Section 79, captive insurance, 412i, 419, audits, problems and lawsuits

By Lance Wallach, CLU, CHFC

Taxpayers who previously adopted 419, 412i, captive insurance or Section 79 plans are in big trouble. In recent years, the IRS has identified many of these arrangements as abusive devices to funnel tax deductible dollars to shareholders and classified these arrangements as “listed transactions.” These plans were sold by insurance agents, financial planners, accountants and attorneys seeking large life insurance commissions. In general, taxpayers who engage in a “listed transaction” must report such transaction to the IRS on Form 8886 every year that they “participate” in the transaction, and you do not necessarily have to make a contribution or claim a tax deduction to participate. Section 6707A of the Code imposes severe penalties ($200,000 for a business and $100,000 for an individual) for failure to file Form 8886 with respect to a listed transaction. But you are also in trouble if you file incorrectly. I have received numerous phone calls from business owners who filed and still got fined. Not only do you have to file Form 8886, but it has to be prepared correctly. I only know of two people in the United States who have filed these forms properly for clients. They tell me that was after hundreds of hours of research and over fifty phones calls to various IRS personnel. The filing instructions for Form 8886 presume a timely filing. Most people file late and follow the directions for currently preparing the forms. Then the IRS fines the business owner. The tax court does not have jurisdiction to abate or lower such penalties imposed by the IRS. Many business owners adopted 412i, 419, captive insurance and Section 79 plans based upon representations provided by insurance professionals that the plans were legitimate plans and were not informed that they were engaging in a listed transaction. Upon audit, these taxpayers were shocked when the IRS asserted penalties under Section 6707A of the Code in the hundreds of thousands of dollars. Numerous complaints from these taxpayers caused Congress to impose a moratorium on assessment of Section 6707A penalties. The moratorium on IRS fines expired on June 1, 2010. The IRS immediately started sending out notices proposing the imposition of Section 6707A penalties along with requests for lengthy extensions of the Statute of Limitations for the purpose of assessing tax. Many of these taxpayers stopped taking deductions for contributions to these plans years ago, and are confused and upset by the IRS’s inquiry, especially when the taxpayer had previously reached a monetary settlement with the IRS regarding its deductions. Logic and common sense dictate that a penalty should not apply if the taxpayer no longer benefits from the arrangement. Treas. Reg. Sec. 1.6011-4(c)(3)(i) provides that a taxpayer has participated in a listed transaction if the taxpayer’s tax return reflects tax consequences or a tax strategy described in the published guidance identifying the transaction as a listed transaction or a transaction that is the same or substantially similar to a listed transaction. Clearly, the primary benefit in the participation of these plans is the large tax deduction generated by such participation. It follows that taxpayers who no longer enjoy the benefit of those large deductions are no longer “participating ‘ in the listed transaction. But that is not the end of the story. Many taxpayers who are no longer taking current tax deductions for these plans continue to enjoy the benefit of previous tax deductions by continuing the deferral of income from contributions and deductions taken in prior years. While the regulations do not expand on what constitutes “reflecting the tax consequences of the strategy”, it could be argued that continued benefit from a tax deferral for a previous tax deduction is within the contemplation of a “tax consequence” of the plan strategy. Also, many taxpayers who no longer make contributions or claim tax deductions continue to pay administrative fees. Sometimes, money is taken from the plan to pay premiums to keep life insurance policies in force. In these ways, it could be argued that these taxpayers are still “contributing”, and thus still must file Form 8886. It is clear that the extent to which a taxpayer benefits from the transaction depends on the purpose of a particular transaction as described in the published guidance that caused such transaction to be a listed transaction. Revenue Ruling 2004-20 which classifies 419(e) transactions, appears to be concerned with the employer’s contribution/deduction amount rather than the continued deferral of the income in previous years. This language may provide the taxpayer with a solid argument in the event of an audit.

 

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One thought on “Section 79, captive insurance, 412i, 419, audits, problems and lawsuits”

  1. Reblogged this on Captive Insurance Plans and commented:

    The use of captive insurance by U.S. companies to manage costs and risks and realize tax benefits has been a legitimate activity for years. However, the IRS has recently focused significant audit resources on small and mid-market companies that are forming small or “micro” captive insurance companies.
    These companies seek to benefit from Section 831(b) of the tax code, which allows insurance companies with less than $1.2 million in premiums to be taxed on their investment earnings rather than on their gross income. We are seeing first-hand while representing a number of small and medium companies with captive insurance companies in audit that the IRS is emptying the bench when it comes to this issue.

    At its core, the IRS’s concern is that some of these small and mid-market companies forming captive insurance companies are not engaged in true insurance. In response, the IRS recently added captive insurance to its annual “Dirty Dozen” list of tax scams for the 2015 filing season. That is not a list you want to be on. Translated, this means that the IRS is taking a heavy, hard look at captive insurance companies and the managers of captive insurance companies.

    The language from the IRS announcement is sobering:

    “In the abusive structure, unscrupulous promoters persuade closely held entities to participate in this scheme by assisting entities to create captive insurance companies onshore or offshore, drafting organizational documents and preparing initial filings to state insurance authorities and the IRS. The promoters assist with creating and ‘selling’ to the entities oftentimes poorly drafted ‘insurance’ binders and policies to cover ordinary business risks or esoteric, implausible risks for exorbitant ‘premiums,’ while maintaining their economical commercial coverage with traditional insurers.”

    Coming from our work on numerous examinations in this area, we have seen the IRS repeatedly focus on several questions:

    Why was the captive created? How did the captive manager market to the captive owner?
    Do the premiums look managed to a tax outcome? That is, do annual premiums vary in tandem with the business’s taxable income for the year, or conversely, do premiums hover at or near the $1.2 million mark year in and year out?
    Were there any claims made against policies? And were there claims made against the risk pool that is often a part of the small captive setup?
    Do coverages appear warranted and do premiums appear correctly calculated? Do the premiums vary by reason of underwriting on an annual basis?
    Who owns the captive? Is it held in trust for the benefit of others or future generations?
    What kinds of investments are present? Has life insurance been purchased?
    Note: The fact that the captive insurance company may have been blessed by the state insurance commissioner will get you easily halfway to a cup of coffee with the IRS.

    It is important for CPAs to understand two things: 1) while the IRS may first contact your client in the context of a promoter audit—don’t kid yourself—the bell tolls for your client as well. You need to treat the contact with the IRS with utmost seriousness, even if it’s initially just a third-party contact. 2) Don’t forget that even if your client is doing things properly, if the client is part of a larger risk pool of insured—and if one of the other members of that pool is not squared away—the entire pool is potentially in jeopardy, including your client.

    CPAs and their clients should bear in mind that the stakes are high. If the IRS finds that the captive insurance company doesn’t pass muster, it means losing not only the premium deduction, but also incurring a 20 percent penalty, along with interest. Moreover, the IRS is now also considering imposing economic substance penalties as well (the 20 percent goes to 40 percent).

    The best practice we believe for CPA firms with clients with captive insurance companies is to have a review conducted to ensure that the captive is conforming to tax law requirements both in form and substance—and a deep look especially at the insurance provided and the overall insurance pool. Obviously, this is best done before the IRS comes knocking on the door. The risks of adverse IRS action can be managed if done proactively on a voluntary basis.

    If your client is already hearing from the IRS, have your eyes open that this is a highly technical area of tax law and involves a detailed understanding and knowledge of insurance questions from a tax law perspective. The fact that captive insurance is on the “Dirty Dozen” list means you can anticipate a thorough audit that is closely managed by technicians and senior officials at the IRS.

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