Captive Insurance and Other Abusive Tax Shelters
Captive insurance arrangements that are funded with cash-value life insurance are the hot tax shelter for 2014. But serious questions exist whether they work as the promoter’s promise they will do.
During the savings & loan crisis of the late 1980s and early 1990s, the courts used a particular acronym to describe cases where a physician had made an obviously bad investment in an oil & gas deal, and then sued to try to recoup their losses. Such a case was known as a "DDC", which was short for "Dumb Doctor Case".
Some doctors have a habit of getting into deals that don't make any sense. There's a saying that doctors will crawl on their bellies over broken glass for a mile to get to a bad deal, but they won't walk across the street to get to a good one.
Life insurance companies started pushing 412i plans and 419 welfare benefit plans in the 90s to business owners. When I spoke at the annual national convention of the National Society of Actuary’s about the problems with 419 and 412i plans in 2002 the IRS invited me to address their high level people that were writing regulations on point. We discussed the problems with these plans. The IRS then came up with additional regulations and set up task forces to audit these plans. The results for the business owners and Doctors were audits and very large taxes. I warned in financial publications and at conventions that I spoke at about the upcoming problems. I told people to file under IRS 6707A properly to at least reduce IRS fines on audit. In 2002 I also wrote to life insurance companies like Hartford Life etc. What was the result? The insurance companies continued to push these abusive plans and the IRS audited them. As an expert witness against these insurance companies and plans my side has never lost a case.
Doctors were an easy target. Why was this? What is the difference between God and a Doctor? God does not think that he is a Doctor. I hope that did not offend anyone, but it is a good reason why Doctors are an easy target for life insurance agents.
Many of these deals are tax shelters. Doctors are drawn to tax shelters like ants to a picnic, and there is no shortage of tax shelter promoters who love selling to physicians.
Every year, October announces the start of tax shelter season. Every year there is a hot tax shelter that it seems everyone is selling to doctors.
Every year life insurance agents desire to boost their year-end sales by offering some scheme, any scheme, whereby life insurance can be funded with pre-tax dollars, thus giving their clients a fat year-end deduction.
And every year promoters come up with a slick idea to provide clients with a new tax deduction, so that they can make a quick buck selling tax shelters to physicians. They are now selling captive insurance and section 79 plans. What are they? Most of them are similar to abusive 412i and 419 plans, now pushed by the same promoters and insurance companies that got people in trouble in the past.
This year's tax shelter pitched by too many life insurance agents and insurance companies is captive insurance.
To make money selling captives to physicians, promoters have gone out to life insurance marketing organizations and stirred up life insurance agents nationwide to go out and sell captive insurance companies funded with cash-value life insurance.
Various promoters are giving seminars and teleconferences telling life insurance agents, financial planners and others of the great benefits -- particularly commissions -- that can be generated by selling physicians captive insurance companies capitalized with cash-value life insurance.
The problem is that captive insurance companies rarely work for small-practice physicians.
What is a Captive?
A captive is an insurance company that is formed by a parent company to offer insurance policies to the parent’s subsidiaries. The captive insures certain risks of its sister companies, which pay insurance premiums to the captive and take a current-year deduction for the insurance premium expense. Underwriting profits are retained by the captive, and not lost to a third-party insurance company.
Captives are used as risk financing tools by many of the largest corporations in America. It is difficult to find a major corporation that does not have a captive. Many other entities such as universities, for-profit and non-profit hospitals, and large religious organizations, also have captives.
The IRS contended for many years that captives were merely (non-deductible) self-insurance programs, and unsuccessfully challenged captives on these grounds. Eventually, the IRS gave up on challenging captives as self-insurance programs, and instead recognized the concept of the captive and published guidelines as to what constitutes a proper captive insurance arrangement.
It is precisely because of these guidelines and existing case law that captive insurance companies do not work in all but the rarest of circumstances for physicians.
The attraction of a small captive is simple to understand. A property and casualty insurance company with net premium income of less than $1.2 million may elect under IRC Sec. 831(b) to be taxed only on its investment income. This means it is not taxed on its insurance underwriting income. If an insured is able to pay tax-deductible premiums of up to $1.2 million to its own captive, which then pays no claims, the insured reduces its taxable business income by $1.2 million and doesn’t pay tax when the captive earns that $1.2 million as premium income.
The Problem with Life Insurance
The hope of selling a large cash-value life insurance policy with pre-tax dollars -- via the captive in this case -- has life insurance agents ringing up their physician clients just as every pre-tax life insurance scheme does.
The problem is that cash-value life insurance makes a captive arrangement look and smell like a tax shelter.
Real insurance companies typically buy little, if any, life insurance as an investment. Instead, they generally hold more traditional and relatively liquid investments like stocks and bonds.
Owning a cash-value life insurance policy in a captive reduces the captive’s liquidity, and thus its ability to pay claims as they arise. It's just not something that a real insurance company would purchase as its principal asset.
The fact that the IRS has never issued guidance that says that a captive insurance company cannot invest in a cash-value life insurance policy doesn’t mean that it’s not a bad idea. Captive owners have worked hard over the years to gain the IRS’s begrudging acknowledgment of the validity of legitimate captive insurance arrangements for tax purposes.
Using a captive as a device to buy cash-value life insurance with pre-tax funds makes it look much less like a bona fide insurance company, and much more like a tax shelter.
One thing is certain: the IRS has shown a strong distaste for arrangements that end up with the pre-tax purchase of life insurance. Captive-owned life insurance will be no different. Think 412(i) plans and 419A(f)(6) or so called 419e plans, and keep that Form 8886 handy.
Some captive arrangements more easily cross the line into the criminal. In an indictment in Michigan, the promoters had their clients make payments for "loss of income" policies to the promoters' captive in the U.S. Virgin Islands. The premiums were later returned to the clients in the form of loans.
Disclaimer: While every effort has been made to ensure the accuracy of this publication, it is not intended to provide legal advice as individual situations will differ and should be discussed with an expert and/or lawyer.For specific technical or legal advice on the information provided and related topics, please contact the author.