On September 15, 2019, the IRS issued News Release IR-2019-157 entitled “IRS offers settlement for micro-captive insurance schemes; letters being mailed to groups under audit.” This appears to be the start of what amounts to the start of a global settlement initiative for qualifying 831(b) captive insurance companies and their owner.
At the outset, it is important to understand that the IRS is not challenging all captive arrangements as abusive, but only a relatively small subset of captives that were marketed and sold as tax shelters, which made the 831(b) election to be treated as a small insurance company, and which engaged in so-called “risk pooling” with similar 831(b) captive arrangements to meet the tax law requirements for risk distribution. Large corporate captives are not under any special scrutiny, bona fide group captives are not under any special scrutiny even if they elected under 831(b), and numerous other types of captives are not under any special scrutiny.
What are under scrutiny are so-called tax shelter captives, where the promoter dummies up insurance policies and risks so that the captive owners can artificially generate large deductions. All of our conversation below is restricted to these tax shelter captives, the point being that the IRS has no problem at all with the vast majority of captive arrangements, and these risk-pooled 831(b) captives are simply one very bad apple in an otherwise mostly non-abusive captive barrel.
We will get to the specific terms of the settlement initiative in a moment. For now, it is important to understand that, accordingly to the News Release, the IRS has only extended this offer to 200 taxpayers, which is a drop in the bucket since there are at least 2,000 captive arrangements that are under audit and probably well north of 10,000 captive arrangements that may ultimately come under scrutiny by the IRS.
Here, it is worth recalling that the IRS has sometimes choked on previous global settlement offers, such as those relating to undisclosed offshore financial accounts, which brought in a tsunami of such offers before the IRS had satisfactory procedural mechanisms for dealing with them. By contrast, here the IRS is dipping a toe into the settlement initiative and testing out 200 taxpayers to see how well their procedural mechanisms will work, determine what issues may arise, and otherwise iron things out before they start making this offer to the masses.
Equally important is that this is an exclusive offer that is only made to certain taxpayers at the IRS’s invitation, and which invitation is being extended at the IRS’s sole discretion, i.e., the IRS is not making this offer to all captive participants, may never make this offer to all captive participants, and no captive participants have anything like any right to have this offer extended to them. If you got the offer, you were lucky; if you didn’t get this offer, then you weren’t lucky and you simply have no right to demand that the be extended to you as well. You can ask for it, but the IRS can tell you “no.”
Another important thing to understand is that the offer will not be extended to captive arrangements and their owners “with pending docketed years under [IRS] Counsel’s jurisdiction.” In other words, the IRS is telling those folks who filed suit before the U.S. Tax Court to go pound sand: They wanted a litigation fight, and the IRS is quite happy to oblige. Enjoy.
Otherwise, the offer will be extended to taxpayers with at least one open year under exam, although the News Release notes that “[t]he IRS is continuing to assess whether the settlement offer should be expanded to others,” presumably including captives and their owners who have not been picked up for examination yet. To this end, the IRS warns that it is far from done in dealing with tax shelter captives and plans to continue to open new exams of such captives.
Anecdotally, it seems that the first 200 offers have mostly gone out to taxpayers who have been cooperative with the IRS, i.e., have not stonewalled the IRS on discovery, and who can show that they in good faith relied upon the advice of independent tax advisers in entering into the deal. These were not particularly good cases for the IRS anyway, and the IRS is probably glad to clear them out and devote its resources to the more abusive arrangements.
Moving on to the offer itself, the operative terms are contained in what the IRS has called “Attachment 1 — Micro-Captive Insurance Resolution Terms” and an Appendix.
The terms offered are take-it-or-leave-it, and Attachment 1 notes that the IRS “will not entertain counteroffers to these terms”. That is not particularly surprising, since the whole point of the settlement initiative is to come up with common settlement terms for all taxpayers.
Section 1 (a) and (b) states that taxpayers must notify the IRS of their acceptance of the notice within 30 days, although the IRS may upon request grant a one-time 30-day extension (but no more).
