Tax Shelters and Insurance
All captive managers in the United States are preparing to file their responses to the IRS’s Notice 2016-66. Much has been said about the Notice all over the internet. While we can debate endlessly about the disclosure requirements in the Notice, the reality is that no one really has any idea what’s going on. However, we have uncovered something interesting while processing our responses.
The average time it takes us to prepare a response for a legitimate captive is about 15 hours. Any representative from the Service probably thinks this is overkill, but the burdens placed upon the taxpayers and captive managers are so broad and so ill-defined that it requires a deep dive into the operations of the insurance company in order to make a good faith regulatory compliance effort. We have also prepared some responses as consultants for captive managers who operate ‘tax efficient’ captive insurance companies. The average time for those tax shelter captives is about 45 minutes. This is probably in line with what the Service anticipated when it issued the Notice.
This creates an interesting dynamic. Real insurance companies that happen to make the 831(b) tax election are completely different from tax shelters abusing the election in order to preclude recognizing income for tax purposes. So, there is no doubt that the IRS is correct in its general assertion that there are a large number of bad actors in the marketplace who are abusing the tax code in order to skip out on paying taxes.
That being said, is the mere fact that someone is paying premiums into a terrorism risk policy necessarily a tax shelter? Your instincts likely say yes, but think hard about tax shelters before you answer. The question really hinges on what constitutes a tax shelter.
The Substance Over Form Doctrine
One of the great challenges for the IRS is to determine the line between where someone takes advantage of smart features of the tax code and where someone simply abuses a loophole. One weapon in the IRS’s arsenal to disrupt abusive tax shelters is the ‘substance over form’ doctrine. This doctrine generally states that the Service will view the ‘substance’ of a transaction over the ‘form’ of a transaction. Thus, if you set up a slew of shell corporations with no legitimate business interest just to escape taxes, then you have a tax shelter.
Of course, the IRS took this power and ran too far with it. The IRS enjoys wielding the substance over form doctrine to unwind any transaction that it dislikes. This has the chilling effect of rendering otherwise perfectly legal economic transactions as abusive. Consequently, an agency of the federal government is frequently contravening the explicit laws set forth by Congress, which is a clear violation of Constitutional law.
The Constitution does not permit any agency of the government to make laws (ignore the effects of regulations and various notices for a moment, because that is very tricky). Every agency must obey the laws set forth by Congress, regardless of the wisdom of the law. Moreover, agencies are required to interpret the law in such a manner as to comply with all other laws passed by Congress. It is neither the job of a federal agency nor the courts to fix Congress’s legislative errors. That is a job exclusively reserved to Congress.
Herein lies the problem with the IRS. They believe they need to prosecute taxpayers who take advantage of unique quirks in the tax code which create an unintended non-taxable event. The IRS has some power via the substance over form doctrine to prosecute these abuses. However, the vast majority of these abuses are legal as a matter of law. Consequently, the IRS is prosecuting taxpayers who enter into legal transactions because the IRS unilaterally determined that the transaction was abusive.
831(b) Captive Insurance and the IRS
This brings us back to captive insurance. The IRS views 831(b) elections as potentially abusive and require all captives to report. The Service’s position is that most 831(b) captives were created only to avoid paying taxes. However, taxpayers are completely allowed to create captive insurance companies and are free to deduct premiums paid into the insurance companies from gross operating income. Thus, taxpayers who legitimately use captive insurance companies have to constantly look over their shoulder to make sure that the IRS doesn’t arbitrarily determine that they are operating a tax shelter.
As we stated before, the IRS isn’t the villain here but they’re certainly not heroes, either. The IRS is prosecuting perfectly legal business transactions on the grounds that there may be abuse. As you can imagine, determining whether tax abuse occurred is a matter of intense debate and results in expensive litigation.
Captive insurance is insurance. Plain and simple. A legitimate insurance company is a complex financial vehicle with a number of moving parts. Small insurance companies generally take the IRC 831(b) election because it is a tax-efficient strategy, not because it is a tax dodge. Notice 2016-66 imposes such broad disclosure requirements that providing the information to the Service is an arduous undertaking requiring the coordination of a number of professionals to secure the correct data, provide it in a meaningful format to the Service, and ensure that the data is presented in a legally compliant manner with the Notice.
For tax shelters, this burden is much easier. All the Notice does to those companies is simply force the captive owners to fill out some forms and then they are on their way.
What Should the IRS Do?
Just as so many others have suggested, the IRS needs to amend the Notice to narrow the scope of the businesses affected. The current Notice essentially demands compliance from every 831(b) captive in the United States. The IRS may believe that disclosure from all is valuable in order to put the captives on the map, but the reality is that the Service does not have the manpower or the resources to adequately sift through the volumes of data and will miss opportunities to prosecute actual tax shelters because they are inundated with too much documentation.
As of the writing of this post, the IRS has provided no indication that it will relieve its disclosure requirements. This is fine for us since we are basically done with all of the heavy lifting. However, this is no way to treat the private industry. Businesses should not be conducting business with a sword of Damocles hanging over its head. If a business is operating a company pursuant to all laws and regulations, then the threat of government interference should be next to nothing.
There are a number of different amendments the Service can implement in order to capture the bad actors without threatening legitimate businesses:
- The IRS can reduce the 70% loss ratio to 5%. The tax shelter captives generally pay zero claims in a year. Simply requiring 5% losses captures the vast majority of the bad actors.
- The IRS could implement a 5 year average to assess over time whether a captive looks more like a shelter than an insurance company. This average could be calculated as the number of claims per year, total dollar value of claims paid, or simply create a five year rolling average of the loss ratio. This would provide a broader view of the captive’s operations and weed out legitimate businesses from the IRS’s net.
- The IRS could limits its investigation to captives that never employed a third party actuary, never conducted an independent audit, or failed to issue any insurance policies. Again, these are standard features of any insurance company and their absence is evidence of a shelter.
These are only three common-sense suggestions that would immediately improve the Service’s hunt for the bad actors in the market. In general, the best solution for the Service would be to work with the private sector to come up with good solutions to help weed out the bad actors. Whether the IRS admits it or not, it does not understand insurance (e.g., the surprising number of cases where the IRS has lost a captive battle in the past 15 years). The reason the Service misunderstands insurance is because insurance is not a function of the tax code. Rather, it is a function of risk management. The tax code does not define insurance and is not easily captured by the existing regulatory structure. As such, an army of tax attorneys and accountants are attempting to regulate an industry by looking at it through an incorrect lens.
Captive managers would prefer the bad actors to be weeded out of the market almost as much as the IRS. Teamwork can lead to better results for the industry and, broadly speaking, the country. The IRS owes it to both the taxpayers and the nation to make efforts to better understand that which they regulate in order to accomplish their job in a better manner.
Until then, they will continue to struggle in court.