While the IRS is most commonly thought about as a tax enforcement agency, it also engages in its fair share of tax fraud deterrence efforts. These efforts to deter taxpayers from engaging in tax violations, tax fraud, or criminal tax evasion bolster the nation’s tax receipts and allows the IRS to focus its enforcement efforts on matters where there is a high likelihood of a significant underpayment of tax and thus a strong likelihood of a return on the tax enforcement investment.
The IRS frequently notes an array of tax scams and potentially fraudulent tax transactions in the lead-up to tax day. Annually, the IRS releases a list of the top “Dirty Dozen” tax scams. However, it also will focus in on particular details regarding certain types of tax scams and fraud. Recently, the IRS released additional information warning taxpayers against the utilization of abusive micro-captive insurance tax shelters. Taxpayers should assume that the use of these entities is on the IRS’s radar and will continue to be an enforcement focus for the 2017 tax filing season.
An abusive tax shelter is a type of entity that can be marketed by financial advisors, asset protection firms, and an array of other individuals dedicated to minimizing taxes. Unfortunately, some tax minimization strategies cross the line into tax fraud. The marketing and use of abusive tax shelters is one strategy that crosses the line from tax minimization to tax fraud.
Under Section 831(b) of the U.S. Tax Code, small insurance companies known as captive insurers are permitted to elect to exclude certain amounts of annual net insurance premiums. This has the tax effect on the insurance company is that it will only pay tax on the company’s investment income. This is a legitimate arrangement that allows companies to create “captive” insurance companies that insulate the larger entity from certain liabilities and risks.
However, when there is a valid use for a certain tax provision, certain illegal tax shelter promoters will leverage respectable applications to promote overly aggressive tax positions or outright abusive tax shelters.
An abusive application of the captive insurance company provision is often referred to as an “abusive micro-captive insurance tax shelter.” The abusive micro-captive application involves a promoter who entices wealth owners of closely-held companies and entities to arrange their captive insurance company in a fashion that lacks many of the traditional hallmarks present in a legitimate captive insurance structure. One example of this is a micro-captive that insures against extremely implausible risks. An abusive captive insurance entity may also fail to comport with needs evidenced in contemporaneous business records. Furthermore, there is typically little actuarial or other reasonable support for the “insurance coverage.” Premiums for abusive micro captive insurance “coverage” is typically much higher than the premiums for legitimate companies. Other signs of an abusive tax structure masquerading as a micro-captive insurance company include:
Generally, the use of an abusive micro-captive insurance scheme will reduce taxes in the short-term. However, the IRS is well aware of these practices. As such, taxpayers who engage in tax fraud by utilizing this method should expect to face scrutiny.
The IRS has long engaged in efforts to identify and stamp out all forms of tax fraud and tax evasion. For the past three years, the IRS has highlighted this particular form of tax fraud in its “Dirty Dozen” list. However, the IRS has also engaged in more substantive rulemaking and enforcement measures. In 2016, the IRS released Notice 2016-66. In this notice, the IRS provided guidance that taxpayers utilizing micro-captive insurance arrangements should beware of the potential for tax fraud or tax evasion. Furthermore, the document also indicated that certain reporting requirements apply to all entities engaging in transactions of this type on or after November 2, 2006. Additional reporting and enforcement procedures were passed into law as part of The Protecting Americans from Tax Hikes (PATH Act) which became effective on January 1, 2017.
If you suspect that you may have fallen under the influence of a tax shelter promoter or have made errors in handling your finances or taxes, the tax professionals of the Tax Law Offices of David W. Klasing may be able to help. To schedule a reduced rate initial consultation at our Los Angeles or Irvine tax law office, please call 800-681-1295 or contact us online.