Growing Concerns for Auto Dealers Still in Reinsurance
By Michael Scolamiero, Harbor First
(this article focuses on the opinion that a percentage of dealers are unknowingly in unlawful positions with their reinsurance companies)
Why now, what has changed? - Well, let’s begin with what hasn’t changed. Once again, for the 4th consecutive year, the Internal Revenue Service has placed abusive tax shelters on its annual “Dirty Dozen” list. Published March 19, 2018 on their website IRS.GOV, the IRS “today warned tax payers to be wary” of these financial structures. So, what does owning a financial structure associated with the “Dirty Dozen” entail? For one, being in the company of the others on the list: identity theft, phone scams, fake charities, phishing, return preparer fraud, inflated refund claims, excessive claims for business credits, falsely padding deductions, frivolous tax arguments, and offshore tax avoidance.
In the auto industry, many dealers participate in the earned premiums of the F&I products that are sold in their stores, often with a financial structure called a CFC (Controlled Foreign Corporation), and referred to as reinsurance. They are generally incorporated and domiciled offshore for multiple reasons, including lower capitalization requirements, and to avoid heavy State regulations. They make an 831(b) election that enables them to be alternatively taxed as a small insurance company. Additionally, many dealers will create multiple reinsurance companies, incorporating them in their spouses’ and/or children’s’ names. When detailing the different abuses with tax shelters, the IRS clearly states on its website that they can be “formed to advance inter-generational wealth transfer objectives and avoid estate and gift taxes.”
We did our due diligence when we entered reinsurance. Why would we need to worry? – If you have not been professionally consulted or advised on recent law changes, then you need to be. For many reasons, the tax code is continuously being updated. When structures and accounting methods aren’t being used for their intended purposes, laws need to be rewritten and passed to curb these abuses. Effective January 1, 2017, PATH (Protecting Americans from Tax Hikes) introduced requirements for both new and existing 831(b) companies. These strict diversification and reporting requirements may not have been an issue addressed when entering reinsurance, but it needs to be now. In the past, we've published articles regarding amendments to the tax code affecting auto dealer’s reinsurance companies, such as the diversification and ownership tests included in the 2015 Appropriations Bill. (found here)
I haven’t heard from the IRS. This must mean I’m in a lawful position, right? – Hopefully, but not necessarily. It is the responsibility of the IRS “for the collection of taxes and enforcement of tax laws.” The IRS has been aware of abuses with these structures for years, but has not had the resources and prior tax court rulings to effectively go after the abusers. However, their attorneys have been in court, and they’ve been winning. The IRS states on their website:
“Through audits, litigation, published guidance and legislation, the IRS continues to address those using abusive micro-captive insurance tax shelters.”
Have there been any recent developments? - On August 21, 2017, the U.S. Tax Court issued a long-awaited decision on an 831(b) Captive Insurance case, which had been sitting on their docket for a couple of years. The IRS won the case, Avrahami v Commissioner of Internal Revenue, with the Court ruling leaning heavily towards the arguments made by the IRS.
There are hundreds of cases in the U.S. Tax Court each year. Why does this one matter? - This particular ruling, 146 T.C. No 7, is no ordinary decision. Most U.S. Tax Court decisions are T.C.M.’s (or, T.C. Memos), which are judgments made by applying already accepted interpretations of the law. However, this was an en banc decision, meaning that the case required discussion by a group of U.S Tax Court judges, and was then voted on. There are a minimal amount of these decisions each year, as this was only the 7th of 2017. It represents a new interpretation of the law.
What did the Court decide in this case? - The court disagreed with the Petitioner’s (Avrahami) purported use of their Offshore Captive Insurance Company. Therefore, it was decided that their 831(b) filing, to be taxed as a small insurance company was invalid. The Petitioner is responsible for back taxes and interest, and will not be afforded the tax advantages that they had hoped to gain by use of the company. Fortunately, this petitioner will not be responsible for most of the penalties, which the IRS was requesting. The court decided that the petitioner had leaned on the advice of their CPA, but warned that this stipulation may not apply to future abusers, especially once this ruling becomes public.
Shouldn’t I be reading this from a licensed tax professional? – D. Sean McMahon, of McMahon & Associates PC, and formerly a Senior Attorney with the IRS Office of Chief Counsel and a Special Assistant United States Attorney, remarked, “The recent Tax Court ruling in Avrahami case declares many commonly promoted captive reinsurance structures involving section 831(b) elections are unlawful. Armed with the clear U.S. Tax Court ruling, the I.R.S. can easily identify captive insurance companies to target for enforcement simply by searching for taxpayers who made 831(b) elections.”
How does this decision affect dealers owning 831(b) reinsurance companies? - Although the Court’s decision is based on this taxpayer’s specific situation, it is significant because it gives the I.R.S continued precedence to challenge 831(b) arrangements. At the moment, there exists another case sitting on the US Tax Court’s docket with the IRS challenging an 831(b) election (James L. Wilson & Vivien Wilson, et al., v. Commissioner). The Court’s highly anticipated decision will further interpret US tax law. As these US Tax Court cases create a more developed interpretation of tax laws, and abuses are properly defined, the IRS will have the resources necessary to root out more 831(b) abusers on their own.
The I.R.S. is aware that offshore 831(b) companies are being used as tax shelters. The recent U.S. Tax Court’s decision is a huge win for the agency, and it gives them a license to go after any taxpayer that has elected this structure and might be abusing it. Many dealers’ reinsurance programs have their tax returns prepared and filed by the same CPA firms. If one dealer is caught abusing a reinsurance company, then all dealer clients using their CPA firm needs to be prepared to defend their own company’s ownership structure, arrangement, and use. If they have any concerns, they should consider changing their position to one that doesn’t place an I.R.S. target on their back.
*Disclaimer - The materials available at this web site are for informational purposes only and not for the purpose of providing legal advice. You should contact your attorney to obtain advice with respect to any particular issue or problem.