The Internal Revenue Service has offered a small group of taxpayers a deal it hopes they won’t refuse: Pay all their back taxes, plus interest, and their case will be closed without penalties.
The offer, which was announced on Monday, pertains to taxpayers who have captive insurance, a vehicle meant to allow companies to insure themselves against risks not covered by traditional means. But these captives, as they are known, have created an incentive for tax avoidance.
Captives can be devised so that the risks are so unlikely that a claim will never be made and the premiums return to the business owners or their heirs with little or no tax. They have become popular among small-business owners who see them as a way to save on income and estate taxes with little possibility of paying out claims.
In one case, a dentist created a captive to insure against his office’s being attacked by terrorists. In another, a Phoenix jeweler used a captive to insure against damage caused by the radioactivity of a dirty bomb or nuclear waste.
There’s nothing unusual about the I.R.S. cutting deals with taxpayers, but what has piqued interest this time is that it is focusing on a group — mostly business owners with a high net worth — who set up captive insurance companies solely to avoid taxes.
The I.R.S. spent years scrutinizing taxpayers who set up captive insurers and the managers who promoted them to small-business clients. The structures first appeared on the agency’s “Dirty Dozen List” in 2014. But the deal that the I.R.S. is offering seems to suggest that it may have found more taxpayers who took advantage of captive insurers than it has resources to audit. By several estimates, the I.R.S. has close to 10,000 captive insurers under review, with 600 of them making their way to court.
The deal was offered to some 200 taxpayers who are being audited, with 30 days to accept. They will be required to pay 90 percent of what they deducted from their tax returns as insurance premiums plus interest, and they will lose the deduction for the fees paid to set up and manage the captive.
By agreeing to the deal, they will be eligible to have the 10 percent penalty canceled if they are first-time offenders and if they can prove that they acted on advice they believed to be correct. But with a 30-day window, taxpayers have only a limited time to act.
“It’s almost like an infomercial,” said David J. Slenn, partner at the law firm Shumaker in Tampa, Fla. “The I.R.S. is going to continue to make things difficult, but if you take the offer, it’s not so bad.”
It could be worse: The I.R.S. could tax the premiums multiple times — once by disallowing them as a deduction and again as income in the captive — and add penalties of as much as 40 percent on the unpaid tax. The agency is coming off three victories in tax court against captive insurance companies, and the announcement suggests that this deal is as good as it is going to get.
“In the worst-case scenario, you could get hit with a 240 percent tax,” said Jay Adkisson, a lawyer and former chairman of the American Bar Association’s committee on captive insurance companies. “I frankly don’t think anyone who gets this offer is going to reject it, and if they do, they need to find better professionals to advise them.”
Many captive insurance companies are legitimate. They are often used by large companies to self-insure or cover risks that would otherwise be too expensive to cover in the regular insurance market.
Some small captives, known as micro-captive insurance, exist for legitimate insurance needs. A doctor’s office can use captive insurance to pay malpractice claims itself, for instance, or to cover excess claims not paid by traditional insurance policies. In this example, the office would not have to pay all the money it contributed to be in compliance; it would just have to operate as an insurance company and pay some claims.
At issue are captives established as tax-avoidance vehicles. The small-business owners who set them up were able to contribute tax-deductible premiums of $1.2 million a year until 2017, when the limit rose to $2.2 million under the Trump administration tax overhaul and was indexed to inflation.
The I.R.S. offer could put an end to a lucrative structure whose economic advantages seemed to overtake its intended purpose.
“It’s the end of the easy captive,” said John Colvin, a lawyer in Seattle specializing in tax controversies. “Going forward, it’s going to be a niche or specialty thing and not something more broadly based and sold to every person.”
Several of the managers that promoted these captives have already been sued. Artex Risk Solutions, which is now owned by Arthur J. Gallagher & Company, was sued last year by people who used Artex to set up their captives and are now under investigation by the I.R.S.
Firms like Artex charged around $50,000 to set up captives and about $50,000 annually to run them, Mr. Adkisson said. The I.R.S. is rejecting the deductibility of those fees in its offer.
The I.R.S. deal has already met with resistance. Tim A. Tarter and Kacie Dillon, partners at the law firm Woolston and Tarter, which is defending many owners of captive insurance companies, said the agency had gone too far.
“The I.R.S. likes to paint all taxpayers with the same brush: ‘If you’re in a micro-captive, it must be abusive,’” Ms. Dillon said. “We need to convince the I.R.S. that, one, it’s not abusive and, two, it’s insurance. You can be in a transaction that’s not insurance but it’s not abusive, either.”
That, she said, was the case with two of their clients, Benyamin and Orna Avrahami, the owners of the Arizona jewelry stores who used their captive to insure against dirty bombs. The Avrahamis lost their case and paid back taxes plus interest. But Ms. Dillon said the I.R.S. was unsuccessful in levying penalties on top of that.
“That the court didn’t uphold the penalties was a major victory for them and for the industry,” she said.
Mr. Adkisson put captives in a different context. “There has always been a tax shelter industry in America,” he said. “And from 2008 to about 2015, captives were the tax shelter du jour.”
Now, the people who participated in them are trying to get out as painlessly as possible. But that could be difficult in situations in which these owners of captive insurance companies joined so-called risk pools to make it look as if they were sharing risks.
To accept the I.R.S. offer, taxpayers are required to exit the captive insurance company. That could be complicated for some because all the people in the risk pool are legally bound by a contract meant to cover claims. In situations where no claims or very small ones have been paid, letting a few people out raises questions about the legitimacy of the pool, Mr. Slenn said.
“The question is, how long do you have to be there and what hoops do you have to jump through to get out?” he said.
The risk pool could demand that all participants remain because it might need the money for future claims. That puts the taxpayers who accepted the I.R.S. offer in a bind. And it risks exposing others in the risk pool to the I.R.S.
Those who are not among the 200 people getting an offer may get a map for what to do down the road. The expectation among many financial advisers is that the I.R.S. is testing this offer to see how many people take it. They believe that the agency may expand the deal to others who are being audited.
But those who have already challenged the I.R.S. in court are not eligible for this deal.
“It fits with how the I.R.S. offers deals,” Mr. Adkisson said. “They want to incentivize people to settle, not go to tax court. And this deal creates a powerful incentive to try to be cooperative.”