Small Captive Insurance Program Exit Planning
David J. Slenn | September 04, 2018
After two consecutive losses for taxpayers involved in small captive insurance programs (i.e., the US Tax Court decisions Avrahami and Reserve Mechanical), some may consider exiting their small captive insurance program. Exiting a captive, however, may be time consuming and expensive. Many captive owners will need to take into account numerous issues and make some difficult decisions. For others, there is no need for concern, and these issues are mostly peripheral to their captive insurance programs.
Captive Insurance Program Requirements and Insurance Coverage Parameter Considerations
For those that are considering an exit, one preliminary issue is whether the captive owner is bound by the captive insurance program documents for a particular term. This may be due to the captive's contractual obligations to a risk pool, upon which the captive relied to distribute risk. Because other participants in the risk pool are also relying on the participation of the captive, the risk pool arrangements may not permit immediate withdrawal, as it would impact other participants in the pool that are relying on the pool to distribute their risks.
In addition to the program requirements, the insurance coverage itself may have varying lengths of tail liability. Regulators may insist that the captive stay in existence (and retain assets to cover potential exposure) until the coverage tail is exhausted. Fortunately, for many in programs that are especially susceptible to Internal Revenue Service (IRS) scrutiny, many lines of insurance that are placed through captives have relatively short tails.
Assuming that IRS scrutiny is a driving force behind a captive owner's decision to exit a program (state and local tax issues may also be a concern), the captive owner will consider mitigating the tax liability associated with the program. However, one cannot simply conclude that a captive is "bad"; most captive programs have strengths and weaknesses, and a program may exist in different forms over the span of years.
The small captive insurer industry has evolved over time, and such evolution has generally resulted in "best practices" that have contributed to the changing nature of captive insurance programs over time. Whereas some transactions may be viewed by the IRS as abusive, a captive insurance program can range from exceptionally strong to less than adequate.
Thus, the captive owner is faced with the initial problem of determining where the captive insurance program rests on the captive tax spectrum. A program's positioning on the captive tax spectrum is beyond the scope of this article, but once a decision is made to cease insurance operations, the analysis includes federal tax reporting.
If the captive owner determines that its program will not survive IRS scrutiny, and if a captive owner is not currently under audit (or is not otherwise limited by the regulations), the owner may elect to file a qualified amended return(s), paying the income tax that would have been due without the deduction for captive insurance premiums and/or the exclusion of underwriting income (for section 831(b) electing companies) in an effort to avoid tax penalties.
In electing to file a qualified amended return(s), one of many factors the captive owner must consider is whether the statute of limitations has expired (or is close to expiring) with respect to the captive participation year(s) and whether all qualified amended return factors are satisfied. For example, the captive owner should determine whether any person who might be considered a "promoter" with respect to the captive program has been placed under promoter audit, thereby impacting the captive owner's ability to file a qualified amended return and avoid penalties. The foregoing statute of limitations analysis may also need to contemplate a particularly egregious program, where the IRS may assert a longer (or indefinite) statute of limitations. In a program bearing potential indicia of fraud, a voluntary disclosure should be considered.
Of course, based on a more optimistic view of the strength of its captive insurance program, the owner may decide to leave the matter alone and let nature take its course. The "audit lottery" approach is contemplated by the qualified amended tax return regulations, which do not afford penalty protection to amended tax returns filed after the taxpayer has received a notice of audit from the IRS.
IRS Audit Considerations
If under IRS tax audit, the captive owner may consider offering to pay the proposed tax and interest associated with the understatement and request abatement of all penalties. At this point, however, it is not likely that a revenue agent would settle for less than a full concession of tax and at least a partial penalty. Penalty and tax abatements are not generally offered to captive owners during examination. Similarly, and especially given the outcomes in Avrahami and Reserve Mechanical, IRS Appeals may not be motivated to settle for anything less than all tax and interest; in fact, it may be that the IRS pursues penalties with little to no room for negotiation.
