Offshore micro captive insurance products were listed as a potential “abusive tax scheme” in a study by the US Government Accountability Office (GAO).
The study, which was published in July, looked at micro captive insurance and variable life insurance policies — two products that the Internal Revenue Service (IRS) has recently warned have the potential for such abuse.
In the report, the GAO explained that offshore micro captive insurance products “may be abused if the corporate taxpayer improperly claims deductions for payments made to a micro captive for federal tax purposes”.
The study highlighted that courts have applied certain considerations to determine whether these deductions can be claimed.
One consideration it noted is whether the insurance legitimately distributes risk across participating entities.
IRS officials said they expend significant resources reviewing these schemes because of the varied ways insurance companies may work, the GAO noted in its report.
Commenting on the study, Peter Kranz, executive managing director and captive practice leader at Beecher Carlson, noted: “While it is unfortunate the study is titled ‘Abusive Tax Schemes’, the preamble to the ‘micro captive’ section clearly states such captives which are used legitimately can be very beneficial and highlights some of those benefits.”
He explained: “The fact the report explicitly notes that the issue isn’t Internal Revenue Code 831(b) but rather the abusive structures established by some promoters is very important. The attention from the report does run the risk of portraying captives, the industry as a whole, in a bad light when the vast majority of captives are established the right way and for the right reasons.”
“It is important that congress and the IRS delineate between the good structures and the bad structures,” he added.
Ryan Work, vice-president of Self-Insurance Institute of America (SIIA), noted that while they appreciate the GAO report and the GAO staff reaching out to SIIA for industry experts to talk to on this issue, SIIA is “disappointed in the one-sided nature of the report and the lack of industry background included”.
Work explained that in many instances the GAO “simply duplicated verbatim past statements from the IRS that are broad sweeping in nature, rather than providing appropriate differentiation between abusive structures and non-abusive”.
He added: “Nor did it provide any context or explanation on the appropriateness of captive structures in mitigating risks that businesses may not be able to access in the commercial market. It is unfortunate that the report did not offer a balanced and accurate approach to the captive market, nor its importance in the current market.”
Elsewhere, Sean King, principal at CIC Services, suggested that this GAO study “provides no new information”.
King highlighted that the abusive potential of micro captive transactions, whether offshore or onshore, has long been well-known and appreciated by tax authorities.
He explained: “The sad thing is that the IRS could end virtually all abusive transactions overnight by simply offering the industry guidance and safe harbours regarding what constitutes and does not constitute a legitimate insurance arrangement for federal income tax purposes.”
“Taxpayers would overwhelmingly comply with such guidance, and the IRS has promised it for literally decades now. But to date it has offered the industry nothing of consequence, despite the fact that IRS Notice 2016-66, the entire purpose of which was supposed to assist the IRS in defining abusive transactions, is now nearly four years old,” he added.
Work also noted that the US Congress gave the IRS rulemaking authority back in 2015 “to curb certain abusive practices”, which he stated the service “has yet to take any action upon despite numerous industry and congressional requests”.
He highlighted that the GAO also fails to make mention of the tens of thousands of data filings and dozens of data requests the IRS has imposed on the industry. He said: “Time and time again the industry has provided that data and the IRS has failed to provide additional clarity.”
“At the same time the industry spends tens of millions of dollars a year in compliance costs, the GAO cites IRS ‘concern' about their own expenditure of resources in reviewing how American small and medium-sized businesses are utilising captives to mitigate against risks, the vast majority of which are doing it for the right reasons”, he continued.
King explained that the industry must ask themselves why the IRS has failed to provide any meaningful guidance.
“It’s quite clear that, despite its posturing, the IRS does not really want greater clarity around the definition of legitimate insurance arrangements. Rather, it has concluded that it can raise more revenue by promoting fear, uncertainty and doubt (FUD) around such arrangements.”
“By keeping the lines blurred, indeed by actively blurring them itself, the IRS believes that it can scare people away from captive insurance arrangements, arrangements that have literally saved hundreds of small businesses and their jobs in just the recent several months alone. And the uncertainty also permits the IRS to extort settlements from even law-abiding taxpayers by arbitrarily claiming that any captive transaction it wants is ‘illegal’ or ‘abusive’ or ‘illegitimate’,” he added.
Work said: “SIIA looks forward to a dialogue with the GAO and federal agencies to better educate them on captives, and continues to have ongoing discussions with a number of members of Senate Finance and captive owners on the benefits of 831(b) captives addressing low-frequency high-cost risk, such as we are currently seeing during the current COVID pandemic.”
He noted that SIIA will follow-up with Senate Finance and others “to correct the inaccuracies we believe are contained in the GAO report”.
In July, micro captives were not listed on the IRS’ ‘Dirty Dozen’ list of tax scams for the first time in five years.
For the last five years, the IRS has referred to micro captives as an “abusive tax shelter” and suggested that certain micro captive “structures, promoters, accountants or wealth planners persuade owners of closely-held entities to participate in schemes that lack many of the attributes of insurance”.
Although micro captives were not mentioned on the IRS’ official list, it did state that an upcoming series of releases will be published on topics such as abusive micro captives and fraudulent conservation easements.
The IRS said that these releases “will emphasise the illegal schemes and techniques businesses and individuals use to avoid paying their lawful tax liability”.
