The IRS summarized its annual "Dirty Dozen" List of Tax Scams for 2017 in February. Practitioners and taxpayers should pay particular attention. The IRS is broadcasting their playbook. This list includes two principal types of tax matters: (1) scams that are intended to victimize taxpayers directly, and (2) scams in which taxpayers voluntarily – or unwittingly – agree to participate. The first set of scams includes identity theft, phone scams, and things like solicitations from fake charities. These items often result from direct attacks on taxpayers. The second set of scams typically involves a taxpayer's voluntary participation, but there often are misunderstandings and reliance questions that can be very important to the resolution of the issue. Whatever the source, each problem creates a set of issues that taxpayers, their CPA advisors, and experienced tax counsel should evaluate very carefully.

Abusive Tax Shelters – Including Captive Insurance – Make the Dirty Dozen List…Again

Key among the scams that make the "Dirty Dozen" list is the abusive tax shelter. Abusive tax shelters have been a perennial target of the IRS for decades, and the IRS annually reaffirms its commitment to uncovering and stopping complex tax avoidance/evasion schemes. 

One abusive tax shelter that repeatedly makes itself a topic for the IRS is the captive insurance structure. Captive insurance is a perfect example of a structure that can be fully defensible, fully abusive, or somewhere between the two. In many cases, captive insurance can be a legitimate business activity; however, often an ill-advised taxpayer will implement a plan that is attacked by the IRS as "abusive" because it was not properly designed. 

Captive insurance generally is a legitimate, legislatively-approved tax structure. However, the IRS often determines that an abuse has occurred with respect to certain small or "micro" captive insurance companies. Federal tax law allows businesses to create "captive" insurance companies to protect against certain risks. The insured business claims tax deductions for premiums paid for the insurance policies, and the premiums are paid to a captive insurance company that normally is owned by the same owners of the insured business. The captive insurance company, in turn, can elect to be taxed only on the investment income from the pool of premiums, excluding taxable income of up to $1.2 million per year in net premiums.

In the type of structure that is likely to be classified as abusive, promoters persuade closely-held entities to create captive insurance companies. The promoters assist with creating and "selling" "insurance" binders and policies from the captive to the business to cover either ordinary business risks, or implausible risks, and charging high premiums while maintaining market rate commercial coverage with traditional insurers.

The promoted structure often results in premiums equal to the $1.2 million annually to take full advantage of the tax code provision. Underwriting and actuarial substantiation for the insurance premiums often do not exist, and the promoters manage the captive insurance companies in exchange for significant fees.

There are myriad variations of legitimate captive structures, and taxpayers should carefully evaluate any existing or proposed captive insurance program. Like other structures that are designated to be "abusive," a captive insurance structure can result in a protracted and costly audit – and potentially a criminal investigation – if it is discovered by the IRS. 

A clear warning sign to practitioners is when their client is advised to exclude you from analysis or review of the strategy or product.

Taking a Proactive Approach to Tax Issues: Considering a Voluntary Disclosure Strategy

It is the specter of exposure, including both investigations and costly audits, that reminds us of the alternative to simply sitting back and waiting for the government to audit: a voluntary disclosure. A voluntary disclosure may be used to address past reporting, non-reporting, or mis-reporting, and may be a viable strategy for many types of missteps – both the types specifically referenced by the IRS in its "Dirty Dozen," and other items that create similar audit risks. The voluntary disclosure alternative is not an unconditional surrender, and it is not without risk, but a well thought-out, designed, and implemented voluntary disclosure can minimize costs, penalties, and the time involved in addressing problems. A thoughtfully designed voluntary disclosure strategy can offer material benefits, but it should never be implemented until after there has been comprehensive analysis conducted in an attorney-client privileged environment.