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THERE BE DRAGONS

THERE BE DRAGONS

THERE BE DRAGONS
November 30
10:03 2020

Public Policy Analysis & Opinion

By Kevin P. Hennosy

THERE BE DRAGONS

“Abusive” offshore insurance operations draw federal attention

Like Santa Claus does, the Government Accountability Office (GAO), the Internal Revenue Service (IRS), and the Senate Finance Committee are “making a list and checking it twice.” That is where the comparison between the legendary jolly ol’ elf and federal authorities ends, because the latter’s list consists of only the names of “the naughty.”

When the new Congress convenes in January, the agenda of the Senate Finance Committee might include the topic of offshore insurance products. In particular, the committee seems interested in the use of micro-captives and life insurance products to perpetrate “abuse” of the federal tax code.

The IRS opines that offshore micro-captives and life insurance products merely present the pretense of insurance.

In a GAO report published in late July 2020, the congressional branch investigators discussed the findings of an audit of offshore insurance as a means of unlawfully evading tax liabilities.

Gimme shelter

The GAO report asserts: “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.”

In the immortal words of Leona Helmsley, the late federal prisoner and tax cheat, “We don’t pay taxes; only the little people pay taxes.” Well, that kind of attitude leads many “little people” to start looking for torches and pitchforks, but that is another story.

Senator Charles E. Grassley (R-Iowa), who chairs the Senate Finance Committee, requested the GAO audit after receiving reports from the IRS and other sources.

In a cover letter to Senator Grassley that accompanied the resulting audit report, the GAO explains: “You asked us to review how taxpayers may abuse offshore insurance products and what guidance IRS provides about complying with laws related to offshore insurance accounts.”

The letter continues: “This report describes (1) how offshore insurance tax shelters provide opportunities for income tax abuse; (2) how offshore micro-captive insurance is used and how it is used in abusive tax schemes; and (3) how offshore life insurance is used and how it is used in abusive tax schemes.”

The GAO report provides a docile recognition of the legality of the use of offshore insurance products to evade taxes: “Some offshore insurance products offered alternatives for taxpayers to hide their assets or engage in tax planning using shelters under less scrutiny.”

The IRS opines that offshore micro-captives and life insurance products merely present the pretense of insurance. In enforcement cases, the IRS argues that these offshore financial transactions do not “shift” or “distribute” risk. In more common insurance jargon, the transactions do not transfer or spread the risk of financial loss.

Micro-captives

The GAO report writers present background on the source of this issue. First, the report notes that “IRS enforcement officials told us they first came across abusive micro-captive insurance schemes in the mid-2000s.” Second, the report states: “IRS has said that the majority of micro-captive cases examined have been determined to be abusive.”

The instances of problems relating to micro-captives used in abusive tax avoidance arrangements increased over time: “Following many years of enforcement action, IRS determined that some micro-captive insurance transactions have the potential for abuse.”

The report continues, “Sometimes micro-captives are established purely for tax reasons, which generally courts have ruled is improper.”

Investigators use several elements when scanning for disreputable micro-captives. “Indicators that businesses have established a micro-captive in an abusive tax scheme include artificially high premiums that do not make economic sense or that are not supported by actuarial science,” the GAO report explains.

In February 2015, the IRS issued its annual news release listing of a “Dirty Dozen of Tax Scams,” which included the abuse of “certain small or ‘micro’ captive insurance companies.” The IRS alleges that sponsoring entities used deception to hide assets from proper taxation under the guise of fake insurance contracts.

“In the abusive structure, unscrupulous promoters persuade closely heldentities to participate in this scheme by assisting entities to create captiveinsurance companies onshore or offshore, drafting organizational documents and preparing initial filings to state insurance authorities and the IRS,” alleges the 2015 Dirty Dozen statement.

The statement continues: “The promoters assist with creating and ‘selling’ to the entities oftentimes poorly drafted ‘insurance’ binders and policies to cover ordinary business risks or esoteric, implausible risks for exorbitant ‘premiums,’ while maintaining their economical commercial coverage with traditional insurers.”