Ultimately, what the IRS is willing to do is primarily driven by the facts and circumstances of each situation. In any event, the captive owner will want fair treatment extended globally throughout the captive insurance program, with denial of deduction treatment to the insured(s) on the one hand but no income to the captive insurer on the other.
Ancillary to this treatment, penalties associated with tax reporting for foreign programs should also be negotiated. Of course, if the captive owner does not receive a reasonable solution in Examination or Appeals (and if a captive owner believes that the captive insurance program and/or facts and circumstances are strong), the owner may decide to litigate and rely on a variety of pro-taxpayer arguments for the validity of its existing captive arrangement under existing law.
Mounting Cost Considerations
The captive owner cannot ignore the cost of representation throughout the IRS audit process and continuous filings, where appropriate, with the Office of Tax Shelter Analysis (OTSA). The scope of the IRS information document request (IDR) can be incredibly broad and, for some business owners, may require accumulating vast amounts of documentation. This documentation must be carefully reviewed before production with attention to privilege and confidential information. Meanwhile, attorney/accountant fees mount in addition to interest and penalties. Essentially, the IRS, through intensive IDRs, interviews, and OTSA reporting, has turned defending captives into a very costly exercise.
Faced with accumulating caseloads and being notoriously understaffed, the IRS Office of Chief Counsel and US Treasury Department might decide that a settlement initiative would make sense when sufficient information exists to facilitate settlement provisions (but not before extracting a pound of flesh in the process). This possibility, along with the potential for a favorable court decision, may cause a small captive owner to hope for more favorable settlement options in the future.
Since not all captive insurers are the same due to differences in design as well as in each captive insurance program's specific facts and circumstances, it is not unrealistic to think that some breaks could be offered for those that enter programs with superior design or "better" facts. One should consider the value of amending returns, perhaps without penalty, and the potential for filing later amended returns that might permit one to take advantage of a favorable settlement initiative. In making this calculation, the taxpayer should be cognizant of the statute of limitations for filing refund claims.
Meanwhile, the captive owner must carefully review program documentation when it comes to exiting. Importantly, the adviser must understand legal exposure and forfeiture of rights upon exit, all of which are beyond the scope of this article.
Advisers must also consider any duties to the captive owner and how a potentially defective program can be remedied or, at least, preserve an owner's ability to be made whole. In some cases, especially those in which the adviser advocated participation in the program, the adviser must consider his or her role in the entire process; the IRS certainly has picked up on this thorny ethical situation, requesting that the adviser obtain a conflict waiver from the client if the adviser wants to represent the client before the IRS. Consequently, the advocate-adviser should carefully review rules governing practice before the IRS in addition to the state bar. Where some advisers may have previously agreed to assist their clients at no charge, the IRS, for perhaps several reasons, is indirectly impacting this agreement.
Once the captive owner has moved beyond a review of the captive, taken a position on the tax treatment of the captive, handled expired liabilities, and successfully navigated an exit from a captive program, attention turns to how to treat the funds held within the corporation. Here, there is no shortage of options, taking into account a prior tax position. One option is the use of traditional liquidation treatment focusing on tax within the corporation on built-in gain and tax on distribution to the owners utilizing the traditional corporate liquidation analysis.
A decision to keep assets in the corporation would require consideration to personal holding company tax issues, converting to taxation under Subchapter S, merging with an operating entity, moving to another jurisdiction, etc. The owner may have multiple tax planning opportunities. Some may suggest that the corporation participate in a split dollar arrangement involving life insurance. Further, others may consider investing funds in a foreign pension, utilizing favorable tax treaties in an effort to mitigate exit taxes and facilitate retirement in a protected environment.
Regardless of the many routes the owner may take as described above, it is clear that the owner might be faced with the costs of yet another "feasibility"-type study—only, this time, the focus will be on closing down a captive insurer rather than establishing one.
David J. Slenn | September 04, 2018