For the 5th Consecutive Year, Captives Make IRS "Dirty Dozen" List

On March 19, the Internal Revenue Service (IRS) wrapped up its annual "Dirty Dozen" listing in Information Release (IR)-2019–47. For the fifth consecutive year, abusive micro-captive insurance companies found their way to the annual listing. Where last year's listing in IR-2018–62 told taxpayers to be wary, the IRS uses a more aggressive tone in the 2019 listing, telling taxpayers to "steer clear" of abusive tax avoidance schemes and the "unscrupulous" individuals who promote them. This year's listing also combines abusive micro-captives along with abusive trusts and syndicated conservation easements.

Preliminary Warning

Before getting to the details of the abusive tax shelters as it had in prior years, the IRS begins the information release with its warning that those who participate in illegal schemes may face prosecution, civil litigation, and ultimately have to pay all taxes owed with "stiff" penalties and interest. The IRS continues the serious tone by stating imprisonment is on the table for those who utilize such schemes for purposes of tax evasion. These warnings underscore the importance of considering each taxpayer's particular facts and circumstances associated with participation in a captive program, including consideration as part of the exit of small captive programs. Similarly, those currently under audit must also keep this in mind since the potential for criminal prosecution is, at least in some situations, "quite real."¹

The IRS acknowledges that each of the three abusive tax shelters can start with a "legitimate tax-planning tool." However, in each case, the planning becomes tainted "almost always by a promoter" who claims to provide benefits that are "too good to be true." Consequently, taxpayers should be "highly skeptical" when presented with such claims.

Intense IRS Focus

The IRS goes on to prove its commitment to curbing micro-captive tax abuse by revealing it has devoted substantial resources to the cause with more than 500 docketed cases in Tax Court ² and numerous income tax examinations. If a taxpayer has not yet been picked for audit, the IRS implies it is just a matter of time as it also reveals it is conducting multiple promoter investigations.

This concern for abusive micro-captives was also reflected in Publication 5319, which set forth the IRS Large Business and International (LB&I) Division strategic goals for 2019. In Publication 5319, the LB&I commissioners stated the division will be working closely with the Small Business/Self-Employed (SB/SE) Division on micro-captives and syndicated conservation easements as they are "areas of significant compliance risk." The LB&I commissioners also stated these issues "involve thousands of taxpayers and advisors." One can speculate as to how resources are being shared and the developing protocol for any audit presenting micro-captive deductions in order to achieve the goals of "bringing taxpayers into compliance" and "seeking to inform others to avoid non-compliant activity."

Abusive Micro-Captives

The IRS addresses the characteristics of a "traditional" captive and notes that the micro-captive, like a "traditional" captive, should "reduce the total cost of insurance and loss events." Another hallmark of what the IRS perceives as a potentially abusive program involves "promoters, accountants or wealth planners" who "persuade owners of closely-held entities to participate in schemes that lack many of the attributes of insurance." The IRS goes on to summarize its victories in Avrahami v. Commissioner and Reserve Mechanical Corp. v. Commissioner, as well as provide a reminder of ongoing reporting requirements pursuant to Notice 2016–66.³ It is worth noting that on December 20, 2018, Reserve Mechanical Corp. filed a Notice of Appeal to the 10th Circuit Court of Appeals.⁴

It remains to be seen whether any injunctions will be sought with respect to alleged abusive micro-captive promoters similar to what has occurred in other abusive tax cases.⁵ Further, given the aforementioned large number of micro-captive controversies and limited IRS resources, speculation persists as to whether the IRS will offer a formal settlement initiative as it has in the past for other abusive transactions,⁶ despite lack of "listed transaction" status and the wide range of differences in facts and circumstances among taxpayers engaged in alleged abusive micro-captive programs.