This 30 or 60 day period sounds like more than enough time to accept the settlement offer, and will be in many cases, but for some captive arrangements a significant hurdle arises: Under § 1(c), every owner of every underlying company paying premiums to the captive, and the captive itself, must agree to the settlement.
This will not be a problem with a so-called pure captive a/k/a standalone captive where the owners of the businesses being insured also own the captive itself — they can simply sign off themselves for both the insured entities and the captives. Where it will be a problem is with so-called program captives a/k/a series captives or cell captives, where a bunch of unrelated folks are thrown into a captive deal.
In such a case, if a number of folks have ownership in the captive, then each and every one of them will have to sign off on the settlement, even if the settlement offer is not made to them in particular. Or, if it is the promoter who owns the captive (which is an alternative way these shelters are structured), then the promoter will have to sign off on behalf of the captive, which may run against the promoters own self-interest in attempting to defeat the IRS in tax court so as to avoid promoter penalties, and for that same reason not to see any of its clients capitulate and turn over incriminating evidence to the IRS. That is a pretty blatant breach of contractual and fiduciary duties by the promoter, but that only means future litigation against the promoter and doesn’t help the taxpayer trying to accept this particular IRS offer.
Thus, even if a cooperative and contrite taxpayer, who relied in good faith upon tax counsel in getting into the deal, receives this offer from the IRS, that taxpayer might not be able to accept because the other captive owners or the promoter will not sign off on the settlement offer. In such an event, the taxpayers should make a good record of the promoter’s refusal to sign off on the settlement offer, provide that record to the IRS, and use it to seek the best terms possible outside of this settlement initiative. Stated otherwise, if the promoter is going to sell the taxpayer out to try to defend their arrangement and avoid promoter penalties, then the taxpayer shouldn’t hesitate for a second to sell their promoter out to the IRS to get a better deal.
Moving on, § 1(d), (e) and (h) require the taxpayer who accepts the offer to execute a Form 906 (closing agreement), Form 8821 (tax information authorization), and, in some cases, Form 872 (consent to extend the time to assess tax).
Section 1(f) then tells us that upon closing, the taxpayer must pay the full balance of the deficiency, penalties and interest owed, and § 1(g) says that a taxpayer who is unable to pay all of this immediately may seek to make financial arrangements acceptable to the IRS.
Now we get to § 1(i) and (j), which are pretty interesting since they require the taxpayers to both “fully cooperate” with the IRS and provide the IRS with such additional information as required, and to agree to make an ex parte waiver of any rights to have their counsel present when they are interviewed by the IRS. While the offer says that this is “[t]o facilitate the resolution”, the clear upshot of this is that taxpayers will be required to cooperate with the IRS as the IRS gathers evidence for use against the promoter and other participants.
That the IRS is using these offers to obtain evidence is not at all surprising, since some of the promoters have been telling their participants to, essentially, stonewall the IRS on information requests and to present a common and unified front to try to fight off the IRS. But if the IRS can get several, or maybe even just one, client of the promoter to “turn state’s evidence”, then the IRS’s case against that promoter and the other participants may be significantly bolstered.
Finally, § 1(k) states that taxpayers who accept the offer will not be able to claim or receive any tax benefits other than as set out in the offer.
This new brings us to §2 of the offer, which is described as the “Financial Terms,” and which is the “Here is what you get, and here is what you give up” segment; or, the carrot and the stick if you prefer. As we go through this, we will attempt to point out how this new offer compares to what the IRS had previously been offering in settlement.
Section 2(a) states that participants will be allowed to take a 10% deduction for insurance premiums they paid to the captive arrangements, and that the other 90% deduction will be disallowed. By contrast, outside of this offer the IRS is disallowing 100% of the deduction, so there is a small carrot here in the form of the 10% deduction that the participant would not get otherwise.
