IRC 831(b) Micro-Captives After the PATH Act: Meeting New - - PowerPoint PPT Presentation

The audio portion of the conference may be accessed via the telephone or by using your computer's

• speakers. Please refer to the instructions emailed to registrants for additional information. If you

have any questions, please contact Customer Service at 1-800-926-7926 ext. 10. NOTE: If you are seeking CPE credit, you must listen via your computer — phone listening is no longer permitted.

IRC 831(b) Micro-Captives After the PATH Act: Meeting New Diversification Requirements and Avoiding IRS Scrutiny

Today’s faculty features:

1pm Eastern | 12pm Central | 11am Mountain | 10am Pacific TUESDAY, JUNE 21, 2016

Presenting a live 90-minute webinar with interactive Q&A F . Hale Stewart, Owner , The Law Office of Hale Stewart, Houston

Tips for Optimal Quality

Sound Quality If you are listening via your computer speakers, please note that the quality

• f your sound will vary depending on the speed and quality of your internet connection.

If the sound quality is not satisfactory, you may listen via the phone: dial

1-866-328-9525 and enter your PIN when prompted. Otherwise, please

send us a chat or e-mail sound@straffordpub.com immediately so we can address the problem. If you dialed in and have any difficulties during the call, press *0 for assistance. NOTE: If you are seeking CPE credit, you must listen via your computer — phone listening is no longer permitted. Viewing Quality To maximize your screen, press the F11 key on your keyboard. To exit full screen, press the F11 key again.

FOR LIVE EVENT ONLY

Continuing Education Credits

In order for us to process your continuing education credit, you must confirm your participation in this webinar by completing and submitting the Attendance Affirmation/Evaluation after the webinar. A link to the Attendance Affirmation/Evaluation will be in the thank you email that you will receive immediately following the program. For CPE credits, attendees must participate until the end of the Q&A session and respond to five prompts during the program plus a single verification code. In addition, you must confirm your participation by completing and submitting an Attendance Affirmation/Evaluation after the webinar and include the final verification code on the Affirmation of Attendance portion of the form. For additional information about continuing education, call us at 1-800-926-7926 ext. 35.

FOR LIVE EVENT ONLY

Program Outline

• Recent Cases
• Securitas
• Rent-a-Center
• RVI
• Legislative Changes
• Dirty dozen listing and business purpose
• Anti-avoidance law
• Substance over form
• Economic Substance
• IRS broad enforcement capabilities.

4

Rent A Center

• Captive formed late 2002
• Needed Deferred Tax Asset (DTA) to meet minimum

capital requirement

• DTA needed a parental guarantee
• One parental guarantee in 2002-2003
• Different guarantee in 2004-2006

5

Securitas

• Foreign parent (FP) owns
• U.S. holding company (HC)
• Irish Reinsurer (IR)
• HC owned Vermont Captive (VC) & a tax exempt

501(c)(15)

• VC ceded 100% of risk to IR
• HC guaranteed of VC’s obligations

6

RVI PROCEDURAL BACKGROUND

• Taxpayer issued “residual value

insurance” policies – which insured against the risk that the value of the asset at the end of a lease would be lower than the expected value

• IRS concluded that RVI’s policies were

not insurance for tax purposes (primarily) because the insureds were purchasing protection against an investment risk, not an insurance risk

7

RVI FACT CTUAL BACKGROUND

• Insureds included leasing companies,

manufacturers, and financial institutions (lessors of assets, or providers of lease financing)

• Assets (risk units) included passenger

vehicles, commercial real estate, commercial equipment (over 2 million in total)

• Policies included standard terminology and

policy provisions adapted for this line of coverage

• Taxpayer paid significant claims

8

RVI CT CTUAL BACKGROUND

• Bermuda mono-line commercial

insurer electing onshore tax treatment under IRC §953(d)

• Policies Owned fully admitted

subsidiary charted in Connecticut and admitted in most states

• Policies were treated as insurance for

state and Bermuda regulatory purposes and received excellent “insurance strength ratings” from rating agency (A.M. Best)

9

OPINION – INS INSURANCE RIS RISK

• States have regulated insurance

contracts that provide coverage against decline in the market value of assets for over 80 years

10

831(b) Legislative Changes

• Starting in 2001, the estate tax credit began

increasing.

• This forced estate planning attorneys to broaden

their offerings, leading them to start forming captives.

• Ideally, the captive would perform 2 functions: risk

mitigation and intra-generational wealth transfer.

