Captive insurance companies or 412(e)(3)?
By Nick Paleveda MBA J.D. LL.M
National Pension Partners
Captives are not a toy for tax deductions or the client will find themselves in a Klass situation — or worse, an OPIS or BLIPS tax shelter. If you are looking at captives, there had better be substantial non-tax reasons for forming a captive and the transaction must be a bona fide insurance transaction.
What does the tax court say on captives?
The promoters or captive insurance companies may be the next big problem in the tax court following the OPIS, BLIPS and 419 disasters. Before you jump into a captive, you must read two tax court cases: Hospital Corporation of America v. IRS T.C. Memo. 1997-482 and the more recent Klaas v. Commissioner T.C. Memo. 2009-90.
In addition, the same IRS attacks used on 419 plans may also be used against captive insurance companies; see Goyak v. Commissioner T.C. Memo. 2012-13.
What happened in HCA?
In HCA, the tax court stated they would look at "all the facts and circumstances" concerning the deductibility of a "purported captive." In HCA, the court held for the taxpayer but also cited cases where the captives were stricken as "the ... (captive) was undercapitalized and the captive arrangement was a sham. See Malone Hyde v. Commissioner, 62 F.3d at 841 where the 6th Circuit overturned the tax court and denied the tax deduction for the captive.
The more recent case, Klaas v. Commissioner, was a different story. The tax court denied deductions to the captive and imposed a 6662 penalty. The Court stated, "Mr. Klaas engaged in aggressive tax planning to minimize his taxes... Mr. Klaas was aware of the potential risk with an offshore insurance company and nevertheless chose to structure the transactions in this matter."
Of course, a simple line of attack on a captive is found in Goyak: Is the contribution an "ordinary and necessary business expense" under section 162? So before you jump on the promoter bandwagon, look at HCA and Klaas.
What does the Tax Court say on 412(e)(3) plans?
Nothing. No reported adverse case as of today. Some argue that the returns on the life policy may not be very good. I disagree. A life policy for a 55-year-old who puts $785,034 into a plan for 10 years and maintains a $1,666,666 death benefit will be able to terminate and receive $898,234 in cash surrender value. Granted, it is not a huge return, but it equals short term CDs and U.S. Treasuries. In addition, the plan maintains a death benefit which has some value to the survivors to replace income in the event of a death.
What should a client look at for his or her situation?
It depends. 412(e)(3) plans are certainly in the mix if contributions are needed between $50,000 and $350,000 and the client understands it is an employee benefit plan. If they plan to contribute less, look at a 401(k) profit sharing plan.
If contributions are more, consider a captive. But once again, this is not a toy for tax deductions or the client will find themselves in a Klass situation — or worse, an OPIS or BLIPS tax shelter. If you are looking at captives, there had better be substantial non-tax reasons for forming a captive and the transaction must be a bona fide insurance transaction.