Over the past decade, business owners have been overwhelmed by a plethora of arrangements designed to reduce the cost of providing employee benefits and taxes while increasing their own retirement savings. The solutions have ranged from traditional pension and profit sharing plans to more advanced strategies.
Some strategies, such as IRS Section 419 and 412(i) plans, used life insurance as vehicles to bring about benefits. Unfortunately, almost all the plans were noncompliant, even though insurance companies vetted them and encouraged their agents to sell them. This fostered an environment that led to numerous IRS crackdowns, disallowed tax deductions, and clients suing their insurance agents and others.
The result has been thousands of audits and an IRS task force seeking out tax shelter promotion. In addition, the IRS has been auditing most 412(i) defined benefit retirement plans and all 419 welfare benefit plans. Many insurance agents sell these plans. The tax consequences are enormous for unknowing clients. The liability may be equally extreme for their insurance advisors. The insurance agent may be called a “material advisor” if the insurance professional sells one of these plans, if the client takes a tax deduction, and if the IRS considers the plan an abusive, listed transaction or substantially similar to such a transaction. The fine for a material advisor is $200,000 if incorporated or $100,000 if unincorporated.
Most insurance agents think that they can avoid the fine by filing Form 8918 with the IRS and informing on their clients. But all of the Form 8918s that we have seen have been filled out improperly. The impression that we received in our discussions with the IRS officials who wrote the regulations is that you are lying to the government if the form is filled out improperly. That is almost as bad as not filing the form. This has also been a problem with all the forms that we have reviewed for accountants and insurance agents.
We have reviewed hundreds of forms and not a single one has been filled out properly. One reason may be that the promoter of the abusive plan sends the form with instructions to the accountant and insurance agent. These instructions tend to protect the promoter, but not necessarily the insurance agent or accountant. Please be careful with this entire situation. We have received hundreds of phone calls recently from accountants and insurance professionals in this predicament. It is very difficult to help them after the fact. For more information on this, see www.taxaudit419.com and www.taxadvisorexperts.org
Recently, there has been an explosion in the marketing of a financial product called “captive insurance.” These captives are typically small insurance companies designed to insure the risks of an individual business under IRS Code Section 831(b). When properly designed, a business can make tax-deductible premium payments to a related party insurance company. Depending on the circumstances, underwriting profits, if there are any, can be paid out to the owners as dividends. Profits from liquidation of the company may be taxed as capital gains.
While captives can be a great cost saving tool, they are expensive to build and manage. Also, captives are allowed to garner tax benefits because they operate as real insurance companies. Advisors and business owners face grave regulatory and tax consequences if they misuse captives or market them as estate planning tools, asset protection vehicles, or tax deferral; or if they market them to obtain other benefits not related to the true business purpose of an insurance company.
A recent concern is the integration of small captives with life insurance policies. Under Section 831(b), small captives have no statutory authority to deduct life premiums. Also, if a small captive uses life insurance as an investment, the cash value of the life policy can be taxable at corporate rates. It will be taxable again when distributed. This double taxation devastates the effectiveness of the life insurance and brings serious liability to any advisor who recommends the plan or even signs the tax return of the business that pays premiums to the captive.
The IRS is aware that several large insurance companies are promoting their life insurance policies as investments with small captives. The outcome looks eerily like that of the 419 and 412(i) plans mentioned above.
Remember, if something looks too good to be true, it usually is. There are safe and conservative ways to use captive insurance structures to lower costs and obtain benefits for businesses. And some types of captive insurance products do have statutory protection for deducting life insurance premiums (although not 831(b) captives). Learning what works and is safe is the first step in helping clients use these powerful, but highly technical insurance tools.
––––––––––
Lance Wallach, the National Society of Accountants Speaker of the Year, speaks and writes extensively about, retirement plans, Circular 230 problems and tax reduction strategies. He speaks at more than 40 conventions annually, writes for more than 50 publications and has written numerous best-selling AICPA books, including Avoiding Circular 230 Malpractice Traps and Common Abusive Business Hot Spots.
