ABUSIVE TAX
SCHEMES
Offshore Insurance
Products and
Associated
Compliance Risks
Report to the Chairman,
Committee on Finance, U.S. Senate
July 2020
GAO-20-589
United States Government Accountability Office
United States Government Accountability Office
Highlights of GAO-20-589, a report to the
Chairman, Committee on Finance,
U.S. Senate
July 2020
ABUSIVE TAX SCHEMES
Offshore Insurance Products and Associated
Compliance Risks
What GAO Found
Federal law provides certain tax benefits for transactions involving genuine
insurance products, including insurance products held offshore. While taxpayers
may lawfully hold offshore insurance products, they contain features that make
them vulnerable for use in abusive tax schemes. For example, offshore
insurance products can be highly technical and individualized, making
enforcement challenging, according to Internal Revenue Service (IRS) officials.
Furthermore, insurance is not defined by federal statute, potentially making a
determination of what constitutes genuine insurance for federal tax purposes
unclear.
Offshore micro-captive insurance products, which are made by small insurance
companies owned by the businesses they insure, may be abused if the corporate
taxpayer improperly claims deductions for payments made to a micro-captive for
federal tax purposes. Courts have applied certain considerations to determine
whether these deductions can be claimed. For example, one consideration is
whether the insurance legitimately distributes risk across participating entities.
IRS officials said they expend significant resources reviewing these schemes
because of the varied ways insurance companies may work.
Offshore variable life insurance products, which are insurance policies with
investment components over which the insured has certain control, may be
abused if the individual taxpayer fails to meet IRS reporting requirements or pay
appropriate federal income taxes. Federal regulations require that taxpayers with
certain foreign life insurance accounts report this information to IRS and the
Financial Crimes Enforcement Network. The structure of life insurance products
may vary and taxpayers are required to pay taxes based on the underlying type
of financial product the policy represents.
The figure below shows how noncompliance may occur when taxpayers use life
insurance and micro-captive insurance in abusive tax schemes.
Abusive Use of Micro-captive and Life Insurance
View GAO-20-589. For more information,
contact
Jessica Lucas-Judy at (202) 512-
9110
or
Why GAO Did This Study
When structured in abusive ways,
insurance products held offshore can
be designed to aid in unlawful tax
evasion by U.S. taxpayers.
Two
products that IRS has recently
warned have the potential for
such
abuse include micro
-captive
insurance and variable life insurance
policies.
GAO was asked to review how
taxpayers may abuse offshore
insurance products. This report
describes (1) how offshore insurance
tax shelters provide opportunities for
income tax abuse; (2) how offshore
micro
-captive insurance is used and
how it is used in abusive tax
schemes; and (3) how offshore
variable
life insurance is used and
how it is used in abusive tax
schemes.
GAO reviewed IRS tax and
information return forms, relevant
U.S. case law and IRS guidance,
academic and trade publica
tions,
and applicable statutes and
regulations. GAO also interviewed
IRS officials and professionals in the
tax preparation and insurance
industries.
Page i GAO-20-589 Abusive Tax Schemes
Letter 1
Background 3
Certain Elements of Offshore Insurance Products Make Them
Vulnerable to Use in Abusive Tax Schemes 7
Offshore Micro-captive Insurance Products: Business Benefits of
Proper Use and Characteristics of Abuse 9
Offshore Life Insurance Products: Individual Taxpayer Benefits of
Proper Use and Characteristics of Abuse 17
Agency Comments 20
Appendix I Guidance that IRS Has Issued about Offshore Insurance 21
Appendix II Tax Forms and Information Returns Related to Offshore Insurance 27
Appendix III GAO Contact and Staff Acknowledgements 31
Tables
Table 1: Revenue Rulings Relating to Abusive Offshore Insurance
Tax Schemes 22
Table 2: Written Determinations that the Internal Revenue Service
(IRS) Identified as Relating to Offshore Insurance Tax
Planning 23
Table 3: Tax Returns Used to Report Insurance and Claim
Associated Tax Benefits, Including Offshore Insurance 27
Table 4: Information Returns Used to Report Offshore Insurances 29
Figures
Figure 1: Description of Insurance Arrangement between a Parent
U.S. Business and its Offshore Micro-Captive Insurance
Subsidiary 10
Figure 2: Description of U.S Individual’s Offshore Variable Life
Insurance Product and An Example of How Abuse Could
Occur 18
Contents
Page ii GAO-20-589 Abusive Tax Schemes
Abbreviations
CCA Chief Counsel Advice
IRB Internal Revenue Bulletin
IRC Internal Revenue Code
IRS Internal Revenue Service
PLR Private Letter Ruling
TAM Technical Advice Memorandum
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Page 1 GAO-20-589 Abusive Tax Schemes
441 G St. N.W.
Washington, DC 20548
July 30, 2020
The Honorable Charles E. Grassley
Chairman
Committee on Finance
United States Senate
Dear Chairman Grassley:
When structured in abusive ways, offshore insurance products can be
designed to hide U.S taxpayers’ assets or falsely claim federal income tax
benefits.
