IRC 831(B) CAPTIVE INSURANCE

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
[email protected] 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
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(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:
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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
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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:
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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:
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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
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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
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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