If an IRS audit disallows the § 419 plan or the § 412(i) plan, not only does the taxpayer lose the deduction and pay interest and penalties, but then the IRS comes back under IRC 6707A and imposes large fines for not properly filing.
Insurance agents, financial planners and even accountants sold many of these plans. The main motivations for buying into one were large tax deductions. The motivation for the sellers of the plans was the very large life insurance premiums generated. These plans, which were vetted by the insurance companies, put lots of insurance on the books. Some of these plans continue to be sold, even after IRS disallowances and lawsuits against insurance agents, plan promoters and insurance companies.
As the IRS started going after 419 and 412i plans people started selling captive insurance and section 79 plans.
The primary use of a captive must be for bona fide risk management purposes, and not to save taxes. Unfortunately, many of the same promoters of tax shelters who a few years ago were selling Son of Boss, CARDS, BLIPS, and other flavor-of-the-day tax shelters, are now selling captives as a way to save taxes, with only the barest lip-service being paid to the risk management function.
A lot of businesses with valid needs for insurance don’t have enough subsidiaries to pass what is known as the “multiple insured” test for risk distribution, and so they instead participate in what is known as a “risk pool” to obtain risk-distribution.
In a nutshell, a “risk pool” is an insurance arrangement involving multiple, usually unrelated captive owners who share certain risks through their individual captives. Risk pools are usually set up by captive managers to facilitate the needs of certain of their captive clients. In various guidance, the IRS has validated the concept of the risk pool when run correctly.
The difficulty is with the “when run correctly” part. The problem with most risk pools is that there is in fact very little sharing of risks, and thus, the large premiums being charged by the pool are neither actuarially sound nor bear anything but a coincidental relationship to reality. The IRS refers to these as “notional risk pools” – there is a notion of a risk, but not much beyond the mere notion.
Many of these pools have been operated for years with few or no claims, which calls into serious question whether the large premiums they charge are realistic (the answer is that they are not). Maybe in the first year when the pool has no loss history, it can be aggressive in how it prices the premiums paid. By the fifth year, however, a run of large premiums with few or no losses probably indicates that the premiums were mispriced.
If the plan that you are looking at is too good to be true, maybe it is. I am now receiving lots of phone calls for help with section 79 and captive audits. Next will come the lawsuits.