Section 2(b) states that participants will not be allowed to deduct the fees paid to get the captive arrangement up and running, or to maintain the captive, including captive management fees. The loss of this deduction can be quite substantial, when it is considered that the recent “street prices” to form a new captive were around $50,000 and the annual cost to run a captive, including captive management fees, license fees, actuarial expenses, etc., were normally in the $50,000 per year range as well. Other, quasi-captive structures instead typically charged around 7% of gross annual premiums paid, which could also be considerable. None of these charges will deductible.
The biggest carrot of all is found in § 2(c), but to understand this carrot you have to understand something that happened in the U.S. Tax Court before this settlement initiative was announced: In Syzygy Ins. Co. v. CIR, T.C. Memo. 2019-34 (April 10, 2019), the U.S. Tax Court dealt the taxpayer in that case a double-whammy when it both denied the deduction for insurance premium payments made to the captive, and also forced the captive to recognize that income over the taxpayer’s objections that it should have treated as a capital contribution instead. Ouch!
Thus, § 2(c) provides that: “The captive will not be required to recognize taxable income for received premiums.” For taxpayers, this avoids this means that while they lose 90% of the deductions for insurance premiums paid to the captive, at least they do not also have pick up the insurance premium payments as income to the captive, and thus avoiding the Syzygy double-whammy. This is a big, fat, juicy carrot that captive owners cannot easily overlook — Christmas came early this year! — and probably makes the entire offer worthwhile to the lucky recipients without anything else.
Following the carrot of § 2(c), we find the stick of § 2(d), which provides that the taxpayer must either liquidate the captive, if it has not been liquidated already, or will take a deemed qualified dividend in the fashion described in the Appendix. This was typically required, in some fashion or another, in previous IRS settlements.
Looking at the Appendix, ¶ a, we find that the § 2(d) stick has large painful thorns if the captive is not liquidated but instead only deemed qualified distributions are made. Each captive owner must take a proportional deemed qualified distribution that includes all of the premium deductions take for the captive arrangement for even closed years, and 10% of the deductions for open years.
Here, the IRS throws taxpayers a bandage of sorts, by allowing taxpayers to reduce the qualified dividend by the captive’s expenses, including premium taxes, bank fees, and tax preparation fees, etc. (but, expressly, not the fees paid to captive managers which will be by-far the largest part of these expenses). The IRS will also allow taxpayers to reduce the qualified dividend by any insurance claims which were actually paid by the captive, if any (the IRS probably gave this one tongue-in-cheek since so few of these captives ever actually paid a claim), and any previous taxable distributions made to the captive’s shareholders.
After the qualified deemed distributions are made, according to the Appendix, the captive’s owners will be deemed to have made capital contributions to the captive in the amount of the deemed distributions, plus additional capital contributions to the captive for the amounts of premium payments that were disallowed as deductions.
Ouch! That is one painful stick to be sure, but here it must be remembered that captive owners would ultimately have paid a good chunk of these taxes anyway when the captive was finally closed and a liquidating distribution was made. The biggest downsides here are that the taxpayer cannot time this distribution to a more favorable year, and of course the taxpayer does not get any credit for fees paid to the captive manager, which could be quite substantial.
Leaving the Appendix and going back to Attachment 1, we find another juicy carrot in § 2(e) in the form of reduced penalties — or perhaps no penalties at all! Again, to understand the carrot, you must understand that the IRS may under IRS Code § 6662 assess either a 20% accuracy-related penalty or a 40% gross non-disclosure of non-economic substance penalty. Anecdotally, it seems that the IRS has routinely been insisting upon the latter (40%) in recent negotiations.
Here, the IRS cuts the accuracy-related penalty to 10% and even that may be reduced to nothing at all if the taxpayer has not previously been involved in another reportable transaction (a 5% reduction) or relied upon the advice of an independent tax professional in getting into the captive arrangement (another 5% reduction), although the tax professional must sign a declaration which is provided with the offer.
Very importantly for professional fiduciaries, trust companies, and estate counsel, § 2(f) says that “for any transfer of value to the shareholders of the captive,” those shareholders must file gift taxes and pay gift taxes and/or absorb the amount against their lifetime credit. Consideration should be given to how the captive was owned for gift tax purposes, such as by a trust, etc., since there might be a gift tax event on top of everything else. If the captive and the underlying business were owned by the same person, however, then this provision will be a non sequitur. But if there was an attempted estate/gift tax play in the captive arrangement, the consequences of that attempt now have to be dealt with.
