By Lance Wallach May 14th
Every accountant knows that increased cash flow and cost savings are critical for businesses. What is uncertain is the best path to recommend to garner these benefits.
Over the past decade business owners have been overwhelmed by a plethora of choices designed to reduce the cost of providing employee benefits while increasing their own retirement savings. The solutions ranged from traditional pension and profit sharing plans to more advanced strategies.
Some strategies, such as IRS section 419 and 412(i) plans, used life insurance as vehicles to bring about benefits. Unfortunately, the high life insurance commissions (often 90% of the contribution, or more) fostered an environment that led to aggressive and noncompliant plans.
The result has been thousands of audits and an IRS task force seeking out tax shelter promotion. For unknowing clients, the tax consequences are enormous. For their accountant advisors, the liability may be equally extreme.
Recently, there has been an explosion in the marketing of a financial product called Captive Insurance. These so called “Captives” are typically small insurance companies designed to insure the risks of an individual business under IRS code section 831(b). When properly designed, a business can make tax-deductible premium payments to a related-party insurance company. Depending on circumstances, underwriting profits, if any, can be paid out to the owners as dividends, and profits from liquidation of the company may be taxed as capital gains.
While captives can be a great cost saving tool, they also are expensive to build and manage. Also, captives are allowed to garner tax benefits because they operate as real insurance companies. Advisors and business owners who misuse captives or market them as estate planning tools, asset protection vehicles, tax deferral or other benefits not related to the true business purpose of an insurance company face grave regulatory and tax consequences.
A recent concern is the integration of small captives with life insurance policies. Small captives under section 831(b) have no statutory authority to deduct life premiums. Also, if a small captive uses life insurance as an investment, the cash value of the life policy can be taxable at corporate rates, and then will be taxable again when distributed. The consequence of this double taxation is to devastate the efficacy of the life insurance, and it extends serious liability to any accountant who recommends the plan or even signs the tax return of the business that pays premiums to the captive.
Over the past decade business owners have been overwhelmed by a plethora of choices designed to reduce the cost of providing employee benefits while increasing their own retirement savings. The solutions ranged from traditional pension and profit sharing plans to more advanced strategies.
Some strategies, such as IRS section 419 and 412(i) plans, used life insurance as vehicles to bring about benefits. Unfortunately, the high life insurance commissions (often 90% of the contribution, or more) fostered an environment that led to aggressive and noncompliant plans.
The result has been thousands of audits and an IRS task force seeking out tax shelter promotion. For unknowing clients, the tax consequences are enormous. For their accountant advisors, the liability may be equally extreme.
Recently, there has been an explosion in the marketing of a financial product called Captive Insurance. These so called “Captives” are typically small insurance companies designed to insure the risks of an individual business under IRS code section 831(b). When properly designed, a business can make tax-deductible premium payments to a related-party insurance company. Depending on circumstances, underwriting profits, if any, can be paid out to the owners as dividends, and profits from liquidation of the company may be taxed as capital gains.
While captives can be a great cost saving tool, they also are expensive to build and manage. Also, captives are allowed to garner tax benefits because they operate as real insurance companies. Advisors and business owners who misuse captives or market them as estate planning tools, asset protection vehicles, tax deferral or other benefits not related to the true business purpose of an insurance company face grave regulatory and tax consequences.
A recent concern is the integration of small captives with life insurance policies. Small captives under section 831(b) have no statutory authority to deduct life premiums. Also, if a small captive uses life insurance as an investment, the cash value of the life policy can be taxable at corporate rates, and then will be taxable again when distributed. The consequence of this double taxation is to devastate the efficacy of the life insurance, and it extends serious liability to any accountant who recommends the plan or even signs the tax return of the business that pays premiums to the captive.
The IRS is aware that several large insurance companies are promoting their life insurance policies as investments with small captives. The outcome looks eerily like that of the 419 and 412(i) plans mentioned above.
Remember, if something looks too good to be true, it usually is. There are safe and conservative ways to use captive insurance structures to lower costs and obtain benefits for businesses. And, some types of captive insurance products do have statutory protection for deducting life insurance premiums (although not 831(b) captives). Learning what works and is safe is the first step an accountant should take in helping his or her clients use these powerful, but highly technical insurance tools.
Lance Wallach speaks and writes extensively about VEBAs, retirement plans, and tax reduction strategies. He speaks at more than 70 conventions annually, writes for 50 publications, and was the National Society of Accountants Speaker of the Year. Contact him at 516.938.5007 or visit www.vebaplan.com.
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.
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IRS Targeting Offshore Captive Insurance Companies And Merchant Accounts
ReplyDeleteI enjoy speaking to dental groups across the country. It’s nice to meet interesting doctors, and even more entertaining to hear their stories, particularly about the latest tax avoidance/evasion scams making the rounds.
