BETA
This is a BETA experience. You may opt-out by clicking here

More From Forbes

Edit Story

IRS Launches Promoter Audits Of Captive Managers Suspected Of Abusive Practices

Following
This article is more than 9 years old.

We have now discovered that in 2013 the IRS finally launched its long-anticipated investigation of certain managers of smallish insurance companies. This has finally culminated in the IRS issuing notices this year that it is conducting so-called "promoter audits" of these manager, and serving subpoenas that request a broad swath of information regarding these captives.

There are more than a half-dozen of these promoter audits of captive managers which have currently been identified, and encompassing many hundreds of individual captives and their owners.

The promoter audits seem to have certain commonalities:

  • The managers being audited predominantly managed smallish "mini-captive" insurance companies, i.e., those which have made the 831(b) election which is available if they receive less than $1.2 million in premiums.
  • The managers being audited place the vast bulk, if not all, of their captives into so-called "risk pools" so as to provide at least 50% third-party insurance so as to meet risk diversification requirements, and those risk pools have had few if any significant claims.
  • Some of the managers have reputations in the captive industry as being sellers of "tax shelter captives", which means that the captive is primarily being sold to clients as a tax-mitigation tool with only lip-service paid to the insurance and risk-management function of those entities (which is their true primary purpose, at least for real captives).

The subpoenas issued by the IRS accordingly focus on the managers' risk pools, including how premiums are calculated and claims paid (if any -- some of these pools are notorious for never paying any substantial claims), as well as on individual client insurance policies. But more importantly, the subpoenas seek marketing materials of the managers, and communications with the clients, which obviously means the IRS is focusing on the true purpose behind the captive: Was it an insurance vehicle as it must be, or a tax-avoidance vehicle which it should not be?

The problem with some captive arrangements is that their premium pricing bears no earthly relationship to the risk being taken on. To put it bluntly, the premium pricing for policies is not just in the same ballpark as reality, it's not even in the same time zone.

For example, let's say that a business owner in Cedar Rapids, Iowa, sets up a captive and uses it to cover terrorism exposure -- in other words, the business owner purchases terrorism insurance for the business from his captive insurance company.

While the rest of us my chuckle at somebody in Iowa buying a terrorism risk policy, the truth is that terrorism can strike anywhere, and, who knows, some jihadist group might take a disliking to cornfields. So, the business owner is correct that he does have a terrorism risk exposure.

But let's say that, because the risk of terrorism in Cedar Rapids is so small, the business owner can buy $10 million of terrorism risk insurance for $10,000 on the open market. Instead, the business owner opts to purchase a $2 million policy from his own captive insurance company for $600,000. In such a case, reality has left the building. It is not a question of whether the risk is there, it is question of whether the risk is being price correctly and in that case it is obviously not.

Not all small captive insurance arrangements are invalid -- far from it. The vast majority of small captive insurance companies making the 831(b) election are valid and play by the rules, and are not going to be bothered by any of this. Unfortunately, the captive industry over the last decade has been inundated with promoters who sell small captive insurance companies as the tax shelter du jour, with only a wink and a nod being paid to what should be the true insurance and risk financing purpose of a captive.

Going after certain managers allows the IRS, limited as it is by scarce resources, to take down many abusive captive arrangements at once. Instead of going after individual captives one-by-one through random audits, by promoter audits the IRS has the opportunity to invalidate several hundred captive arrangements at one time.

Consider the promoter of abusive captives who is managing 200 such captives. If the businesses of the captive owners are paying on average $1 million a year in premiums, that means that in the aggregate they are paying $200 million in premiums -- and taking deductions in the aggregate of $200 million dollars. If those companies have been in existence for three years, then $600 million in deductions have been taken.

If the IRS is able to invalidate all of these captives at once, and deny the deductions, that gives the IRS the opportunity to recapture $600 million in the deductions -- not a small sum. Further, the IRS could very well tack on substantial underpayment penalties, and maybe even tax shelter penalties, meaning that the business owners might end up paying 50% or more in non-deductible penalties in addition to losing their deductions.

You can see that this is a high-stakes game. It is not about a few million dollars in lost taxes, it is about hundreds of millions of dollars in lost taxes and penalties in the aggregate. It is a smart, and frankly quite predictable, strategy that the IRS is following.

Fortunately, only a relatively small number of captive managers are subject to the promoter audits. By far, the vast majority of captive managers do things the right way, and realistically have no expectation of any such troubles. Their clients need not worry about any of this. But for a few managers, and hundreds of their clients, many sleepless nights are ahead.

Similarly, it should be caveated that the mere fact that the IRS is conducting promoter audits doesn't mean that the involved managers will ipso facto see their arrangements invalidated. For all we know, most or all of these managers will go through the audits with flying colors. It is for that very reason that I refuse to name the managers known to be under promoter audits. But I wouldn't put my money on that bet, since the IRS usually doesn't even start a promoter audit (a substantial and resource-draining event for the IRS) unless it already has some evidence that something is rotten in Denmark.

Moreover, the IRS has historically lost most of its court challenges to captive arrangements. These challenges, however, were to predominantly large, corporate captives, which are a different breed entirely. Large corporate captives are able to spread their risk over many subsidiaries, and so they usually have no need for risk pooling arrangements to meet their risk diversification requirements. Plus, the large corporate captives that have prevailed in the court cases had gone to very substantial lengths up-front to really treat their captives as risk-financing vehicles, doing things that would usually be impractical for much smaller captives to even consider.

So, how should business owners considering a captive protect themselves? The answer here is the same as it has always been: Conduct substantial due diligence of the captive manager, and get advice from independent tax counsel (not tax counsel recommended by a manager) that the particular captive arrangement is valid and meets IRS requirements. Particular care should be taken if the captive will require risk pooling to meet risk diversification requirements, to validate that the risk pooling arrangement will withstand scrutiny.

Also, some practical advice: If somebody is trying to sell a captive as tax-avoidance tool, as opposed to an insurance and risk-financing tool, run.

The same advice goes to the owners of existing captives: When in doubt, hire independent tax counsel who is experienced with captives to review the arrangement. This advice rings particularly true if you receive a notice that your captive manager is under a promoter audit.

[By the way, I don't practice in the area of tax for captives or anything else, so don't call me, although I'll be happy to give out the names of well-known and experienced captive tax attorneys who can give this sort of advice.]

That these promoter audits are going on should not deter in the slightest the formation of legitimate captive arrangements. Even if somebody were to get hooked up with a manager who later comes under a promoter audit, so long as their individual captive is sound, they shouldn't expect any problems. Conversely, if they get into a captive just as a tax deal, then they'll probably end up getting what is coming to them, and that is trouble.

But, really, that's always been the case.

This article at http://onforb.es/1r4Qqub and http://goo.gl/pN3NLI