UNCERTAIN LANDSCAPE: POTENTIAL IRS ENFORCEMENT ISSUES WITH INVESTMENT STRATEGIES OF IRC 831(B) CAPTIVE INSURANCE COMPANIES PROF. BECKETT G. CANTLEY ATLANTA’S JOHN MARSHALL LAW SCHOOL TEL. (404) 502-6716 BGCANTLEY@ ATLLAWGROUP. COM Western Region Captive Insurance Conference ~ May 19-21, 2014 Overview This is not a speech about which investments perform best in a CIC. This is a speech about how the investment management can run afoul of the IRS. This speech is solely focused on 831(b) CICs. Western Region Captive Insurance Conference ~ May 19-21, 2014 IRC s. 831(b) Tax Attributes Premiums received by CIC not currently taxed (deferred until distributed) Profits distributed to CIC owners taxed at dividend/capital gains rates (23.8%) Result: Conversion from high of 39.6% to 23.8% Tax on investments at corporate rates (35%) With fees & costs, this is not much of net benefit – so why would the IRS care? Western Region Captive Insurance Conference ~ May 19-21, 2014 Pretextual Investments IRS has no problem with captives per se IRS has no problem with captives investing IRS concern is investments driving formation of a captive – not insurance needs Thus, if the investments are wagging the CIC dog, the IRS is likely to take a hard look at it The more the CIC looks like a pretext for the investment, the less likely it is to stand up Western Region Captive Insurance Conference ~ May 19-21, 2014 So How Do We Know the IRS Cares? IRS Personnel Statements IRS Civil Investigations IRS Promoter Investigations Criminal Warrants Issued Grand Jury Investigations How Do I Know These Things? Taxpayers & attorneys directly involved Expert witness cases Third party meetings w/ IRS personnel Western Region Captive Insurance Conference ~ May 19-21, 2014 IRS Personnel Statements Statements Include: IRS planning on bringing “a great many” CIC cases IRS planning on “expanding” promoter exams IRS very interested in the “investments” as driver for CIC formation & operation IRS concerned with promotional material that focuses on tax benefits & investment return IRS hiring private sector forensic personnel required for ramping up caseload Western Region Captive Insurance Conference ~ May 19-21, 2014 IRS Civil & Promoter Investigations Forensic audits of taxpayers. IRS will drill down deep into a case Determining issues that should concern IRS Common touch points across other cases Specific professionals or risk pools in common Open 6700 promoter examinations of: Risk Pools CIC companies Western Region Captive Insurance Conference ~ May 19-21, 2014 Criminal Warrants & Grand Juries Criminal warrants issued in cases in several states. Risk Pools Captive professionals Grand jury indictment in one advanced case. Clients told better not to make claims Promoters focused on tax savings (not insurance) Generally DOJ takes 5-6 years to develop a case before indictment Western Region Captive Insurance Conference ~ May 19-21, 2014 IRS Investigation Pattern Familiar First: targeted forensic audits Discover common denominators Begin 6700 promoter investigations Begin criminal investigations We are here Issue broad based guidance Start broad audit program based on guidance Western Region Captive Insurance Conference ~ May 19-21, 2014 IRS Litigation Weapons Economic Substance Doctrine Circular Cash Flows Cases Step Transaction Doctrine A full discussion of these is beyond the scope of this talk. Feel free to contact me to discuss any of these in detail. Western Region Captive Insurance Conference ~ May 19-21, 2014 CICs Driven by Investment Accumulation Instead of Insuring Risks Western Region Captive Insurance Conference ~ May 19-21, 2014 Investment Return is Driver of CIC Primary purpose of CIC must be insuring risk. If sales pitch, illustrations, proposals all emphasize tax benefit & investment returns, IRS can argue CIC’s primary purpose is not insuring risk. If sold as “Super IRA”, IRS can argue purpose is wealth accumulation. Good fact: making distributions where no longer needed to support potential claims. Western Region Captive Insurance Conference ~ May 19-21, 2014 Example If primary focus is always on investment return, especially if driven by tax benefits, this is troublesome. In audit, IRS will review: Advisor discussions with potential clients Promotional material & illustrations Transaction documentation Post-formation discussions, emails, & actions If fails test, could determine it does not qualify as an insurance company Western Region Captive Insurance Conference ~ May 19-21, 2014 Accumulated Earnings Tax Currently Dormant IRS Tool Western Region Captive Insurance Conference ~ May 19-21, 2014 Accumulated Earnings Tax (AET) Tax for Certain C Corps – where corp has excessive retained funds that should be distributed to shareholders IRS wants its money! AET – IRS can dust off AET to tax accumulated premiums not actually needed for running an insurance company Avoiding AET – IRS rulings on what an insurance company needs on hand to run itself – rest has potential for AET Western Region Captive Insurance Conference ~ May 19-21, 2014 Example If accumulating large amount of funds that are not used for claims, & not making dividends, then may have to prove to IRS that such large reserves has a real purpose for not being distributed. If not, AET could be applied. Western Region Captive Insurance Conference ~ May 19-21, 2014 Offshore Investment Flexibility Western Region Captive Insurance Conference ~ May 19-21, 2014 Offshore CIC Investment Flexibility Investment Flexibility – one argument made for using an offshore domicile is the flexibility offered for potential CIC investments (less regulation) 953(d) Election – election to be treated as a “US taxpayer” required Western Region Captive Insurance Conference ~ May 19-21, 2014 Crackdown on Offshore Structures & Investments Senate Finance Committee 2006-Present. IRS changed name of LMSB to “Large Business and International Division”. UBS & Other Swiss Cases: Swiss relented to allow US access to Swiss Bank Accounts, in violation of Swiss bank secrecy laws. Extended: India, Israel, Singapore, etc.. Why Wouldn’t this Extend to CICs? Western Region Captive Insurance Conference ~ May 19-21, 2014 Potential Negative Results If lose CIC status, also lose 953(d) election. Triggers numerous & significant adverse tax results & high penalties. If get caught in the crackdown, just proving you are compliant could be very costly. Might not be worth the investment flexibility at this point. Western Region Captive Insurance Conference ~ May 19-21, 2014 Pre-Planned Life Insurance Investments Focus: New Life Insurance on Business/CIC Owners Western Region Captive Insurance Conference ~ May 19-21, 2014 Life Insurance Investment Argument CIC must maintain liquid reserves for claims CIC may invest reserves as long as liquidity met Part of premiums can be in non-liquid assets Potentially high cash value life insurance used as investment Potential to be liquid and tax free build-up reduces (or eliminates) 35% tax on investments Functionally, certain life insurance policies have 100% liquidity from day 1, which theoretically could meet the liquidity requirements of a CIC. Western Region Captive Insurance Conference ~ May 19-21, 2014 How Does this Fit In to Pretextual IRS Concerns? If you cannot deduct life insurance premiums directly, IRS may challenge CIC as a vehicle for getting the deduction indirectly. To win, must be able show: life insurance investment decision made independent of CIC insurance needs Life insurance not the driver of the CIC Life insurance contract truly liquid both now & prospectively Overcome historical IRS & court skepticism (412i, 419) Western Region Captive Insurance Conference ~ May 19-21, 2014 Where Does the IRC Stand on This? IRC 264 – Life insurance premiums are generally not tax deductible. Specific Exceptions for Employee Benefit Plans: 412(i) 419 BOLI Aggressive versions of these have been attacked too. A CIC is not an employee benefit plan. Western Region Captive Insurance Conference ~ May 19-21, 2014 NAIC Argument NAIC position on life insurance in a captive NAIC has nothing to do with IRS NAIC is a state law-oriented group of insurance commissioners IRS is an independent agency of the US applying federal tax law No IRS code or Regulation references NAIC This is like arguing that the states’ position on car emissions set the rules for the EPA. Western Region Captive Insurance Conference ~ May 19-21, 2014 Compare: US Virgins Islands Cases USVI is a self-governing US territory. Large US tax credit afforded companies who set up enterprises in USVI. USVI set up rules for when federal standards met in practice & blesses enterprises. IRS determined USVI process was being abused & cracked down hard. USVI blessing completely disregarded by IRS. Bottom line: if IRS sees tax non-compliance, outside standards won’t make any difference. Western Region Captive Insurance Conference ~ May 19-21, 2014 Pac-Life Warning Western Region Captive Insurance Conference ~ May 19-21, 2014 Loan Back Investments Western Region Captive Insurance Conference ~ May 19-21, 2014 Loan Backs Some CIC Programs have “loan back” options to permit the client to borrow back CIC funds. Effectively, the client deducts the premium, then borrows it back out without paying taxes on the money. Rev. Rul. 2002-89, the IRS Manual, and case law indicate such CIC loan backs are at least subject to strict scrutiny, and may be prohibited under certain circumstances. The IRS has asked for comments on the facts and circumstances that would give rise to loan back determinations. This issue has come up as a focus in audits. Western Region Captive Insurance Conference ~ May 19-21, 2014 Example If shortly after premiums paid (or earned), significant amount of such funds are loaned out to insured business (or owner) for use in business or outside investments, then IRS may challenge as an improper tax-free distribution If interest rate paid is a true market rate, is actually paid, & use of funds is secure, then may be able to overcome these concerns. Western Region Captive Insurance Conference ~ May 19-21, 2014 Conclusion Western Region Captive Insurance Conference ~ May 19-21, 2014 Be Careful Out There Only form captives to insure real risks, not for other investment purposes Control what your agents say to clients Make sure your marketing material & transaction docs are consistent with the real purpose of the CIC (insuring risks) Be careful how you conduct yourself afterward formation Western Region Captive Insurance Conference ~ May 19-21, 2014 The End Western Region Captive Insurance Conference ~ May 19-21, 2014
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