Business Owners in
419, 412i, Section 79 and Captive Insurance Plans Will Probably Be Fined by the
IRS Under Section 6707A
by Lance
Wallach
Taxpayers who
previously adopted 419, 412i, captive insurance or Section 79 plans are in big
trouble. In recent years, the IRS has identified many of these arrangements as
abusive devices to funnel tax deductible dollars to shareholders and classified
these arrangements as “listed transactions.” These plans were sold by insurance
agents, financial planners, accountants and attorneys seeking large life
insurance commissions. In general, taxpayers who engage in a “listed
transaction” must report such transaction to the IRS on Form 8886 every year
that they “participate” in the transaction, and the taxpayer does not
necessarily have to make a contribution or claim a tax deduction to be deemed
to participate. Section 6707A of the Code imposes severe penalties ($200,000
for a business and $100,000 for an individual) for failure to file Form 8886
with respect to a listed transaction. But a taxpayer can also be in trouble if
they file incorrectly. I have received numerous phone calls from business
owners who filed and still got fined. Not only does
the taxpayer have to
file Form 8886, but it has to be prepared correctly. I only know of two people
in the United States who have filed these forms properly for clients. They told
me that the form was prepared after hundreds of hours of research and over
fifty phones calls to various IRS personnel. The filing instructions for Form
8886 presume a timely filing. Most people file late and follow the directions
for currently preparing the forms. Then the IRS fines the business owner. The
tax court does not have
jurisdiction to
abate or lower such penalties imposed by the IRS.
Many business owners
adopted 412i, 419, captive insurance and Section 79 plans based upon
representations provided by insurance professionals that the plans were
legitimate plans and
they were not
informed that they were engaging in a listed transaction. Upon audit, these
taxpayers were shocked when the IRS asserted penalties under Section 6707A of
the Code in the hundreds
of thousands of
dollars. Numerous complaints from these taxpayers caused Congress to impose a
moratorium on assessment of Section 6707A penalties.
The moratorium on
IRS fines expired on June 1, 2010. The IRS immediately started sending out
notices proposing the imposition of Section 6707A penalties along with requests
for lengthy extensions of the Statute of Limitations for the purpose of
assessing tax. Many of these taxpayers stopped taking deductions for
contributions to these plans years ago, and are confused and upset by the IRS’s
inquiry, especially when the taxpayer had previously reached a monetary settlement
with the IRS regarding the deductions
taken in prior
years. Logic and common sense dictate that a penalty should not apply if the
taxpayer no longer benefits from the arrangement.
Treas. Reg. Sec.
1.6011-4(c)(3)(i) provides that a taxpayer has participated in a listed
transaction if the taxpayer’s tax return reflects tax consequences or a tax
strategy described in the published guidance identifying the transaction as a
listed transaction or a transaction that is the same or substantially
similar to a listed
transaction. Clearly, the primary benefit in the participation of these plans
is the large tax deduction generated by such participation. It follows that
taxpayers who no longer enjoy the benefit of those large deductions are no
longer “participating” in the listed transaction.
But that is not the
end of the story. Many taxpayers who are no longer taking current tax
deductions for these plans continue to enjoy the benefit of previous tax
deductions by continuing the deferral of income from contributions and
deductions taken in prior years. While the regulations do not expand on what
constitutes “reflecting the tax consequences of the strategy,” it could be
argued that continued benefit from a tax deferral for a previous tax deduction
is within the contemplation of a “tax consequence” of the plan strategy. Also,
many taxpayers who no longer make contributions or claim tax deductions
continue to pay administrative fees. Sometimes, money is taken from the plan to
pay premiums to keep life insurance policies in force. In these ways, it could
be argued that these taxpayers are still “contributing,” and thus still must
file Form 8886.