• However, the Service was concerned that the

underlying subjective intent of these transactions was suspect, leading them to request legislative changes to the statute.

11

831(b) Legislative Changes

• Insurance company = captive
• de minimis = 2%
• specified assets = parent company
• specified holder = wife or child/children
• Using the above substitution scheme, we arrive at the following language:
• “(II) such captive does not meet the requirement of subclause (I) and no person

who holds (directly or indirectly) an interest in such captive is a wife or child who holds (directly or indirectly) aggregate interests in such captive which constitute a percentage of the entire interests in such captive which is more than 2% percentage higher than the percentage of interests in the parent company with respect to such captive held (directly or indirectly) by such wife or child

• While the language is still confusing, we can distill the section’s intent down to

the following sentence: If the lineal descendants’ or wives captive ownership is greater than 2% of their ownership of the parent company, then the captive can’t make an IRC 831(b) election.

12

831(b) Legislative Changes

• 1.) Father owns 100% of the parent company and captive. The captive

can make the 831(b) election because no lineal descendants own the captive.

• 2.) Father owns’ 100% of the parent company; child/children/wives

directly own 100% of the captive. The captive can’t make the IRC 831(b) election; the lineal descendant’s captive interest is greater than 2% of their interest in the parent company.

• 3.) Father owns’ 100% of the parent company; child/children/wives own

100% of the captive, but through a trust/family corporation. The captive can’t make an IRC 831(b) election; the statute applies to indirect and direct ownership.

• 4.) Father owns 50% of parent company and the captive;

child/children/wife directly or indirectly own 50% of the parent company and captive. The captive can make the IRC 831(b) election; lineal descendants’ own the same percentage of the captive that they do of the parent company

13

Program Outline

• Recent Cases
• Securitas
• Rent-a-Center
• RVI
• Legislative Changes
• Dirty dozen listing and business purpose
• Anti-avoidance law
• Substance over form
• Economic Substance
• IRS broad enforcement capabilities.

14

Recent Dirty Dozen Listing

• From the DD listing: In the abusive structure, unscrupulous

promoters, accountants, or wealth planners persuade the

• wners of closely held entities to participate in these

schemes.

• “abusive structure:” this implies there’s a non-abusive

structure

• “Accountants and wealth planners:” specifically mentioning
• professions. The implication is they are NOT in the

insurance industry

• “Persuade the owners:” there’s an outward effort to sell or

market this idea

• “closely held entities:” family companies
• “scheme:” negative connotation; usually used with the

adjective “Ponzi”

15

The Business Purpose Test

• To show business purpose, we need to document:
• there is a genuine multiple-party transaction
• with economic substance that is
• compelled or encouraged by business or regulatory

realities,

• that is imbued with tax-independent considerations, and
• that is not shaped solely by tax-avoidance features to

which meaningless labels are attached.

• Frank Lyon Co. v. United States, 435 U.S. 561 (U.S. 1978)

16

Captive Visions Article

• Let us begin with a CPA who is intimately involved with a client. He maintains

the client’s daily records and advises the client throughout the fiscal year on larger, more complex tax matters. During his regular third quarter client meeting, he notes, “Mr. Client, after taking all appropriate deductions and projecting your receipts through the end of the fiscal year, it appears you will have final net income of $500,000.” His next statement is potentially problematic, when he notes, “Have you considered forming a captive insurance company?” The CPA is not intentionally placing the client in legal jeopardy. However, should the client form a captive based on this recommendation, the Service could argue the taxpayer’s subjective intent was to lower taxes, not mitigate risk.

• Now consider a client visiting an estate-planning lawyer for the first time. The

attorney first asks the potential client about his family and then broadly discusses probate and non-probate transfers. He mentions trusts and discusses various charitable planning options. Then, the attorney asks, “have you ever heard of a captive insurance company?” Like the CPA, the attorney doesn’t intend to place the client in jeopardy. However, the Service could potentially argue that a captive formed on this fact pattern wasn’t incorporated to underwrite risk, but instead to pass wealth to the owner’s children.

• CAPTIVE INSURANCE COMPANIES & THE BUSINESS PURPOSE DOCTRINE

17

Three key questions.

• Ask to see insurance policies
• What keeps you up at night?
• Relate a story about a recent risk

18

Captive Insurance and Market Failure

• Starting in the 1950s, certain businesses either couldn’t find insurance,
• r could only find very expensive insurance.
• Flood Cases
• Oil and Gas
• Large Contractors (Stearns Rogers)
• Hospitals (Humana)
• In the 1970s, the US insurance industry was sued under four causes of

action

• Asbestos
• Professional Liability (Med Mal)
• Environmental Claims
• Products Liability
• These cases were very expensive leading to some bankruptcies and

major payouts.