1
Federal law generally allows U.S. taxpayers to enter into
insurance policies with offshore entities and provides certain tax benefits,
such as income-tax deductions for insurance premiums, for genuine
offshore insurance transactions.
2
However, when taxpayers abuse these products, they threaten our tax
system’s integrity and fairness. This is in part because taxpayers may
believe that individuals and businesses are not paying their fair share of
taxes and instead are contributing to the tax gap, which is the difference
between the taxes people and businesses owe and what they annually
pay voluntarily and on time in the United States. In 2019, the Internal
Revenue Service (IRS) estimated the average annual gross tax gap for
tax years 2011 through 2013 to be $441 billion. After taking into account
its enforcement activities and late payments, IRS calculated that the
average net tax gap was $381 billion per year.
While taxpayers can hold offshore insurance for a number of legitimate
reasons, IRS has identified instances where taxpayers have used
offshore insurance products to improperly reduce their tax liabilities.
These abusive offshore insurance tax schemes can involve sophisticated
tax shelters, devised and marketed to taxpayers by accountants, estate
planners, and attorneys. These shelters may also be constructed or
recommended by professionals that have established relationships with
1
We will refer to financial products that have been marketed and sold to U.S. taxpayers as
insurance as “insurance products” throughout this report. These insurance products may
be later determined by IRS or the courts to be arrangements that are not insurance for
federal income tax purposes.
2
For purposes of this report, genuine insurance is insurance products that are considered
insurance for federal income tax purposes. The characteristics of genuine insurance may
vary based on the specific type of insurance being considered.
Letter
Page 2 GAO-20-589 Abusive Tax Schemes
taxpayers. IRS officials have said that when insurance is held offshore, it
can be more resource intensive to identify abusive insurance tax
schemes and take enforcement action.
You asked us to review how taxpayers may abuse offshore insurance
products and what guidance IRS provides about complying with laws
related to offshore insurance accounts. This report describes (1) how
offshore insurance tax shelters provide opportunities for income tax
abuse; (2) how offshore micro-captive insurance is used and how it is
used in abusive tax schemes; and (3) how offshore life insurance is used
and how it is used in abusive tax schemes.
To describe how offshore insurance tax shelters provide opportunities for
income tax abuse, we reviewed academic and trade publications;
reviewed IRS guidance on its website; summarized applicable statutes,
regulations, and case law; and interviewed IRS officials and industry
professionals, whom we identified from referrals from professional
associations and our own literature searches. Specifically for IRS
guidance, we confirmed with IRS officials what they considered to be key
guidance on helping ensure compliance with offshore insurance products.
We summarized this information and categorized the guidance according
to our previous work, which defined types of guidance and reviewed
guidance IRS communicates publicly.
3
Additionally, to describe micro-captive insurance and life insurance tax
shelters and any non-tax benefits these shelters offer and to determine
how they are used in abusive tax schemes, we reviewed relevant case
law and industry websites and interviewed industry professionals and IRS
officials.
We conducted this performance audit from October 2019 to July 2020 in
accordance with generally accepted government auditing standards.
Those standards require that we plan and perform the audit to obtain
sufficient, appropriate evidence to provide a reasonable basis for our
findings and conclusions based on our audit objectives. We believe that
the evidence obtained provides a reasonable basis for our findings and
conclusions based on our audit objectives.
3
GAO, Regulatory Guidance Processes: Treasury and OMB Need to Reevaluate Long-
standing Exemptions of Tax Regulations and Guidance, GAO-16-720 (Washington, D.C.:
Sept. 6, 2016).
Page 3 GAO-20-589 Abusive Tax Schemes
We previously reported that tax shelters can be legitimate to the extent
they take advantage of various provisions in the tax code to lawfully avoid
paying federal taxes; however, according to IRS, abusive tax shelters
result in unlawful tax evasion.
