Beckett G. Cantley
Geoffrey C. Dietrich
Cantley Dietrich, PC
This article is another in our ongoing series on Internal Revenue Service (“IRS”) treatment of rogue Internal Revenue Code (IRC) section 831(b) captive insurance promoters and schemes. In this article, we discuss the IRS settlement initiative released on September 16, 2019. The IRS decided on a carrot and stick approach to resolving taxpayer issues, with a sweeter deal for the least offenders, followed by a harsh hit for those who decide not to accept the IRS offer.
The Unheeded Warnings Ring True
Consistently named an IRS “Dirty Dozen” tax rogue, certain 831(b) captive insurance company (“CIC”) transactions are repeated targets of IRS ire. The IRS commitment to curbing abusive CIC arrangements has manifested itself through audits, investigations, and litigation. In the IRS’ view, unscrupulous promoters schemed to misuse captive insurance as a vehicle for meritless tax deductions, and typically involve money loans from the Captive, estate planning schemes, and circular flows of funds through fake reinsurance programs. Beyond those sins, these bad actors often seek to address nonsensical risks in their now-judicially decreed “non-insurance” reinsurance schemes.
As we have consistently warned, Promoters sent taxpayers on a merry chase while pocketing thousands (or millions) of dollars in fees. We are aware of over 500 cases currently docketed against 831(b) CIC transactions. It is impossible for any budgeted bureaucracy to sustain a long-standing litigation attack for such a high case load. IRS resources are not best utilized in going to trial 500-plus times on what will largely be the same issues.
The IRS follows a near lockstep approach to abusive transaction litigation. After determining forensically the extent of a problem, the IRS will determine the players and then begin to audit. Through the audit process, the IRS builds its case and cherry picks the best fact scenarios for litigation. All that remains is for the IRS to garner enough early wins to put an industry on its heels.
Early Courtroom Successes: the Szygy and Reserve Mechanical Cases
There are enough articles (written by us and others) on the Avrahami case that we do not need to re-address Avrahami. Following their success there, the IRS sought a ruling in Reserve Mechanical Corp. v. Commissioner, T.C. Memo* 2018-86 (June 18, 2018). There, the Tax Court held that captives must resemble real-world insurance. Reserve Mechanical followed the same promoter failures as Avrahami, especially because each policy listed PoolRe Insurance Corp. for risk-pooling stop loss insurance, administered by Capstone Associated Services, Ltd.—a well-known Captive promoter. In another blow to Captives, the Tax Court ruled Reserve was not an insurance company for lack of true risk distribution and circular cash flows. Like other cases, premiums were larger than necessary, instead of being actuarially determined. The Reserve Mechanical case laid the groundwork to establish law that risk pools had gone nuclear and the industry standard practice should be avoided as toxic.
The Tax Court beat the horse dead in Syzygy Ins. Co. v. Commissioner, T.C. Memo 2019–34. The Tax Court ruled that since Syzygy was not an insurance company and had no right to elect under IRC § 831(b). Therefore, premiums remitted to Syzygy were neither deductible as such or as other “ordinary and necessary expenses” under IRC § 162. Judge Rowe beat down the “no claims filed because we were too busy” with the note that the insured entity “had claims processes for commercial policies that they did not implement for the captive program policies.” Further strikes came as the Court found the CIC asset allocations did not align with those of a regular insurance company but instead were invested in life insurance for the CIC’s ownership. Szygy rounded out with the IRS’ consistent arguments of: circular flows; not meeting the definition of insurance, and reinsurance that did not properly distribute risk. In three consecutive cases, the IRS had wielded the ugly stick of reality and the façade of substance, purpose, and insurance failed.
As we would expect, with a couple of wins under its belt—and recognizing similar fact patterns in the remaining hundreds of docketed cases—the IRS apparently felt confident enough to roll out a global settlement initiative.
Details of the Global Settlement
Why is the IRS Making the Offer?
There are as many as 500 docketed 831(b) cases that the IRS must battle absent some form of settlement – an impossible number to fight. As such, IRS offered a settlement to a significant number of taxpayers that is likely to extend in some form to nearly all 831(b) CIC abusing taxpayers. The IRS does not want to repeat the former experience when deals on offshore tax shelters were dangled and the response overwhelmed them.
Who’s Invited to Accept the Offer?
Beginning September 2019, some 200 audited CIC users were mailed IRS offers for deals, with response due in 30 days. The offer requires payment of 90% of CIC-derived tax deductions plus interest. They also lose deductions for captive setup and management fees. If accepted, the audited are eligible to waive the 10% penalty for first-time offenders who acted sincerely upon advice they thought was correct. It’s a safe but not wholly painless resolution.
The number of cases being reviewed includes 2,000 under audit and another 10,000 in peril of IRS action. And after three wins in court, the IRS believes it now has leverage and a road map to offer a legally defensible settlement. Paring off some cases for expedited adjudication makes perfect sense given the large scope of the problem. The ultimate purpose of this initial offer is for the IRS to test the waters and tweak details to perfect their approach before launching it, en masse.
Declining the Offer
So what happens to those brave souls who receive an IRS offer letter who don’t accept? The outcome could be ruinous. Those choosing to fight could be taxed on the premiums multiple times, by disallowed deductions and again as income in the captive. Also, penalties of perhaps 40% on the unpaid tax. Jay Adkisson, lawyer and former chair of the American Bar Association’s committee on captive insurance companies says, “In the worst-case scenario, you could get hit with a 240% tax. I frankly don’t think anyone who gets this offer is going to reject it, and if they do, they need to find better professionals to advise them.” Finally, those who are offered this private resolution and decline will not be eligible for any potential future settlement initiative.
Summing up their position, IRS Commissioner Chuck Rettig states, “The IRS is taking this step in the interests of sound tax administration. We encourage taxpayers under examination and their advisers to take a realistic look at their matter and carefully review the settlement offer, which we believe is the best option for them given recent court cases. We will continue to vigorously pursue these and other similar abusive transactions going forward.”
Peering into the Foreseeable Future
As we stated above—and have many times previously—the IRS traces a very specific path from transaction they do not like to classification of a Reportable or Listed Transaction. We are consistently astounded by the professionals who seem surprised by this revelation. The IRS does not act in secret. Their actions are regular. As such, it is reasonable to peer into the future and describe the landscape.
The IRS has three landmark 831(b) CIC wins. The facts are largely the same in those cases. Unless the marketing materials were significantly different, the facts in the remaining 500 docketed cases are likely very similar. We have, in fact, seen many IRS audit reports, upcoming class litigation, and existing case law which bears out that assumption. The IRS has no reason to assume that they will have anything but success with the facts as laid out. Settlement is their way of lightening their load while offering the barest of concessions to the taxpayer.
What is the future then? This is the point in our narrative where the guppies turn on the sharks that have fed on them. The roll out of a settlement offer by the IRS leads to documentable losses by the individual business owners who were misled by unscrupulous promoters and some trusted advisors into a Captive. The best case the taxpayer can expect from the IRS is to lose the tax benefit on 90% of their premiums paid. That is the best case—and that is before penalties, interest, and more penalties. For those taxpayers, they should immediately contact the attorneys who will require reparation at the hands of the unscrupulous promoters and their cohorts.
As a reminder to tax litigators, CPAs, and other concerned professionals. Immediate care should be taken to toll the statute of limitations with advice to clients to engage competent counsel to litigate for reparations.