1. See United States v. LaMotte, 2016 WL 2731623, at *7 (D. Mass. Apr. 19, 2016), report and recommendation adopted sub nom. United States v. Timothy Lamotte, Treasurer of N. Tree Serv., Inc., No. 15-MC-93017-MGM, 2016 WL 2733103 (D. Mass. May 10, 2016). ("The IRS recently included abusive captive insurance structures on their 2015 dirty dozen list of '[i]llegal scams [that] can lead to significant penalties and possible criminal prosecution.' I.R.S. News Release IR-2015–19 (Feb. 3, 2015) (emphasis added).... The United States even acknowledged at the show cause hearing that while every IRS civil investigation carries the potential for criminal prosecution, the promoter examination involving the use of the captive insurance structure sets this case apart from such a standard civil case (Dkt. 17 at p. 22). Considering Revenue Agent Britten's questions in this larger context underscores the conclusion that Respondent's fear of criminal prosecution is not a product of his unchecked imagination. Castro, 129 F.3d at 239. To the contrary, the possibility is quite real.")
2. It is not clear whether this figure counts the potential for multiple cases for each taxpayer.
3. Final regulations regarding nondisclosure penalties under section 6707A of the Internal Revenue Code were made effective March 26, 2019. See 84 FR 11217. ("In the final regulations, § 301.6707A-1(d)(1)(ii) is revised to clarify that, when a taxpayer whose participation in a subsequently identified listed transaction or transaction of interest is reflected on more than one return and when that taxpayer fails to file, as required by § 1.6011–4(a), a complete and proper disclosure statement in the time prescribed under § 1.6011–4(e)(2)(i), the amount of the penalty will be calculated by aggregating the decrease in tax shown on each return for which the period of limitations on assessment remains open at the time the transaction becomes reportable, subject to the statutory minimum and maximum penalty amounts.")
4. Appellate case number 18–9011.
5. See, e.g., "Justice Department Sues To Shut Down Promoters of Conservation Easement Tax Scheme Operating Out of Georgia," US Department of Justice 18–1672. ("The suit alleges that defendants have organized, promoted, and sold at least 96 conservation easement syndicates resulting in the syndicates reporting over $2.0 billion of tax deductions from overvalued and improper 'qualified conservation contributions,' and have passed those tax deductions through to the thousands of customers of defendants' scheme, resulting in hundreds of millions of dollars of tax harm.... In the past decade, the Tax Division has obtained injunctions against hundreds of unscrupulous tax preparers and tax scheme promoters. Information about these cases is available on the Justice Department's website. An alphabetical listing of persons enjoined from preparing returns and promoting tax schemes can be found on this page. If you believe that one of the enjoined persons or businesses may be violating an injunction, please contact the Tax Division with details."). See also, Gardner v. Commissioner, 145 T.C. 161, 162 (2015), aff'd sub nom. Gardner v. Commissioner of Internal Revenue, 704 F. App'x 720 (9th Cir. 2017). ("Agreeing with the IRS, the U.S. District Court for the District of Arizona (District Court) determined that the Gardners had engaged in conduct in violation of section 6700 by making statements as to the availability of tax benefits that they knew or had reason to know were false or fraudulent and enjoined them from promoting their plan in the future.") 
6. See, e.g., Settlement Initiative, 2005–2 C.B. 967 (2005) for terms applicable to certain transactions, prior to the existence of "transactions of interest." ("The following transactions are eligible for settlement under this initiative. Stated by each transaction is the accuracy-related penalty on the underpayment attributable to the transaction that a person will be required to pay, unless one of the exceptions listed in paragraph E of section 4 applies."); IR-2005–129, Oct. 27, 2005. ("Under the settlement terms, participants, both individuals and companies, will be required to pay 100 percent of the taxes owed, interest and, depending on the transaction, either a quarter or a half of the penalty the IRS will otherwise seek. There is penalty relief for transactions disclosed to the IRS or where the taxpayer got a tax opinion from an independent tax advisor. Transaction costs paid by the taxpayer to do the deal, including professional and promoter fees, will be allowed."); Rev. Proc. 2002–67, 2002–2 C.B. 733 (2002) ("Under the Fixed Concession Procedure, an Electing Taxpayer is permitted a capital loss deduction equal to 25% of the amount of the capital loss reported for the sale of the transferee stock received in the Contingent Liability Transaction."); Settlement Initiative for Section 302/318 Basis-Shifting Transactions., 2002–2 C.B. 757 (2002). ("The taxpayer will concede the deduction of all transaction costs (other than deemed transaction costs, as described above) relating to the basis-shifting transaction. The taxpayer will concede 80% of the deemed transaction costs and treat 20% of the deemed transaction costs as a capital loss. The cost of the option or the warrant in the foreign corporation shall not be given any other effect.")