Section 2(g) states that if a party to an abusive captive arrangement failed to disclose the transaction as required by Notice 2016-66, then a one-time penalty of $5,000 will also be assessed, and a taxpayer who accepts this offer agrees not to seek rescission of that penalty. Similarly, § 2(h) provides that there could be additions to the tax for failure to file estimated returns and pay estimated taxes, but there will be no other penalties imposed.
Going back to the Appendix, in ¶ b we see that if the captive was outside the United States, i.e., offshore, then the captive’s IRC § 953(d) election will be terminated and the assets deemed transferred to a foreign corporation. The IRS also states that the step transaction doctrine will apply to vitiate an attempt to avoid tax through what is known as an “inbound F reorganization” to become a U.S. corporation. This is a carrot for those with offshore captives, since the IRS had the authority to assess substantial penalties if the § 953(d) election was deemed to be invalid and the taxpayer then had what was in essence an unreported foreign entity.
Moving on to ¶ c of the Appendix, the IRS states simply that: “The captive’s § 831(b) election will be terminated.” In other words, the IRS is telling taxpayers that if they want to try to continue on as an ordinary non-831(b) insurance company for tax purposes then have it, but no more funny business in abusing the 831(b) election with this particular entity.
Finally, ¶ d of the Appendix states that special provisions may apply if the captive has more than one class of stock or has participated in a reorganization.
At the outset, it must be understood that what is going on with the IRS enforcement efforts with captive insurance companies is something that affects only a particular, tightly-defined, minority of captives, being captives that have made the 831(b) election, participate in a so-called “risk pool” to attempt to meet tax law risk distribution requirements, and were mass-marketed by particular captive managers as a tax shelter with only a wink-and-nod towards the insurance benefits.
The IRS is not, repeat not, targeting captive insurance arrangements generally. The large corporate captive arrangements are not under any special scrutiny, so-called group captives where homogeneous businesses attempt to deal with particular insurance issues, such as workmen’s compensation, are not under any special scrutiny, and even numerous 831(b) companies used by farm cooperatives in the Midwest are not under any special scrutiny although they too have made the 831(b) election. It should be remembered that bona fide captives are not a tax play, but an insurance play, and perhaps more than half of all the captive insurance companies which have been licensed do not even attempt to qualify as insurance companies for federal tax law purposes.
So, as you read through this, keep in mind that it is only and exclusively 831(b) tax shelter captives that we are talking about, and no other form of captive.
The first thing to realize about this settlement initiative is that it really isn’t anything like a “global” settlement initiative, unless you want to think of the globe as consisting only of Denmark. To the contrary, this is an exclusive invitation-only affair which only is being offered to the relatively small number of 200 very lucky taxpayers, and the rest have to wait for the next lifeboat to be lowered from the deck of the Titanic (if it ever is) to see who will be allowed in it. Very likely, the IRS will extend this offer to other taxpayers, small group by small group, so as to weed out the less abusive cases that the IRS doesn’t want to have a trial before the U.S. Tax Court anyway. But we will have to wait and see how that pans out.
We have already discussed what is in the offer, but there is also something that is not mentioned in the offer which is of potentially very significant value, which is that the affected captive owner gets to stop the bleeding in terms of paying what are typically very expensive costs for quality independent advisers. From a tax-defense perspective, captive insurance companies are extraordinarily complex, document-intensive, and on top of everything else require expensive expert actuarial and underwriting witnesses to attempt to explain the validity of the arrangement to the U.S. Tax Court. Thus, a captive owner under audit quite likely faces legal expenses that will easily go into the six-figures and in some cases possibly beyond. This offer allows those lucky taxpayers who received it to immediately stop that bleeding.
