I've previously discussed that the IRS Office of Chief Counsel has taken an interest in captive insurance companies. Further evidence of this is found in the March 7, 2014, Memorandum issued by that office (No. AM2014-002), relating to the election made under Internal Revenue Code section 953(d).
So, what the heck is a 953(d) election? Very simply, the 953(d) election is an election that is only available to a "foreign insurance company", and basically says that the foreign insurance company will be treated as a U.S. insurance company for most tax purposes. This keeps the foreign insurance company from being treated as a Controlled Foreign Corporation ("CFC") for U.S. tax purposes, which might have onerous consequences.
This brings us back to AM2014-02, which makes three points on behalf of IRS Chief Counsel's Office:
First, if the foreign insurance company fails for whatever reason to qualify as an "insurance company", then the 953(d) election becomes invalid, and the company will be taxed as a CFC.
Second, if the company is then treated as a CFC, then the time for the IRS to make a tax assessment against the company is extended until three years after the company then files its returns (typically, Form 5471) as a CFC.
Third, if the company didn't file a Form 5471, it can't get buy just with its filing of a general corporation return, Form 1120-PC.
Seems pretty dry and technical, and frankly boring, right?
To understand why this is interesting, you have to ask the question: The 953(d) election has existed in the Tax Code for many years, so why just now is the IRS Chief Counsel's Office taking an interest all of a sudden in the 953(d) election?
The reason is that the IRS is expecting a good number of foreign insurance companies to cease to qualify as "insurance companies" for tax purposes. Some insight into why the IRS has that expectation is found in my last article, IRS Noose Starting To Tighten On Sham Risk Pools.
Some additional insight is found in this new AM2014-002:
If it is determined that a CFC does not qualify as an insurance company under subchapter L, the CFC will fail to meet the requirements for electing under section 953(d)(1) to be treated as a domestic corporation, and it will be treated as a foreign corporation for federal income tax purposes. Section 953(d)(1)(B).
Section 6038(a)(4) requires any U.S. person who controls a foreign corporation, including U.S. persons who are U.S. shareholders of a foreign corporation that is treated as a CFC, to file a Form 5471 to report the information as prescribed in section 6038(a)(1). Further, section 6038(a)(2) provides that the required information must be furnished for the annual accounting period of the foreign business entity ending with or within the U.S. person’s taxable year. The penalty for failure to file a Form 5471 is $10,000 for each annual accounting period with respect to which such failure occurs and $10,000 for each 30-day period (or fraction thereof) after the U.S. person has been notified of such failure for more than 90 days. The maximum continuing failure to file penalty is $50,000. See section 6038(b)(1) and (2).
Note that this penalty is for each year the Form 5471 is not filed -- if a company was a CFC but did not file the Form 5471 in four tax years, that would mean a minimum fine of $40,000. But there could be much greater penalties if the captive arrangement fails to qualify as insurance, the deductions by the operating business are then disallowed, and there are substantial understatement penalties tacked on.
Fitting these pieces together, it is clear that the IRS is expecting hog killing season to start soon regarding offshore captives that are in bogus risk pools, and is preparing its CFC knife by taking it out of the 953(d) scabbard.
After AM2014-02 was released, some captive tax counsel have suggested that offshore captives that have made the 953(d) election might consider making a "protective filing" of the Form 5471 to at least stop the bleeding on a go-forward basis, should something bad happen later on.
Suffice it to say that these issues should make a new captive owners apprehensive about forming the new insurance company outside the U.S., and should make existing captive owners with offshore captives at least consider whether their companies should be redomiciled to one of the many states (if not, indeed, their own state) that has captive legislation.
[For what it is worth, unless there is some specific, compelling reason for a captive owned by a U.S. person to be offshore, a captive should usually be formed in a domestic jurisdiction just so these myriad foreign tax compliance issues are avoided. Plus, I think there is a general respect for rulings and determinations of state regulators that can have positive effects in tax controversies; with the offshore jurisdiction that inherently carry the general taint that those places are historically used to commit tax evasion, the effect can be decidedly negative, although maybe a very well-known captive domicile such as Bermuda might be exempt from this taint.]
At the very least, these recent actions by the IRS at various levels clearly indicate that the IRS is finally starting its long-predicted move against captive arrangements that it considers to be abusive or technically invalid, and captive owners, managers, and tax professionals alike should make sure that all their "i"s are dotted and "t"s are crossed, and keep their own fingers crossed that it is not too late already to do that.
This article at http://onforb.es/1eXfNIq and http://goo.gl/bv9Bkm
