Captive Insurance Tax Schemes
What Is Captive Insurance and What Are the Related Tax Benefits?
A Captive Insurance Company (“CIC”) is a corporation created to offer insurance to companies that are related parties to the CIC, either in a parent (CIC) – subsidiary (insured) relationship or where the CIC owners also own the insured company. The non-tax benefits of a CIC may include premium cost stabilization; elimination or reduction of brokerage commissions and marketing expenses; lower administrative costs; the ability to provide niche coverage for a unique or specific risk that would not otherwise be transferable in the commercial insurance market; and the potential to control certain CIC investment decisions and portfolio management.
The tax benefit of an IRC § 831(b) CIC can be extensive. Premiums paid to a CIC by its shareholder insured are generally deductible, similar to the deductibility of premiums paid on commercial insurance. IRC § 162(a) provides that there shall be allowed deductions on necessary and ordinary expenses incurred in carrying on a business, and Treas. Reg. 1.162-1(a) states that business expenses include insurance premiums on policies covering certain business losses. IRC § 831(b) provides that certain electing insurance companies may receive tax-free annual premiums up to $2.2 million, although the CIC would still be liable for tax on its investment earnings. As such, the shareholder insured deducts the premium payments, the CIC receives the premium payments tax-free, and will not be taxed on the premiums until the CIC makes a dividend distribution or the CIC stock is sold – either of which would be at long-term capital gains rates (15%) instead of ordinary income rates (35%).
Captive Insurance Compliance Issues
To achieve the available tax benefits, a CIC must be considered an “insurance company” and the arrangement must be considered an “insurance contract”. To meet these “insurance” requirements, each CIC with U.S. shareholders must use IRS safe harbors or otherwise to both show: (i) that it has properly shifted the risk of economic loss (“risk shifting”) from the insured to the insurer; and (ii) that the insurer has adequately distributed the risk among several insurance companies (or other unrelated entities) so that no single insurance company (or entity) has too much of the risk for an economic loss.
The IRS is also aware of certain less-prevalent IRC § 831(b) CIC tax-motivated compliance problems, that include: (i) the use of life insurance on the CIC owner’s life as a major investment of the CIC; (ii) engaging in tax motivated loan back arrangements between the CIC and its owners; and (iii) structuring the CIC ownership in the name of a children’s trust (or other entity) to avoid Federal Estate and Gift Taxes.
Required Disclosures and Audit Risks
A CIC engaging in any of these compliance issues is likely to eventually come under significant IRS scrutiny and face serious consequences if done non-compliantly. The IRS designated IRC § 831(b) CIC transactions as “reportable transactions.” As with all reportable transactions (a designation for transactions that IRS believes to be illegal and abusive tax shelters), the IRS will eventually require all CIC promoters to file a list with the IRS identifying all taxpayers who engaged in their CIC deals. In addition, as in all prior tax shelter transactions, the IRS has required each taxpayer who participated in an IRC § 831(b) CIC deal to file a Form 8886 Disclosure, which identifies the taxpayer’s participation in the transaction to the IRS.
Ultimately, this will likely lead to numerous IRS audits. And if the past is any indication of the future, taxpayers who participated in a tax motivated IRC § 831(b) CIC transaction will suffer substantial damages. Either way, the IRS knows the identity of taxpayers that participated in what the IRS believes to be an illegal and abusive tax shelter, and if you are such a participant, it is only a matter of time before the IRS will be contacting you, a tax dispute will proceed, and there is a significant chance your transaction will be disallowed, resulting in substantial damages to you.
If you have participated in an IRC § 831(b) CIC transaction, time is of the essence in making the decision as to whether to hire a firm to pursue your claims for damages against the promoters and other professional advisors as the statute of limitations may have already begun running or will soon begin to run.
We have substantial experience, expertise, and success, as well as a sterling reputation, in representing taxpayers who have participated in illegal and abusive tax shelters in litigation against the largest accounting firms, law firms, and investment firms. We are very interested in talking with you about your case, your options, and our team representing you.
The Firm’s tax shelter practice is led by David R. Deary, W. Ralph Canada, Jr., and Jim Flegle. We have significantly fortified our team, however, through a co-counsel arrangement with both Beckett Cantley and Ed Rappaport.
Beckett G. Cantley is a well-known tax lawyer and law professor with special expertise in the areas of captive insurance and syndicated conservation easements. His body of work includes some of the most cited law review articles, mainstream media publications, and speeches throughout the country and particularly in association with the ABA Committee on Captive Insurance (where he served as Chairman of the Subcommittee on Taxation of the main ABA Committee on Captive Insurance). Mr. Cantley is known as one of the foremost experts on abusive captive insurance transactions, and has a similar reputation with respect to syndicated conservation easements.
Ed Rappaport is a tax lawyer who has significant experience in representing clients in tax controversy matters and representing victims of fraudulent tax shelters. He also has significant experience in both syndicated conservation easements and captive insurance transactions.
Our team is built to be not only a highly successful trial team but also highly qualified in the areas of the applicable tax laws that determine if a syndicated conservation easement or captive insurance transaction is an abusive and illegal tax shelter, enabling us to develop and implement the best strategy to recover damages.
If you would like to speak with David R. Deary, please call 214-572-1700 and ask for Janet Bailey, his assistant, and she will schedule a time to talk with Mr. Deary and the team.