September 12, 2014
by Tom Cifelli, Managing Director
CAPTIVE TAX AUDIT CONCERNS
If you engage a captive manager with experience you should not be concerned about tax or regulatory audits other than the extra time and expense they might incur to defend positions taken. The IRS and the industry have established pretty clear guidance on what is required for a captive program to be created for legitimate business purposes and what a solid design and management program looks like.
The increased attention by the IRS in auditing 831(b) electing captives and even doing some promoter audits is a good thing; it will force all firms to improve practice standards and others to get out of the industry where they lack requisite skills and experience to properly design, form and manage excellent customized captive risk management solutions. There most certainly are promoters pushing tax shelter attributes of captives and buying life insurance with pre-tax captive dollars who are not focused on helping clients improve risk management. These promoters are hurting the captive industry and may be found in violation of tax shelter promotion restrictions.
Some captive managers who are legitimately trying to help clients improve risk managers may be found to have defectively designed programs for a variety of reasons ranging from poor underwriting to defective risk pool structures and practices.
The IRS audit activity increase in recent years is not isolated to captives. Click here for a law firm release advising clients the IRS tax audit activity has been increasing across many areas under President Obama’s administration. The IRS audit of captives is certainly nothing new; from 1970s until 2001, the IRS challenged every captive program. It was only due to its many defeats in court that in 2001 it abandoned its economic family doctrine challenge to captives and adopted the seminal 2002 revenue rulings that underlie the industries accelerated growth in recent years.
Properly designed and managed 831(b) electing captives should still be fine, and should expect no audit adjustments required after an IRS review. Some may be required to defend positions taken in tax court, as the IRS continues taking some unreasonable positions despite acknowledging the importance of captives to an increasing number of US businesses. Click here to read a recent press release announcing the tax court ruled in some captives favor implicitly approving participation in 3rd party risk pools to achieve risk shifting and distribution relying on IRS revenue Ruling 2002-89 guidance.
However, those 831(b) captives formed purely to save taxes, without requisite due diligence and care required to properly design and operate a customized captive risk management program, could find the IRS denying the deductibility of premiums paid the captive.
The IRS is also increasing the scope of its captive promoter audits, recently serving several larger enterprise risk “micro-captive” focused firms with extensive information discovery request. The IRS will evaluate these firms marketing and operating practices.
IRS associate legal counsel has advised they are walking a fine line as they do want to chill captive formations with legitimate risk management objectives that are operated properly. She stated they will look at reasonableness of underwriting practices, citing as an example of a practice they have problems with is a New Jersey company buying volcano insurance from its affiliate captive. She said while this would not make the arrangement a sham, the premium should be very low considering the remoteness of the covered risk.
We do anticipate the IRS will take issue with some widespread industry practices, such as back dating of policy periods and auto renewing of policy and premium programs without any underwriting or actuarial updates from year to year reflecting consideration of loss history and changed circumstances.
The IRS may also take issue with some risk pooling practices in this industry. Some risk pools allegedly went many years without paying any claims. In fact, possibly not even having any records of having made any claims calls and inquiries with insured companies. Some risk pools do not require any collateral for paying losses, a practice the IRS may argue is evidence they never intended to have any.
Over the next several years there is sure to be associated litigation.
We are available to assist as subject matter experts in the event you need assistance due to tax treatment uncertainty of your captive program. We also offer strategic captive reviews – these identify areas of weakness. If your current captive program has deficiencies of serious concern, we can help with captive rescues and create an improved successor program.
Contact us for a free consultation today.