested in its Examination Reports that the taxpayers should be penalized solely because they acquired Tax Defense Insurance. The Examination Reports reasoned that “the taxpayer did not act in good faith that the amount on the tax return was correct, as the taxpayer obtained an insurance policy to reimburse its costs in the case the deduction on the tax return was audited” and “the taxpayer did not have the belief that its treatment of the transaction was proper, as the taxpayer obtained an indemnity contract to be reimbursed for its defense expenses pertaining to an IRS audit of the transaction.” Importantly, these are just statements by low-level IRS personnel during the first phase of a tax dispute, which have not been validated by the Tax Court.
Staying Vigilant
Tax Defense Insurance and Tax Result Insurance both seem to be on the rise, which is logical for several temporal, financial, and practical reasons. These products are designed to reduce risk, but, as this article demonstrates, they might create certain risks, too, at least when it comes to the IRS. Those offering the products, as well as those purchasing them, need to stay updated as the IRS floats more positions and courts issue critical rulings.