4
Abusive offshore insurance tax schemes
include transactions that are also considered scams or schemes based
on erroneous interpretations of tax law.
U.S. taxpayers may qualify for tax benefits associated with certain types
of insurance, but they are responsible for ensuring that (1) they accurately
report assets to the U.S. government on applicable tax forms and
information returns, (2) they only claim these tax benefits as appropriate,
and (3) they pay appropriate taxes based on the true type of financial
instrument. These principles apply whether taxpayers hold assets,
income, and financial instruments in the United States or offshore.
Whether a transaction or product constitutes insurance has numerous
federal tax consequences and determines whether taxpayers may claim
certain tax benefits. For example, the Internal Revenue Code (IRC)
provides businesses and individuals with multiple tax benefits for utilizing
insurance to guard against the financial consequences of various risks,
such as environmental disasters, legal issues, and mortality. Although the
IRC does not define insurance, the U.S. Supreme Court has held that,
“historically and commonly, insurance involves risk-shifting and risk-
distribution.”
5
In the decades that followed, IRS and the lower U.S. courts
have applied these two factors when litigating whether certain
arrangements are considered insurance for federal tax purposes.
Captive insurance. Section 162 of the IRC generally allows for the
deduction of ordinary and necessary expenses associated with running a
business, thereby reducing the amount of taxes owed.
6
These expenses
include premiums paid for insurance against risks inherent in conducting
4
Our report reviewed what is known about abusive tax avoidance transactions and the
results of IRS enforcement efforts against such transactions. See GAO, Abusive Tax
Avoidance Transactions: IRS Needs Better Data to Inform Decisions about Transactions,
GAO-11-493 (Washington, D.C.: Mar. 12, 2011).
5
The Court also had held that an insurance transaction must involve an actual insurance
risk at the time the transaction is executed. Helvering v. Le Gierse, 312 U.S. 531, 539
(1941).
6
26 U.S.C. § 162(a).
Background
Tax Benefits of Insurance
for Businesses and
Individuals
Page 4 GAO-20-589 Abusive Tax Schemes
business. Generally, premiums that are deductible under section 162 are
for insurance against risks that only have negative results—referred to as
insurable risks. Risks that could have either positive or negative results—
for example, a risk that a business will recuperate its investment in new
equipment—is considered a speculative risk according to IRS audit
guidance and is not an insurable risk.
While many businesses choose to insure their risks through commercially
available insurance policies, some choose to create their own insurance
companies that can provide tailored and sometimes more affordable risk
coverage. These insurance entities, called captive insurance companies,
are generally wholly owned by the businesses they insure. The courts first
addressed the tax consequences of owning captive insurance in 1978,
and captive arrangements gained popularity throughout the 1990s and
2000s.
7
One IRS enforcement official estimated that as many as 85
percent of Fortune 500 companies today utilize captive insurance
arrangements.
Before 1986, the costs of forming and managing a captive insurance
company were greater than the potential benefits to many small and
medium-sized businesses. The Tax Reform Act of 1986 amended the
IRC to revise the framework allowing certain small insurers to elect to be
taxed only on their taxable investment income.
8
In this report, we use the
term micro-captives to refer to small captive insurance companies—
including domestic or offshore companies—that make this election under
7
Carnation Co. v. Commissioner, 71 T.C. 400 (1978), affd, 640 F.2d 1010 (9th Cir. 1981).
The Court held that payments made by the taxpayer to an insurance company that were
then paid to the taxpayer’s subsidiary for reinsurance were not deductible as a business
expense.
8
Tax Reform Act of 1986, Pub. L. No. 99-514, § 1024(a)(4), 100 Stat. 2085, 2405 (1986),
codified at 26 U.S.C. § 831. To qualify as a small insurance company for purposes of
making this election, the insurance company could not be a life insurance company and
could have no more than $1.2 million in premium income. In 2015 section 831(b) was
amended (1) to increase this threshold to $2.2 million and index it to inflation and (2) to
impose certain diversification requirements. These requirements state that either (1) no
more than 20 percent of the net or direct premiums written by the insurer are attributable
to any one policyholder or (2) that no family member of an owner of an insured business
have a financial interest in the micro-captive that is 2 percent or more larger than their
stake in the insured business. Pub. L. No. 114-113, div. Q, § 333, 129 Stat. 2242, 3106–
3108 (2015).This second requirement limits the ability of owners of insured businesses
from treating micro-captives as estate planning tools.