• Starting in the late 1970s, the insurance industry started to greatly limit

their actual exposure, slowly eliminating expensive insurance coverage.

19

The 1980s Market Failure

• The Department of Justice issues

a report: The Causes, Extent and Policy Implications of the Current Crisis in Insurance Availability and Affordability.

• The Rise and Fall of Commercial

Liability Insurance, Kenneth Abraham

• The Current Insurance Crisis and

Modern Tort Law

• Sources of the Crisis in Liability

Insurance: An Economic Analysis

• On Liability Insurance Crisis, by

Gene Lai, et. al.

20

The Texas Mold Epidemic

• In the late 1990s, when Texas experienced a mold
• epidemic. Due to a very humid environment, Texans

use a large amount of air conditioning, which, in addition to cooling a building also de-humidifies it. The water removed from the air has to go somewhere. Unfortunately, at least some moisture winds up being trapped in the duct work. The combination of excessive moisture and Texas heat led to mold colonies growing in a large number of buildings. While some homeowners successfully sued their insurers to pay for mold remediation, the situation became too costly for some insurers, who eventually stopped writing the policy altogether.

21

How Does and Insurance Company Work?

• They have two businesses:
• Investment Management
• Claims Payment
• Insurance Companies want PREDICABILITY
• That means they don’t write stochastic (low

frequency, high payout) risk

22

All Common Insurance Policies Have Large Exemptions

• Employment Claims
• Employee Fidelity

(employee theft)

• Cyber-Risk
• Products Liability

23

Program Outline

• Recent Cases
• Securitas
• Rent-a-Center
• RVI
• Legislative Changes
• Dirty dozen listing and business purpose
• Anti-avoidance law
• Substance over form
• Business Purpose
• Economic Substance
• IRS broad enforcement capabilities.

24

What is Anti-Avoidance Law?

• Anti-avoidance law is a series of judicial doctrines

that allow the government or courts to recast a transaction if its form is different from its substance.

• The tax code provides “form” while other materials

such as treasury regulations, revenue rulings, PLRs and case law provide “substance.”

25

There are 5 Judicial Anti-Avoidance Rules

• Substance over form
• The Sham Transaction
• Business Purpose
• Economic Substance
• The Step Transaction

26

Substance Over Form

• “In these circumstances, the facts speak for

themselves and are susceptible of but one

• interpretation. The whole undertaking, though

conducted according to the terms of subdivision (B), was in fact an elaborate and devious form of conveyance masquerading as a corporate reorganization, and nothing else.….. To hold

• therwise would be to exalt artifice above reality

and to deprive the statutory provision in question

• f all serious purpose.”
• Gregory v. Helvering, 293 U.S. 465, 470 (U.S. 1935)

27

Insurance, Part 1

• For example, Section 162(a) allows

a deduction for “ordinary and necessary” expenses.

• But the treasury regulations

provide further guidance on the meaning of “ordinary and necessary,” with Treas. Reg. 1.162(a)(1) specifically mentioning P&C expenses.

• “…together with insurance premiums

against fire, storm, theft, accident, or

• ther similar losses in the case of a

business,”

28

Insurance, Part III

• Subchapter L of the tax code and

its accompanying regulations provide further guidance.

• Treas. Reg. 803-1(a)(1) The term

insurance company means a company whose primary and predominant business activity during the taxable year is the issuing of insurance or annuity contracts or the reinsuring of risks underwritten by insurance companies.

29

Insurance, Part II

• According to case law, insurance must have the

following five elements (the “substance” of the “ordinary and necessary” deduction)

• A Definite Risk
• Fortuity
• An Insurable Interest
• Risk Shifting
• Make sure you can demonstrate adequate consideration.
• Risk Distribution

30

Substance Over Form

• The facts that make up the transaction is its “form”.
• The “substance” of the transaction is what is actually

below the surface of the facts, sometimes where such facts are created solely for such substance.

• This doctrine disregards the form in favor of the true

substance to disallow the tax benefits generated by the artificial nature of the transaction.

31

IRC 831(b) Example

• IRC 162 deduction for ordinary & necessary

expenses, potentially including insurance.

• Assume a risk pool is used to create the insurance,

& risk is being kidnapped.

• An oil and gas executive who spends 6 mos in

Nigeria needs a kidnapping & ransom policy. A dentist in Boulder, Colorado does not.

