Most folks think of tax season being that period shortly before April 15 and ending on that date. Actually, that is tax return season. The true tax season usually begins on October 15 of each year after the late individual returns are filed. This is when folks who are looking to have a financially good year start thinking about reducing the taxes they will have to pay in April. Tax professionals will start meeting with clients to talk about their businesses and how things are looking for the end of the year. Most of the time, this will result in relatively mundane decisions, such as plans to take certain depreciation allowances or make contributions to some kind of plan. But for some clients, the mundane just will not be enough and they will start looking for some tax shelter to reduce their tax burden. Thus, if you were to characterize the period between October 16 and December 31 as tax shelter season that would be pretty close to the truth.
Captive insurance is one of those things that frequently gets late-season discussion, such that November and December are commonly considered to be captive season. I don’t know the statistics these days, but a decade or so ago the data put out by the state insurance commissioners showed that approximately 90% of the captives made applications late in the year. This does not mean that all these captives were tax shelters: Even if a company were going to form a completely legitimate captive without a desire to save taxes, it would probably wait until the end of the year to see what its financials looked like for purposes of supplying capital to the new captive. But a goodly number of these late-season captives are indeed captive tax shelters, which are captive arrangements formed with the primary purpose to defer or avoid taxes and with risk management (the true sine qua non of a captive) being given at best secondary consideration.
Now, one might think that with all the IRS activity in dealing with the microcaptive tax shelter, and four U.S. Tax Court cases where microcaptive tax shelters were eviscerated in historic fashion would convince folks that captive tax shelters are dead and they should look for something else. Makes perfect sense, but it doesn’t comport with reality. Even after everything that has gone on with microcaptive tax shelters, they continue to be sold. Sometimes the deal has slightly changed to try to avoid the IRS’s radar screen, but the core shelter aspects are the same: Take a tax deduction for insurance payments, defer taxes on the payments in the captive, and just give lip service to the ostensible insurance purposes of the captive.
This season, there are at least four varietals of captive tax shelters still being marketed to taxpayers.
Classic microcaptive shelters. These are the very same risk-pooled captives that have made the 831(b) election of the type which have lost all four U.S. Tax Court cases. Filing tax returns based on transactions involving a microcaptive shelter is nothing more or less than a fast-track to penalties, but promoters keep selling them and folks keep buying them. Recalls Einstein’s comment about repeating the same experiment and expecting a different result.
Series microcaptive shelters. A series microcaptive is basically the poor man’s microcaptive where the taxpayer doesn’t get their own standalone captive, but instead shares a captive arrangement with others through a Series LLC structure. There is no separate risk pool, but instead either Series 1 or Series A or something similar acts as the risk pool. These deals are even worse from a tax perspective than standard microcaptives because they generally have backdoors built in so that the taxpayer makes good the organization of the whole for any significant losses, i.e., there just isn’t any risk distribution present. Another fast-track to penalties.
Puerto Rico captive shelters. This is a variant of microcaptive shelters where, usually, the operating business of a taxpayer makes an insurance payment to a large insurance company set up for this purpose and owned by some third-person, and then the money is either held in the insurance company under some arrangement or transferred to the client’s reinsurance captive, with the idea that ultimately the client will take the money in Puerto Rico under that territory’s lower tax rates. Sounds good at first glance, but there’s really no insurance going on in the tax sense, plus to take advantage of Puerto Rico’s favorable tax rates, one has to actually live in Puerto Rico. Good luck with that strategy.
PPLI-related captive shelters. There are many variations of this scheme, but the basic idea is that a taxpayer’s operating business pays premiums indirectly through a fronting company to a captive that is owned by the taxpayer’s private-placement life insurance policy (known as a PPLI policy). Because the cash value of a PPLI policy is not taxed, any distributions taken by the captive are not taxed, and yet the owner of the PPLI policy can get the cash by borrowing against the cash value. In other words, the taxpayer gets a deduction for the insurance premium paid by his operating business, and then never pays tax on that money. Too good to be true? Yes. The main problem is the same as with all the aforementioned captive shelters, being that the insurance sold to the taxpayer’s operating business is not insurance in the first place and so therefore is not entitled to any deduction.
The bottom line is this: The IRS has significantly slowed the sales of microcaptive and psuedo-microcaptive tax shelters, but nothing like stopped those sales. To the contrary, there seems to be (anecdotally) a slight rebound of the sales of these shelters. Further, much of the infrastructure that supports microcaptive shelters is still vibrant, meaning actuaries who will pull risk numbers out of the air, captive managers who continue to run risk pools and manage Series LLC structures, and state and offshore insurance regulators who are all too willing to cooperate in the licensing of sham captives so long as they can report better numbers to their state legislatures for budgeting purposes. The IRS designating microcaptive shelters as “transactions of interest” has resulted in decidedly mixed results. It’s time for stronger medicine.
The problem with captive tax shelters is that they look, feel and taste much like completely legitimate captive arrangements. But that’s what tax shelters do, which is to attempt to pass by hidden in the shadow of real transactions. So how does a business owner who really needs a legitimate captive for risk management purposes distinguish a real captive from a captive shelter?
As always, the best way to avoid getting into any abusive tax shelter is to seek a independent opinion by a qualified tax professional, and one that you have found yourself and was not recommended by the promoters of the transaction (who, of course, will always recommend a friendly tax professional to give it a rubber-stamp of approval no matter how bad it is). It is a bright red flag when a promoter of any tax deal requires the signing of a confidentiality or secrecy agreement that prevents such review. Another bright red flag is when somebody says, “Your own tax professional will never understand this.” Remember: If a deal is legitimate, there will be consensus among tax professionals that it is legitimate.
But if there is no such consensus, run.
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