We’ve helped extricate dozens of doctors from various tax shelter scams over the past decade. Offshore employee leasing arrangements, Section 419 welfare benefit plans, Voluntary Employee Beneficiary Associations (VEBAs) are some of the abusive tax shelters which were…
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DeleteBefore I would jump into a captive I would have a client read klaas v commissioner us tax court 2009. For those interested you may find the case on the us tax court website.. go to opinion search and type in captive. Granted in klaas the taxpayer lost before the sham and step transaction were discussed,however it is clear our friends at the service are awaiting the next victim. The taxpayer escaped the 6663 fraud penalty but was hit with the 6662a penalty. However captives are beyond the discussion of this thread...but you happened to mention them. Reply »
ReplyDeleteRoccy Defrancesco By Roccy DeFrancesco on Wed, 27th Feb 2013, 9:16 am
I’ve read the Klass opinion and I’m not sure why anyone would use that case in connection with a useful discussion about captive insurance companies. Klass is an overtly abusive case where the client jumped through several hoops with tax avoidance as his initial and sole purpose. It has no similarities to the proper and traditional use of small CICs and to use it as a negative example is misplaced. Additionally, Klass uses a 501(c)15 CIC which really are no longer viable tools after the last law change (now 831(b) CICs are the tool of choice).
www.taxaudit419.com for a lot more
ReplyDeleteBefore I would jump into a captive I would have a client read klaas v commissioner us tax court 2009. For those interested you may find the case on the us tax court website.. go to opinion search and type in captive. Granted in klaas the taxpayer lost before the sham and step transaction were discussed,however it is clear our friends at the service are awaiting the next victim. The taxpayer escaped the 6663 fraud penalty but was hit with the 6662a penalty. However captives are beyond the discussion of this thread...but you happened to mention them. Reply »
Roccy Defrancesco By Roccy DeFrancesco on Wed, 27th Feb 2013, 9:16 am
I’ve read the Klass opinion and I’m not sure why anyone would use that case in connection with a useful discussion about captive insurance companies. Klass is an overtly abusive case where the client jumped through several hoops with tax avoidance as his initial and sole purpose. It has no similarities to the proper and traditional use of small CICs and to use it as a negative example is misplaced. Additionally, Klass uses a 501(c)15 CIC which really are no longer viable tools after the last law change (now 831(b) CICs are the tool of choice).
IRS Targets New Scheme In Employment Plan Arena – Captive Management Companies
ReplyDeleteBy Brian M
People think that accountants and tax lawyers lead boring lives. Perhaps that may be true for some, but there is plenty of action these days with the IRS and their Employment Plans tax group. Recently, the IRS identified an “emerging issue” that it calls a potential Abusive Tax Avoidance Transaction. If you are a small business with an employment benefit plan, those words are never good to hear.
According to an internal IRS training document we recently obtained, the IRS is now targeting for audit small and medium sized businesses that created their own separate management companies. While creating a separate company to provide management services is legal, the IRS wants to make sure there is a legitimate business reason for doing so. The IRS is actively examining (auditing) businesses that are funneling large sums of money from the operating company to the management company and thus insuring the operating company pays little or no taxes. By transferring funds to the management company, the business strips away much of the income from operations.
Once the money is in the management company, the owners create a defined benefit plan that benefits only the owners and none of the rank and file workers.
Accountants and business owners with these set ups should expect an audit. While there are many valid business reasons to create captive management companies, those with well funded defined benefit plans that only benefit the owner should expect a knock on the door from the IRS and some high penalties as well.
Recently the IRS has been focusing a great deal of audit resources within the employment plan area. In addition to the management company issue, IRS continues to look for noncompliant 412 and 419 plans, often called “welfare benefit plans” or similar names. These are considered reportable transactions and many are abusive tax shelters. The penalties for these plans can be $100,000 to $200,000 per year!
Plans set up by Internet and outside promoters often look slick but are often fraught with problems. We have seen some marketing materials replete with supposed IRS opinion letters and legal opinions. Before you sign the dotted line, have the plan reviewed by a tax attorney or experienced CPA. (Some CPAs and lawyers have even been duped by these plans – if you lose an audit and relied on professional advice in purchasing a plan, you may have a professional malpractice claim.)
The above article is not mine, but I agree with a lot of it. If you have or are looking at a captive you must watch out. Many will be audited by IRS. We have received lots of phone calls about this. For more give us a call or Google Lance Wallach.
Lance Wallach, CLU, ChFC, CIMC, speaks and writes extensively about financial planning, retirement plans, and tax reduction strategies. He is an American Institute of CPA’s course developer and instructor and has authored numerous best selling books about abusive tax shelters, IRS crackdowns and attacks and other tax matters. He speaks at more than 20 national conventions annually and writes for more than 50 national publications. For more information and additional articles on these subjects, visit www.vebaplan.com, www.taxlibrary.us, lawyer4audits.com or call 516-938-5007.
The information provided herein is not intended as legal, accounting, financial or any type of advice for any specific individual or other entity. You should contact an appropriate professional for any such advice.
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