Further, the IRS observes, “Total amounts of annual premiums often equalthe amount of deductions businessentities need to reduce income for the year; or, for a wealthy entity, total premiums amount to $1.2 million annually to take full advantage of the Code provision.

“Underwriting and actuarial substantiation for the insurance premiums paid are either missing or insufficient. The promoters manage the entities’ captive insurance companies year after year for hefty fees, assisting taxpayers unsophisticated in insurance to continue the charade,” concludes the IRS statement.

Why the charade? Well, the GAO report observes “some businesses may benefit from their micro-captive’s ability to accumulate offshore assets.”

The IRS statement describes a form of financial reverse alchemy, where a magic box transforms income into a tax-deductible expense—for a fee.

In the details

The GAO report notes, “When micro-captive insurance products are located offshore, they may provide additional benefits to the business, such as less onerous insurance regulations.”

The need to move offshore seems to beg attention from the Senate and federal regulatory agencies.

The report reveals, “One industry professional told us that offshore jurisdictions may have a simpler or faster process for establishing a micro-captive insurance company or they may have lower taxes.”

Further, the report says “some countries have laws that may provide protection for the micro-captive’s funds and assets in cases involving large claims or lawsuits against the micro-captive or its parent U.S. business.”

Layered products

The report also cites problems with offshore life insurance policies used for nefarious tax avoidance. The use of complex layered products attracted the greatest attention from IRS enforcement officials.

“Layered arrangements are those in which several financial products are used in combination with one another,” the GAO report explains. Also, the report says, “One IRS official told us that these layered arrangements are intentionally complex and used by taxpayers to hide assets from IRS.”

The report explains, “These [life insurance] products are created specifically to evade taxes, and IRS auditors often need to sort through voluminous evidentiary documents and use subject matter experts to review technical materials.”

The GAO report continues, “One IRS official told us that 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.”

The use of offshore life insurance can also hide assets from civil jeopardy in U.S. courts. 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.

Control issues

Unlike most life insurance products, these offshore arrangements do not separate ownership from control when it comes to investment decisions. The GAO report observes: “While policyholders are permitted to allocate the funds in the separate asset account among these investment products as they wish, courts have indicated that in order to maintain tax benefits, the policyholders must not exercise significant control over the account, so the frequency of transfers and reallocations may be limited by the insurance company.”

To clarify this point, the report explains, “IRS officials told us that policyholders should not be allowed to select specific individual investments (e.g., Apple common stock).” The report documents that offshore products do not always conform with this standard.

Yet policyholders of offshore life insurance products can illicitly maintain that power to select individual investments. For example, the GAO investigators cite, “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.”

Legislative aims

The GAO report will not mark the last time these offshore insurance issues come before the Senate Finance Committee. The IRS and GAO describe legislative aims that they believe will address the tax evasion described in the report.

The GAO report recounts several legislative priorities for the IRS for both offshore micro-captives and life insurance products.

With regard to micro-captives, the IRS wants to address the pretense of insurance issue through a three-criteria test:

  1. Is There an Actual or Insurable Risk?
  2. Are Both Risk Shifting and Risk Distribution Present?
  3. Does the Product Fit Commonly Accepted Notions of Insurance?

With regard to life insurance, the report echoes two questions that the IRS wants answered about all offshore life insurance products:

  1. Did the Taxpayer Properly Report Insurance Accounts to the U.S. Government?
  2. Did the Taxpayer Pay All Required Taxes Based on the True Type of Financial Vehicle?

One can expect the new Congressto take up these issues in the coming year.

The author

Kevin P. Hennosy is an insurance writer who specializes in the history and politics of insurance regulation. He began his insurance career in the regulatory compliance office of Nationwide and then served as public affairs manager for the National Association of Insurance Commissioners (NAIC). Since leaving the NAIC staff, he has written extensively on insurance regulation and testified before the NAIC as a consumer advocate.

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