Very similarly, this offer allows captive owners the chance to finally wind down their captive, considering that there is a belief, not without substantial foundation, among tax controversy counsel that to shut a captive down before the trial in U.S. Tax Court is tantamount to an admission that the arrangement was not really serving a bona fide insurance purpose (since, if it was indeed providing non-tax insurance benefits, why get rid of it?). This means that in addition to the hefty legal defense fees, the captive owner was also having to pay the costs to keep the captive alive. This offer allows captive owners to finally stop that bleeding too.
So, to summarize the benefits (the carrots) of this offer, the taxpayer avoids all the following:
- Having to treat the (now) non-deductible insurance payments as income to the captive;
- The 40% non-disclosure of non-economic substance penalty entirely;
- Potentially all of the 20% accuracy-related penalty;
- 10% of the deduction taken by the operating businesses for insurance payments to the captive;
- For offshore captives, avoidance of substantial penalties if the § 953(d) election is invalidated;
- Future legal tax-defense fees and expenses; and
- Continued ongoing management fees and expenses for the captive.
That was the good; now for the bad. What the taxpayer gives up to accept this offer include:
- 90% of the deductions by the operating businesses for insurance payments to the captive;
- Any federal gift tax avoidance benefits of the captive arrangement;
- Up to a 10% accuracy-related penalty;
- Immediate liquidation of the captive and/or the making of a deemed qualified dividend, without being able to obtain credit for the insurance payments to the captive or any captive management fees paid to the promoter; and
- The taxpayer must cooperate in providing information to the IRS and sitting for an interview by IRS personnel without the benefit of representation.
Whether a taxpayer lucky enough to the recipient of this offer, had the ability to accept, and it makes sense for them, might be an issue in some cases. At least, where the taxpayer actually owns and controls the captive, i.e., the pure captive situation, the ability of the captive owners to accept the offer is not in doubt.
But the ability to accept might be a very significant problem where the taxpayer has entered into a program captive, being a (often hinky) program run by a promoter where the taxpayer does not own or control the captive, but instead is either a non-equity “participant” or is lumped-in with numerous unrelated taxpayers in a captive arrangement organized as a series LLC or protected cell company. These are sometimes known as a poor man’s captive since such arrangements are typically restricted to business owners who cannot afford a pure captive of their own, and instead the captive manager charges everybody in the program something like an annual fee of 7% of their individual gross premiums paid into the program to participate. For a variety of reasons, these program captives are among the most abusive of all from a tax shelter viewpoint, and the IRS has targeted several such programs with promoter audits.
In such a situation, presumably all of the owners in a given series or cell arrangement would be required to vote to accept this offer — even if the offer has not been extended to the other taxpayers. Thus, a lucky taxpayer who receives this exclusive offer may see it slip away unaccepted because the taxpayer was not able to procure the consent of the captive manager or other captive owners.
One should also see that the IRS is using this offer to drive a wedge between those captive owners who are offered this deal and their captive managers. For instance, the IRS requires the accepting taxpayer to cooperating in providing information to the IRS and sitting for an interview with IRS personnel without their representative being present.
Also note that the IRS is disallowing fees paid to the captive manager (which the IRS is basically treating as promoter fees) when calculating the tax consequences of the liquidation of the captive or the deemed qualified dividend to be made, and which creates a hefty financial incentive for taxpayers to sue their captive manager for damages based on those fees. Suffice it to say that the class action attorneys who are circling the captive managers like so many vultures prepared to pick at their dead carcasses could not be happier with this result.
For the same reasons, the folks who do not seem to be the least bit happy with offer are the captive managers under promoter audits. From the day that Notice 2016-66 was issued, captive managers have put on a brave face and assured their clients that whatever else has happened to other captives, their own program was somehow better and success against the IRS could be expected. These same captive managers under promoter audits are now just trying to poopoo this offer and hope that their clients do not accept it (and, potentially, turn state’s evidence against the captive manager and their other clients), for to have substantial numbers of their clients accept this offer destroys the utterly false mystique that somehow their program is better than the others.
