Captive Insurance Companies Draw IRS Eye

July 14, 2016

Captive insurance companies can bring significant benefits to physicians, yet the risk of an IRS audit can increase.

In part one of this interview,Physicians Practice associate editor Erica Sprey spoke with Philip Garrett Panitz, a tax attorney based in Westlake Village, Calif., about the benefits of physician-owned captive insurance companies. In part two, Panitz discusses the potential risks in creating this type of insurance vehicle.

ES: What potential risks are attached to captive insurance companies?

PP: The real true risk is that the IRS is very skeptical about these arrangements and has challenged them on a regular basis. And these cases have gone to court. And the cases where the taxpayer has won, let's say in the case where the doctor has won, is if every "I" is dotted and every "T" crossed, where there is real insurance, where there is risk shifting and risk distribution, and the United States Tax Court has ruled that in fact this is real insurance. And all the requirements to be insurance have been met. And the IRS has lost those cases. But that hasn't dissuaded the IRS from attacking those arrangements and look for new ways to attack them.

I represent a number of tax payers who are under scrutiny by the IRS. That is why I got involved in this in the first case, because they came to me and said "We are under audit by the IRS, they are looking into our captive insurance companies, and so we are litigating against the IRS on those." So there are two ways that I can help tax payers. One, is if they are already under the audit process and I come in and help them in that regard. And two, help them set up the actual captive insurance arrangement. We do it in a way that complies with all the IRS rules in this area.

ES: Should a physician contact a tax attorney who is experienced in this type of vehicle?

PP: Yes absolutely. So that we can set it up with the minimization of the risk. But I have to tell you that because the IRS is scrutinizing these, the IRS has the goal of looking into almost every captive insurance arrangement to make sure these are done right, because they are highly skeptical about them. One of the reasons that they are, and it is a valid reason for the IRS to look into it, is there have been tremendous amounts of abuse. So if a doctor is going to do this, he really needs to make sure he does it right. Because there are a lot of unscrupulous promoters out there that set up these captive insurance companies and unfortunately are perhaps overly aggressive and don't do things right. [So] the IRS has good reason to look into this.

ES:Why does the IRS take a dim view of captives?

PP: The main reason the IRS was attacking these was because a number of [captives] look to the IRS to be somewhat of a tax shelter. Let's say … a doctor creates his own captive insurance company, pays premiums, gets to deduct it, and then if he gets all the money back, was it a legitimate insurance company? That was something that the IRS looked at with a very jaundiced eye, if you will. But the cases where the tax payer has won, is where the money was transferred to the captive insurance company and the captive insurance company joins a pool of captive insurance companies that are contributing to a re-insurer. And there are in fact malpractice claims, and there is in fact risk. The risk has been shifted, there's a distribution of risk, and the doctor could be subject to losses due to these malpractice claims that aren't even necessarily his malpractice claims. That's legitimate insurance, and [those are] the cases where the IRS has lost.

So, if it is done right, it's a great vehicle, because ultimately the doctor could make money on the money that he has contributed - he gets a tax deduction, the money is growing in the captive insurance company, and eventually he gets the money back with some growth. And by the way, there is a tax consequence, because when you dissolve a company and you have capital gains … you have to pay taxes on it. So that's legitimate too. You have to pay taxes ultimately when you dissolve your captive insurance, but you have it at capital gain rates, not ordinary income rates. So there are benefits there too, but you do have to pay taxes at the end of this. And a lot of doctors will transfer their interest in their captive insurance as part of estate planning and provide that to their children or to their grandchildren. So they are giving away their captive insurance company as part of a trust. And this is all part of legitimate estate planning as well.

ES: Are more physicians participating in this type of insurance company? What are the external forces that are influencing them?

PP: Yes. There are two forces at work ... the high cost of malpractice insurance. That certainly drives physicians to say, "Well, if I am going to pay that kind of a cost for malpractice insurance, I might as well do it in a way that may benefit me in the future and maybe get a lot of it back." So that's one of the forces. And the other force is doctors that have done it and withstood IRS challenges and are doing it legitimately, there is sort of this word of mouth going around that [says] "Wow, you can do it this way." And people talk and say this is a new way of estate planning, really. That you can put malpractice insurance premiums to work for you as part of an estate plan. That's one of the things that the IRS is looking at, "Is it really insurance or is it estate planning?" And if done right, it can be both.

ES: If a physician decides to go this route, what are the first steps?

PP: A physician should seek out professional help in doing this correctly. And most attorneys who do incorporations don't know anything about captive insurance and the tax ramifications. So I would go to a certified tax specialist, a tax attorney who has experience in the captive insurance realm, and who can explain to a physician what the risks are, what the benefits are, so the physician can make intelligent choices about what he wants to do.

ES: What would be a worst case scenario, if a physician were audited by the IRS for captive insurance?

PP: Well, the worst case scenario would be if you weren't incorporated correctly as a captive insurance and [didn't] follow all the insurance rules, which you must to be a true captive insurance company. Then the captive insurance entity would be disregarded and the deductions that you took for the premiums that you paid would not have been tax deductible and so that would be an adjustment to your taxable income, because you took these deductions and they would be disallowed.

ES: Do you think this practice will continue to grow?

PP: If the IRS keeps losing in tax court on these types of cases, there will be a very large increase in this industry, because it really is pretty phenomenal for doctors, if done correctly. And if the tax court keeps giving it the seal of approval, it will be a very good vehicle for doctors to use.

*To learn about the benefits associated with captive insurance read Part 1 of this interview.