Page 5 GAO-20-589 Abusive Tax Schemes
section 831(b) or claim tax exempt status under IRC section 501(c)(15).
9
Generally, businesses that pay premiums for genuine insurance issued
by or reinsured by their micro-captive insurance companies can deduct
the value of these premiums under IRC section 162. To claim the tax
benefits associated with micro-captives, offshore insurers making the
election under section 831(b) must first elect under section 953(d) to be
treated as a domestic entity for tax purposes.
Life insurance. The IRC provides three main tax benefits for life
insurance policyholders. First, the policyholder is not taxed on growth in
the value of life insurance policies.
10
Second, the policyholder may be
able to access the value of the policy during their life, such as taking out a
loan against the policy, tax-free.
11
Third, the beneficiary is generally not
taxed on proceeds from the life insurance after the insured’s death.
12
A
policy will be treated as a life insurance contract for tax purposes only if it
satisfies certain tests that require complex calculations involving the
relationships among premium levels, mortality charges, interest rates,
death benefits, and other factors.
13
In general, even though a policyholder of a variable life insurance policy
has a separate account, for federal tax purposes the assets in it are
considered the life insurance company’s property, not the policyholder’s
9
To qualify as a small insurance company for purposes of making an election under 26
U.S.C. § 501(c)(15) to be exempt from income taxation, the insurance company could not
be a life insurance company and could have no more than $600,000 in gross receipts.
Further, premiums must make up more than 50 percent of these gross receipts. Mutual
insurance companies making the 501(c)(15) election must have no more than $150,000 in
gross receipts, of which premiums must make up more than 35 percent.
10
In general the insurance company is also not taxed on this growth in value.
11
26 U.S.C. § 72(e); Atwood v. Comm’r, 77 T.C.M. 1476 (1999) (loans against an
insurance policy constituted true loans, not cash advances, and were not taxable
distributions when received). This benefit is not available to certain life insurance products
called modified endowment contracts. 26 U.S.C. §§ 72(e)(10), 7702A. The amount the
policyholder can access tax-free may be limited by the amounts paid as premiums for the
policy.
12
26 U.S.C. § 101(a).
13
26 U.S.C. § 7702.
Page 6 GAO-20-589 Abusive Tax Schemes
property.
14
While the assets held in a variable life insurance policy’s
separate account are sometimes called cash-value funds, in this report
we refer to them as separate account assets.
The separate account assets are invested among a variety of investment
products offered by the insurance company (such as stocks, bonds, and
mutual funds). The policyholder is permitted to allocate the assets in the
separate account among these investment products as they wish, though
the insurance company may limit the policyholder’s control over these
separate account asset allocations.
For variable life insurance policies, the amount paid out to the beneficiary
once the insured person dies generally depends on how the investments
of the separate account assets perform. The beneficiary typically receives
the larger of the policy’s minimum death benefit value and the policy’s
separate account assets. In contrast, policyholders do not direct
investment strategies of separate account assets in nonvariable universal
or whole life insurance policies because the funds are held in general
accounts of the insurance company, which manages the investment of all
funds in the general account.
15
In 2016, we found that IRS issues thousands of publications in a variety
of forms to help taxpayers and their advisors understand the law.
16
IRS
guidance that most directly addresses the types of offshore insurance tax
schemes discussed in this report fits into three categories:
14
While variable and variable-universal life insurance policies have some differing
characteristics, in this report we refer to them both as variable life insurance policies.
Variable life insurance has both a standard death benefit and a separate account asset
component, some or all of which is held by the life insurance company in an account
separate from the insurer’s other assets.
15
Individuals may choose to guard against their risk of mortality using a variable life
insurance policy or instead they may choose to use another type of life insurance, such as
nonvariable whole or universal life insurance policies.
16
For a more detailed discussion of IRS guidance overall, see GAO, Regulatory Guidance
Processes: Treasury and OMB Need to Reevaluate Long-standing Exemptions of Tax
Regulations and Guidance, GAO-16-720 (Washington, D.C.: Sept. 6, 2016).
IRS Guidance
Page 7 GAO-20-589 Abusive Tax Schemes
• Guidance published in the Internal Revenue Bulletin (IRB), such as
revenue rulings, revenue procedures, notices, and other
announcements.
17
• Written determinations, including private letter rulings and technical
advice memorandums.
• Other IRS information, such as forms and publications, FAQs, news
releases, and videos.
Appendix I describes these types of guidance in greater detail, including
examples of guidance that relate to offshore insurance tax schemes.