For three of these captive managers (Celia Clark in Avrahami, Capstone in Reserve Mechanical, and Alta in Syzygy), this bravery so far has proven to have been bravado as their client’s captive arrangements were unsuccessful in varying degrees in those cases. The taxpayers in each case fared progressively worse than the taxpayers in the case before it: The captive owners in Reserve Mechanical came out worse than their counterparts in Avrahami, and the captive owners in Syzygy came out worse than their counterparts in Reserve Mechanical. Very simply, things in the U.S. Tax Court have been going from bad to worse, despite almost frantic predictions to the contrary by the captive managers under the promoter audits.
But what about the other captive managers under promoter audits who haven’t yet lost a case? Some of these captive managers assure their clients that, examinations and even assessments from the IRS aside, their clients’ captive arrangements can be expected to prevail in the U.S. Tax Court. There is no explanation of how their programs are better or why they should expect a different result from those who have gone on before, but instead they offer meaningless platitudes to the effect that their programs are the “best” and are very differently designed (even when they are not) and so better outcomes are to be expected. Some captive managers who are under a promoter audit have even mislead their clients by either telling them that they are not under a promoter audit or have simply failed to advise their clients of that important fact.
Indeed, some of the captive managers who are under promoter audits are still out there trying to sell new folks into their programs! Bet you $1 that the fact of the promoter audits and that numerous of their clients are under examination doesn’t come up in their sales pitch. There are also “new” programs out there which are even more abusive than the programs under the promoter audits (such as the hot-selling Puerto Rico pseudo-captive arrangement which is almost indistinguishable from similar previous tax shelters that ended in indictments for tax fraud) for taxpayers to get trapped in, although the promoters claim (quite falsely) that their programs are significantly better than the abusive captive programs being attacked by the IRS. Caveat emptor.
If a captive owner under examination has not been lucky enough to receive this offer, can they request it? The answer is “yes,” but if and when and of course how the IRS responds is entirely at the whim of the Service. Anecdotally, the taxpayers who have received this offer have been both contrite, i.e., willing to admit that their captive arrangement is flawed, and cooperative in giving the IRS the information that it has sought and not tried to stonewall discovery requests. It is thus suggested that if a taxpayer desires to request this offer be extended to them as well, that should be the posture that they adopt and not a scorched-Earth adversarial one.
Here, it is worth again pointing out that the IRS’s announcement makes clear that this offer will not be made available to those taxpayers who are under the jurisdiction of IRS Counsel’s office, meaning those who have commenced their appeal to the U.S. Tax Court. Basically, the IRS is here adopting a “you wanted a fight, so we’re going to give you one” approach, and which also makes an example of those taxpayers to the taxpayers who have not yet filed an appeal. Taxpayers who have already commenced their appeal can probably expect to get a pretty harsh deal (if they can get one at all) compared to the offer in this settlement initiative. In the meantime, they’ll keep paying litigation defense fees and costs.
Suffice it to say that taxpayers who have not yet fallen under the jurisdiction of IRS Counsel’s office should probably think twice before crossing that line and also seek an independent second opinion.
The IRS’s settlement initiative offer is a “Christmas came early this year” sweetheart deal for the 200 taxpayers who have been lucky enough to receive it. The deal allows clients to cut their losses and get out of abusive risk-pooled 831(b) captive arrangements with a relatively minimum of pain. The offer is, however, full of complexities and nuances unique to captive insurance planning, and taxpayers who do accept this offer should utilize experienced counsel to assist them in the process. Importantly, a lucky taxpayer who receives this offer must move with alacrity to accept the offer within the 30 days (or 60 with an extension) and to timely fulfill all the numerous terms of the settlement prior to obtaining the closing agreement.
Professional fiduciaries, trust companies, and estate counsel who have clients with targeted captive insurance companies may need to start working now with those clients try to work out the federal gift tax consequences of accepting this offer (or not), draft the federal gift tax return that may be required by the terms of this offer, and make sure that the client has the funds available to pay these taxes if the lifetime credit will not be used or is unavailable because it has already been used up.
This is, after all, not the lifeboat that you want to miss getting into if you have the opportunity.