Each year the IRS publishes a list of common tax scams that taxpayers may encounter during the tax year. These annual lists serve as a way for the IRS to remind taxpayers to use caution during the tax season to protect themselves against a wide range of schemes. This year’s list includes abusive tax structures, specifically mentioning misuse of trusts and captive insurance schemes.
Abusive tax structures is a staple of the “Dirty Dozen” list and generally includes any structure that is created to conceal the true nature and ownership of taxable income and/or assets. These structures range from simple structuring of abusive domestic and foreign trust arrangements to strategies which take advantage of financial secrecy laws of some foreign jurisdictions. IRS Criminal Investigation has a nationally coordinated program to combat abusive tax structures, which focuses on the identification and investigation of the tax scheme promoters as well as those who play an integral role in facilitating, aiding, assisting, or furthering the abusive tax scheme. The IRS states that taxpayers should be on the lookout for tax products that are too good to be true, especially where there is a claim of eliminating or substantially reducing your tax liability. Some things to watch out for are unnecessary steps in transaction and where the form of the transaction does not match the substance of the transaction.
The IRS highlighted abusive captive insurance schemes as an abusive tax structure this year. Captive insurance companies can and often do serve a legitimate business purpose, a seeming tide of unscrupulous promoters have been abusing the provisions that make these captives feasible. These promoters often market these captives as bringing something that has long been used by large companies to manage risk and reduce their tax burden to taxpayers of all size. It has been well established that businesses are able to create captive insurance companies to insure against certain risks. The insured operating business claims deductions for premiums paid for the insurance policies with the captive insurance company owned by the same owners of the insured. The tax benefit for this scheme comes from section 831(b), which allows for small insurance companies, whose premium income does not exceed $1.2 million, to elect to be taxed on only the investment income from the pool of premiums. This functionally allows for the exclusion of up to $1.2 million per year in net written premiums from taxable income by the group of companies. However, in order to receive the tax benefits the operating business must pay premiums to an actual insurance company for insurance. The framework for what constitutes insurance requires that there be (1) risk shifting, (2) risk distribution, (3) insurance risk; and (4) whether the arrangement meets commonly accepted notions of insurance.
A number of unscrupulous promoters market this scheme to closely held businesses and assist these entities in creating captive insurance companies onshore or offshore, drafting organizational documents, and preparing initial filings to state insurance authorities and the IRS. These promoters often attempt to match the premiums to the amount of income that the business owner would like to shelter from tax, up to $1.2 million, rather than price the premiums according to the actual risk of loss that is being insured. The promoters often times poorly drafted “insurance” binders and policies to cover ordinary business risks or esoteric, implausible risks for exorbitant “premiums,” often leaving the operating business’s commercial coverage with traditional insurers largely, if not entirely, unchanged. This leads to no real shifting of insurance risks, two requirements for insurance for Federal income tax purposes, from the insured operating business to the captive insurance company.
Unscrupulous promoters find new products to promote as the old products are determined to be abusive by the IRS and the courts. As such, we expect that the IRS will continue to pursue unscrupulous promoters and the latest trends in abusive tax structures. If you have knowledge of an abusive tax structure, contact The Ferraro Law Firm to discuss filing a claim for an award for providing this information to the IRS.