• The form is the risk pool, the substance is an

unnecessary expense creating a deduction.

32

The Business Purpose Test

• To show business purpose, we need to document:
• there is a genuine multiple-party transaction
• with economic substance that is
• compelled or encouraged by business or regulatory

realities,

• that is imbued with tax-independent considerations, and
• that is not shaped solely by tax-avoidance features to

which meaningless labels are attached.

• Frank Lyon Co. v. United States, 435 U.S. 561 (U.S. 1978)

33

How Do We Tell “Real” Transactions From Tax Shelters? (1 of 2)

• Peter C. Canellos Business Purpose, Economic Substance

and Corporate Tax Shelters, 54 SMU L. Rev. 47 (2001)

• Real Transactions v. Tax Shelters
• Real transactions
• Originate In-House or from an ancillary consulting

industry

• They have a fundamental business purpose; they are

based on a desire to earn a profit, lower costs or raise capital

• Solve A Significant Problem
• Involve real parties in interest
• They are open-ended with undefined outcomes

34

How Do We Tell “Real” Transactions From Tax Shelters? (2 of 2)

• Tax Shelters
• United States Senate Committee on Government Affairs, Report on

U.S. Tax Shelter Industry: The Role of Accountants, Lawyers and Financial Professionals (November 18 and 20, 2003)

• Donald Korb, Shelters, Schemes and Abusive Transactions,

presented at the University of Cambridge December 14, 2005

• Donald Korb, Remarks at the 2005 University of Southern California

Tax Institute, January 25, 2005

• Finally
• Take a look at the Worldcom and Enron bankruptcies from the early
• 2000. While they don’t involved anti-avoidance law, they both

contain good examples of very bad behavior that should be avoided.

35

Therefore, Remember the Following Two Rules (2 of 2)

• Occam's razor (or Ockham's

razor), is the meta-theoretical principle that "entities must not be multiplied beyond necessity" (entia non sunt multiplicanda praeter necessitatem) and the conclusion thereof, that the simplest solution is usually the correct one.

36

Pre-UPS Risk Subjective Intent

• 1.) Ocean Drilling and Exploration Co. v. United States, 24 Cl. Ct. 714,

715 (1991) (‘‘Because of the limited experience in insuring the new rigs and a number of substantial losses on these rigs, insurance rates increased sharply’’);

• 2.) Kidde Industries Inc. v. United States, 40 Fed. Cl. 42 (1977) (‘‘In 1976,

in the midst of a products liability insurance crisis in which many insurance companies either ceased or significantly restricted their coverage of products liability. . . . Travelers informed Kidde that it would not renew Kidde’s products liability insurance policy for 1977’’);

• 3.) Malone and Hyde Inc. v. Commissioner, T.C. Memo. 1989-604 (‘‘By

the mid-1970s, the Hyde Insurance Agency found that insurance premiums were increasing each year and certain insurance was not

• btainable for some clients’’);

37

Pre-UPS Subjective Intent: The Humana Decision Tree

• 1. Going naked: not an option when several

successful wrongful death claims could bankrupt the company

• 2. Forming a reserve: rejected because there were

no tax benefits

• 3. Forming a group captive: this was rejected out of

concern the other participants had financial problems

• 4. Forming a captive: accepted and approved

38

Demonstrate You Business Purpose in Your Files

• Think of client files like a news story
• “Due to spiking insurance premiums, Acme

corporation, a Texas manufacturer, formed a captive insurance company in January 20XX”.”

39

Economic Substance Doctrine

• (1) Application of doctrine: In the case of any

transaction to which the economic substance doctrine is relevant, such transaction shall be treated as having economic substance only if—

• (A) the transaction changes in a meaningful way

(apart from Federal income tax effects) the taxpayer’s economic position, and

• (B) the taxpayer has a substantial purpose (apart

from Federal income tax effects) for entering into such transaction.

40

Economic Substance Doctrine

• Meaningful: “having real importance or value.”
• Substantial: “not imaginary or illusory; strongly

made.”

• Merriam-Webster online dictionary

41

The Economic Substance Doctrine

Now Codified

• Prong 1: The transaction is rationally related to a

plausible non-tax business purpose

• Prong 2: The transaction results in a meaningful

and appreciable enhancement in the net economic position of the taxpayer other than to reduce tax.

• Code: penalties as high as 75% and there is no way

to use a tax opinion to use “reasonable cause” as a defense.

42

IRC 831(b) Example Loan Backs

• Insured deducts premium paid to CIC. The insured (or its
• wner) immediately borrows significant funds back out

without paying taxes on the money.

