Ernie Guerriero, CLU®,ChFC®,CEBS,CPCU®,CPC®,CMS,AIF®,RICP®,CPFA
The Government Accountability Office (GAO) on Aug. 31 released a report on abusive tax schemes with a focus on offshore insurance products and associated compliance risks. (GAO-20-589)
Some tax shelters can be legitimate to the extent they take advantage of various provisions in the tax code to lawfully avoid paying federal taxes; however, according to IRS, abusive tax shelters result in unlawful tax evasion. Abusive offshore insurance tax schemes include transactions that are also considered scams or schemes based on erroneous interpretations of tax law.
Captive insurance. Section 162 of the IRC generally allows for the deduction of ordinary and necessary expenses associated with running a business, thereby reducing the amount of taxes owed. These expenses include premiums paid for insurance against risks inherent in conducting business. Generally, premiums that are deductible under section 162 are for insurance against risks that only have negative results—referred to as insurable risks. Risks that could have either positive or negative results, for example, a risk that a business will recuperate its investment in new equipment—is considered a speculative risk according to IRS audit guidance and is not an insurable risk.
While many businesses choose to insure their risks through commercially available insurance policies, some choose to create their own insurance companies that can provide tailored and sometimes more affordable risk coverage. These insurance entities, called captive insurance companies, are generally wholly owned by the businesses they insure. The courts first addressed the tax consequences of owning captive insurance in 1978, and captive arrangements gained popularity throughout the 1990s and 2000s. IRS enforcement officials estimated that as many as 85 percent of Fortune 500 companies today utilize captive insurance arrangements.
While most speculative risks could result in either a loss or a gain, insurable risks can only result in a loss. For example, whether a business will recuperate its investment in new equipment is a type of speculative risk because the businesses could experience either a financial loss or gain. In contrast, the risk that a building will catch fire is an insurance risk.
IRS has warned that some abusive micro-captive insurance tax shelters involve insurance of implausible risks. While some such risks are clearly unlikely, others require careful analysis to determine whether the insured did not truly face the risks covered under their policy. For example, I have heard of a micro-captive providing insurance specifically against damages caused by satellites falling out of Earth’s orbit. While technically possible, such an event is extremely unlikely.
Life insurance. The IRC provides three main tax benefits for life insurance policyholders. First, the policyholder is not taxed on growth in the value of life insurance policies. Second, the policyholder may be able to access the value of the policy during their life, such as taking out a loan against the policy, tax-free. Third, the beneficiary is generally not taxed on proceeds from the life insurance after the insured’s death. A policy will be treated as a life insurance contract for tax purposes only if it satisfies certain tests that require complex calculations involving the relationships among premium levels, mortality charges, interest rates, death benefits, and other factors.
IRS has also determined that offshore life insurance arrangements have the potential for tax abuse. Offshore variable life insurance products have been used to conceal assets from the U.S. government, including undeclared assets at risk of being discovered during investigations of foreign banks. Further, some taxpayers closely control how their premiums are invested and may direct premium funds toward illiquid assets they currently own in an attempt to convert taxable income to tax exempt income that is eventually passed on to their beneficiaries tax-free.
However, IRS has acknowledged that there are many legitimate uses of offshore life insurance products and that when used properly these products offer important benefits to taxpayers. In addition to the various tax benefits outlined, offshore policies may also offer taxpayers certain legal benefits, depending on the jurisdiction. For example, individuals or other entities wishing to sue the policyholder for assets held in an offshore life insurance policy must file the lawsuit with the offshore jurisdiction’s legal authority.
When taxpayers display significant control over assets held offshore in separate asset accounts of their life insurance policies, they can be considered the owners of such accounts for tax purposes. Having significant control but not paying certain taxes has been considered an abuse by the courts.