Physicians-owned captive insurance companies are often thinly disguised as abusive tax shelters. As captives, their owners and promoters are currently being harshly examined by the IRS. Knowing what to ask, what do and what not to do will be vital to the financial futures of all involved. It can also put you into conflict with the folks that sold it to you.
Over the last few years, we have had many discussions on this issue, including a look at the details of good captives for the few doctors that are actually qualified and multiple warnings about year-end tax planning sales targeting doctors that may be tax fraud. In addition to knowing this, additional, time sensitive threats have emerged and may require you to seek experienced legal counsel.
Abuse Leads to "Promoter Audits"
Many American captive owners continue to get themselves involved in onerous and expensive audits because the "promoter" (the individual or company that sold them) came to the attention of the IRS because of some kind of perceived red flag. In some cases, this first "bad apple" leads them back to the rest of that promoter's client base, causing them to audit every other client that promoter has ever sold a captive to. This audit exposes the captive’s owners, including many doctors, to expensive legal defense costs on top of huge surprise tax bills. The tax bills include the back taxes owed on any part of the millions of dollars in premiums they paid, which were disallowed as deductible expenses, plus penalties and interest.
In some high profile captive insurance audit cases, such as the Avrahami case out of Arizona, the government also imposes a 20 percent "accuracy penalty". In that case, a combination of questionable moves caused the authorities to find that the captive was not managing real risks and complying with the substance of the law, therefore the deductions they took for paying oversize premiums to their own company were found to be “inaccurate”. Based both on the issues predictably confirmed in the Avrahami case, previous case law and the continuing guidance of captive experts I work with like attorney Jay Adkisson, these are some of the key issues I look at when examining this issue.
• Overt promotion of the captive primarily as a tax shelter, including in the sales materials of the people selling them and even the correspondence between the buyer and the seller;
• A lack of real risks being insured and the insurance of risks highly unlikely to occur;
• Funding captives with inappropriate assets, like life insurance;
• A lack of compliance with tax law and other rules and conditions imposed by the jurisdiction;
• Paying unreasonably high premiums for the risks being covered;
• Structural issues designed to provide the captive owner an early return of premium in violation of tax law by allowing large sham "loans" of the premium back to the owner, up to 80 percent in some cases
According to a recent scholarly article by insurance law expert John Michael Johnston, who litigates and consults on these cases nationally, the potential abuse issues listed above and presented by Avrahami are not unique. Johnston feels that physician captive owners, (including 831 (b) captives) will continue to face audits and will require immediate representation with both the tax authorities and increasingly, against their own captive promoters.
I believe that there are potential tax problems for many current captive insurance participants in view of the Avrahami ruling. I feel that there are a number of other captive insurance programs which have many of the same weaknesses and flaws as did the one in Avrahami. Unfortunately, I have also learned that having a large potential tax liability is not the end of the story.
Johnston warns that if your captive manager sends you a "Material Advisor Disclosure Statement" (Treasury Department form 8918), they have disclosed your captive to the IRS as one they provided "material aid, assistance or advice regarding organizing, managing, promoting, selling, implementing, insuring, or carrying out any reportable transaction". This is where complex new conflicts are emerging between owners and promoters and what we will review in our next and final installment for 2017.