• Rev. Rul. 2002-89, the IRS Manual, and case law indicate such

CIC loan backs are at least subject to strict scrutiny, and may be prohibited under certain circumstances.

• This issue has come up as a focus in audits.
• IRS may challenge as an improper tax-free distribution.

43

IRC 831(b) Example Loan Backs

• Prong One: Hard to argue that the transaction is

rationally related to a useful non-tax business

• purpose. If you needed the money enough to have it

loaned out shortly after paying it, why did you make the premium payment to start with other than to get the tax deduction?

44

IRC 831(b) Example Loan Backs (4 of 4)

• Prong Two: Transaction appears that there is no

meaningful enhancement in the net economic position of the taxpayer other than to reduce tax. Your position is identical before and after the transaction with respect to the loaned funds. The

• nly difference is that you have deducted the

premium.

45

Listed Transaction Designation

• IRS can designate a transaction as “listed” and trigger

reporting requirements and potentially severe penalties for taxpayers and advisors.

• IRS rarely does this, so it is usually reserved for

transactions that are done across the US among numerous taxpayers.

• IRS states its position in the listing notice, and

judiciary has taken this designation seriously.

46

IRC 831(b) Example

• In early 2000’s IRS designated a captive variant

structure as a listed transaction.

• The IRS eventually withdrew the listing on a go

forward basis, apparently in part because the deal was not widespread enough.

47

Transaction of Interest Designation

• IRS can put a transaction with certain attributes on

a sort of “watch list” where the IRS thinks the transaction is abusive, but is not ready to “list” the transaction permanently.

• Transactions of interest have similar reporting and

penalty attributes to listed transactions.

• It is up to taxpayers and advisors to keep up with

what the IRS posts to this list. There is no ignorance defense.

48

IRC 831(b) Example

• It would not be surprising to find a captive

transaction that involves a captive being used as a tax deductible vehicle to fund some sort of investment, and either (a) severely overstates coverage costs, or (b) improperly distributes risk, as a transaction of interest.

49

Promoter Investigations

• If IRS finds several taxpayers who have a common

advisor or pool that appear to be taking the same abusive activity, IRS may open a promoter examination of the advisor.

• If IRS determines the advisor is a promoter, IRS may

penalize them as such at the close of the investigation.

50

IRC 831(b) Example (1 of 2)

• IRS Personnel Statements Include:
• IRS planning on bringing “a great many” CIC cases
• IRS planning on “expanding” promoter exams
• IRS seems very interested in the “investments” as driver

for CIC formation & operation

• IRS concerned with promotional material that focuses
• n tax benefits & investment return
• IRS hiring private sector forensic personnel required for

ramping up caseload

51

IRC 831(b) Example (2 of 2)

• Forensic audits of taxpayers.
• IRS will drill down deep into a case
• Determining issues that should concern IRS
• Common touch points across other cases
• Specific professionals or risk pools in common
• Open 6700 promoter examinations of:
• Risk Pools
• CIC companies

52

List Maintenance Requests

• The IRS can request a list of all clients of an advisor,
• r pool participants if investigation is of a pool.
• Where IRS has found an offending taxpayer, this

tool allows IRS to quickly locate a large number of potential taxpayers to audit that may have done the same thing.

• IRS will look for similar touch points among

taxpayers to map out the web of promoters.

53

IRC 831(b) Example

• IRS finds one captive that has risk distributed

improperly in a pool.

• IRS will request the pool to provide a list of all

participants, and then will audit some or all of the participants, to see if the pool has improperly risk distributed all its participant captives.

54

Criminal Investigations

• CID investigations can now progress

simultaneously with civil promoter examinations.

• A promoter exam can be referred to CID for

potential criminal prosecution.

• This is obviously reserved for the worst actors.
• To date, these cases appear to involve “pretend we

are doing it right” discussions with taxpayers.

55

IRC 831(b) Example

• Criminal warrants issued in cases in several states.
• Risk Pools
• Captive professionals
• Grand jury indictment in one advanced case.
• Clients told better not to make claims
• Promoters focused on tax savings (not insurance)

56

Where is this Going? IRS Investigation Pattern Familiar

• First: targeted forensic audits
• Discover common denominators
• Begin 6700 promoter investigations
• Begin criminal investigations
• Broad based warnings to taxpayers
• We are here
• Issue broad based guidance
• Start broad audit program based on guidance

57

Thank You

• F. Hale Stewart

The Law Office of Hale Stewart 832.330.4101