It is clear that the
extent to which a taxpayer benefits from the transaction depends on the purpose
of a particular transaction as described in the published guidance that caused
such transaction to be a listed transaction. Revenue Ruling 2004-20, which
classifies 419(e) transactions, appears to be concerned with the employer’s
contribution/deduction amount rather than the continued deferral of the income
in previous years. This language may provide the taxpayer with a solid argument
in the event of an audit.
Lance Wallach,
National Society of Accountants Speaker of the Year and member of the AICPA
faculty of teaching professionals, is a frequent speaker on retirement plans,
financial and estate planning, and abusive tax shelters. He writes about
412(i), 419, and captive insurance plans; speaks at more than ten conventions
annually; writes for over fifty publications; is quoted regularly in the press;
and has been featured on TV and radio financial talk shows. Lance has written
numerous books including Protecting Clients from Fraud, Incompetence and
Scams (John
Wiley and Sons), Bisk Education’s CPA’s Guide to Life Insurance and Federal
Estate and Gift Taxation, as well as AICPA best-selling books including Avoiding Circular 230
Malpractice Traps and
Common
Abusive Small Business Hot Spots. He does expert witness testimony and has
never lost a case. Contact him at 516.938.5007, wallachinc@gmail.com or
visit www.taxadvisorexperts.org or www.taxlibrary.us.
The information
provided herein is not intended as legal, accounting, financial or any other
type of advice for any specific individual or other entity. You should contact
an appropriate professional for any such advice.
WASHINGTON – For the third consecutive year, the IRS places abusive micro-captive insurance tax shelters on its list of “Dirty Dozen” tax scams. The list, compiled annually, describes a variety of common scams that taxpayers may encounter. Many of these schemes peak during filing season as people prepare their returns or hire others to help them.
ReplyDelete“Taxpayers should avoid unscrupulous promoters who encourage the use of phony tax shelters designed to avoid paying what is owed,” said IRS Commissioner John Koskinen. “These scams can end up costing taxpayers more in penalties, back taxes and interest than they saved in the first place.”
The IRS continues to address those using abusive shelters through audits, litigation, published guidance and legislation.
Tax law generally allows businesses to create “captive” insurance companies to protect against certain risks. Traditional captive insurance typically allows a taxpayer to reduce insurance costs. The insured business claims deductions for premiums paid for insurance policies. Those amounts are paid, either as insurance premiums or reinsurance premiums, to a “captive” insurance company owned by the insured or parties related to the insured.
Under section 831(b) of the tax code, captive insurers that qualify as small insurance companies can elect to exclude limited amounts of annual net premiums from income, so that the captive pays tax only on its investment income.
In abusive “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 genuine insurance. For example, coverages may insure implausible risks, fail to match genuine business needs or duplicate the taxpayer’s commercial coverages. Premium amounts may be unsupported by underwriting or actuarial analysis, may be geared to a desired deduction amount or may be significantly higher than premiums for comparable commercial coverage.
Policies may contain vague, ambiguous or deceptive terms and otherwise fail to meet industry or regulatory standards. Claims administration processes may be insufficient or altogether absent. Insureds may fail to file claims that are seemingly covered by the captive insurance.
Captives may invest in illiquid or speculative assets or loan or otherwise transfer capital to or for the benefit of the insured, the captive’s owners or other related persons or entities. Captives may also be formed to advance inter-generational wealth transfer objectives and avoid estate and gift taxes. Promoters, reinsurers and captive insurance managers may share common ownership interests that result in conflicts of interest.
In Notice 2016-66 (Nov. 1, 2016), the IRS advised that micro-captive insurance transactions have the potential for tax avoidance or evasion. The notice designated transactions that are the same as or substantially similar to transactions that are described in the notice as “Transactions of Interest.” The notice established reporting requirements for those entering into such transactions on or after Nov. 2, 2006, and created disclosure and list maintenance obligations for material advisors.
Congress has also acted to curb micro-captive abuses. The Protecting Americans from Tax Hikes (PATH) Act, effective Jan. 1, 2017, established diversification and reporting requirements for new and existing captives.