Taylor English
The IRS’s attempt to put a stop to unlawful micro captives means legitimate captives will be caught up as collateral, Vivian Hoard, partner at Taylor English, explains that good captives need to stand up and fight their case
On 20 March, the Internal Revenue Service (IRS) named micro captives on their ‘Dirty Dozen’ list of tax scams for the fourth consecutive year. The much-anticipated move is a continuation of the IRS’s campaign to put a stop to the micro captives that are abusing the 831(b) tax election and are set up purely for tax purposes.
A landmark moment in the IRS’s campaign came with the Avrahami verdict in August 2017 and the court’s ruling continues to influence the captive industry. We spoke to Vivian Hoard, partner at Taylor English, about her thoughts on the post-Avrahami micro captive market and whether the good captives caught up in IRS audit campaign should stand up to their accusers.
What impact will micro captives featuring on the IRS’s ‘Dirty Dozen’ list have on the captive industry?
Vivian Hoard: It shouldn’t have any impact on the legitimate micro captive market at all. Micro captives are legal and perfectly appropriate. The government is trying to get at transactions that are tax motivated rather than insurance motivated.
What happened when all this started was tax professionals were doing and promoting these transactions without the assistance of insurance professionals, so, there wasn’t risk shifting or risk distribution, or insurance in the general sense. It is those types of micro captive transactions that the IRS is targeting. It is the inappropriate micro captives that should be worried. The legitimate micro captive market shouldn’t be too concerned, however, some of them will get caught by the IRS in audits and they’re going to have to defend against those audits even if they are legitimate.
I don’t see the market slowing down post-Avrahami. People who are doing the transactions, if they think they’re doing them appropriately aren’t going to slow down at all. It may slow down the tax driven promoters and that is the goal, that’s what the IRS is hoping for.
What are the key things micro captives can learn from the Avrahami verdict?
What people need to realise is that a micro captive is an insurance company. It has to act like an insurance company and really be insurance in the legal sense that we understand it. There needs to be risk shifting, risk distribution and a real risk that should be actuarially calculated and I think if they do all of that and they are appropriately insuring a legitimate risk then they should be fine.
If the premium is comparable to a market premium then there shouldn’t be any problem with insuring your own risk and being incentivised to manage your own risk.
Everybody seems to be very worried about the post-Avrahami market and even legitimate captive managers are a little bit worried because they know some of them are going to get caught up in the IRS web of audits.
But I don’t think anyone who is really using micro captives for legitimate insurance needs the way they should be done has much cause for concern because Congress increased the deductible amount from $1.2 million to $2.2 million recently so they’re sending the message that it is a legitimate form of managing risk if it is done appropriately and the IRS is just trying to go after the people who are abusing it and using it as a tax shelter.
Is there anything good micro captives can do to avoid being caught up in IRS audits?
There will be legitimate micro captives that get caught up in audits. Since this is a campaign audit, people at the lower level of the audit process will lose discretion. Since it is a coordinated issue one group of people decide the cases and these cases move up through that coordinated structure. Sometimes the IRS won’t figure out that a legitimate captive is legitimate until everyone is on the courthouse steps or until a judge decides. Unfortunately people are going to get caught in that process.
How effective will the IRS campaign against bad micro captives be? Will we see a reduction in the numbers set up for tax purposes?
No, not until we see more IRS activity. My understanding is there is several criminal cases out there brewing.
What the IRS sometimes does is find one particular person that is behaving in an egregious manner, they will try to prosecute them and then they will publicise that prosecution because they don’t have the funds to deal with everyone and once they prosecute that one person it is theoretically supposed to scare other people into compliance. So, I think we might see some more criminal cases.
Can you see the IRS shifting their focus to the larger captive market anytime soon?
No, I don’t see that happening. The IRS is looking for people misusing the 831(b) tax election. If you make the election you can deduct up to $2.2 million in premiums so the business can pay for premiums to their own micro captives and deduct up to $2.2 million. The micro captive takes that $2.2 million and they don’t have to pay tax on the receipt of the premium, they just have to pay tax on the investment income. So a lot of tax professionals were setting up these micro captives and there was actually no risk involved. They didn’t have risk distribution or shifting, they were just setting aside some money they can deduct from one company and put it in another company. Those are the kind of transactions the government is after, where no claims are going to be made and they’re just saving up money in a tax advantageous way in another company that they will dissolve down the road, pocket it and save tax on the $2.2 million. It is that kind of transaction that the government is trying to target.
People are buying terrorism insurance—do you really spend $2.2 million in terrorism insurance? No, nobody is going to pay that. That is what the IRS is going after, they’re not going after legitimate transactions although legitimate transactions are going to get caught in the mix.
Is it important that legitimate micro captives stand up to the IRS and fight their case?
Absolutely legitimate small captives need to fight the IRS. Absolutely they need to go to trial. Don’t roll over and play dead.
There are two ways taxpayers can handle the dispute. They can litigate in tax court, which you don’t have to pay the tax if you litigate in tax court, or they can pay the tax in dispute and sue for a refund in district court. If you’re not guilty and you haven’t done anything wrong you need to fight it. You will get a fair trial in the United States tax court and you will get a fair trial in a district court, but, no you should not pay something you do not owe.
They all need to fight their cases. If they’re a good captive and they get caught up in this they definitely need to litigate, they do not need to roll over. You can litigate cost effectively in either forum. Definitely, anyone who doesn’t owe tax needs to fight it. Go and get a fair trial.
Do you think the more legitimate captives that fight the IRS, win and set a precedent, the less colateral of good micro captives that are likely to get caught up?
Yes. The IRS doesn’t like to pursue a case unless they think they can win it. I’m not a big fan of these campaign audits because they have this one size fits all approach, and it doesn’t work. When the IRS lose several of these then they will decide they need to be a bit more selective and analyse their cases better and that’s what happens.
When you try a case in tax court, at the end of the trial you brief a case and then it might be two years later before the judge issues an opinion but you get immediate gratification in district court with a jury.