Insurance is not defined in statute, and generally IRS and the courts have
served as arbiters of what insurance products are considered genuine
insurance for federal tax purposes, which requires significant resources.
IRS enforcement officials said some taxpayers abuse insurance tax
shelters specifically because of the complexity of conducting enforcement
actions against these schemes, including those held offshore.
Officials said some abusive schemes involve sophisticated layered
products.
18
These products are created specifically to evade taxes, and
IRS auditors often need to sort through voluminous evidentiary
documents and use subject matter experts to review technical materials.
Further, IRS officials told us it can be more difficult to conduct
enforcement actions against offshore insurance tax shelters because
audit staff may encounter roadblocks created by bank secrecy laws when
trying to obtain information about the insurance arrangement and the U.S.
taxpayers involved.
17
A revenue ruling is an official interpretation of the IRC, related statutes, tax treaties, or
regulations as applied to a specific set of facts. A revenue procedure is an official
statement of a procedure that affects the rights or duties of taxpayers or other members of
the public under the IRC, related statutes, tax treaties, and regulations.
18
Layered arrangements are those in which several financial products are used in
combination with one another. One IRS official told us that these layered arrangements
are intentionally complex and used by taxpayers to hide assets from IRS.
Certain Elements of
Offshore Insurance
Products Make Them
Vulnerable to Use in
Abusive Tax Schemes
Page 8 GAO-20-589 Abusive Tax Schemes
In response, IRS has issued public warnings about promoters offering
offshore insurance products that may in fact be abusive tax schemes.
19
In
abusive schemes, the insurance products lack the characteristics of
genuine insurance that are required for claiming deductions and other tax
benefits, such as risk shifting and risk distribution. IRS officials told us that
the use of certain offshore insurance products, including micro-captive
insurance and variable life insurance, started appearing in examinations
involving offshore assets more frequently between 2008 and 2012.
This marked a time when U.S. federal agencies were receiving more
information from foreign banks on undisclosed foreign assets held
offshore in traditional bank and investment accounts and the agencies
increased enforcement activity on abusive tax schemes.
20
Some offshore
insurance products offered alternatives for taxpayers to hide their assets
or engage in tax planning using shelters under less scrutiny.
In the next two sections, we provide examples of how taxpayers have
abused insurance with micro-captive insurance and life insurance
products.
21
19
The term “promoter” includes a person who (1) organizes an investment plan or
arrangement affecting taxes or participates in selling it and (2) makes a statement about
its tax benefits. See 26 U.S.C. § 6700. Appendix I contains more information about
announcements and other communications IRS has issued about abusive tax schemes
involving insurance.
20
Appendix II describes some of the information available to IRS on offshore insurance
from tax forms and information returns where taxpayers may report various aspects of
their insurance, such as related deductions, assets, or taxes owed. For example, some tax
forms listed require taxpayers with financial interests in offshore insurance specifically to
provide information or pay relevant taxes.
21
IRS has identified other types of offshore financial products that may be used as part of
abusive tax schemes, including certain uses of trusts and annuities. For example,
according to IRS, offshore private annuities are sometimes used with variable life
insurance products by taxpayers to evade taxation on related income. Annuity products
are used to insure against longevity risk and may be structured to pay out funds to the
policyholder over the rest of their lifetime. There are numerous ways that offshore financial
products, including insurance and annuity products, have been used to create abusive
schemes and improperly claim various tax benefits. We do not attempt to address all
permutations of abusive offshore insurance tax schemes in this report.
Page 9 GAO-20-589 Abusive Tax Schemes
Offshore micro-captive insurance products can provide several important
benefits to businesses that use them legitimately. For example, the
insured businesses might benefit from
• new or better risk coverage because the insurance policies may be
tailored to their needs,
• monetary savings on insurance premiums compared to commercially
available policies,
• stable insurance premiums, or
• profit generated by the micro-captive if premium revenue exceeds
claims.
Figure 1 depicts how an offshore 831(b) micro-captive insurance
company that insures its parent may operate to ensure it meets legal
requirements.
22
22
There are many ways that micro-captives may be structured, based on the goals of the
insured business. For example, micro-captives can insure their parent’s risk if the
premiums and risks of the parent are adequately pooled with premiums and risks of
unrelated parties. Rev. Rul. 2002-89. A micro-captive can also insure the risks of other
subsidiaries of its parent. Human Inc. v. Comm’r 881 F.2d 247 (6
th
Cr. 1989); Rev. Rul.
2002-90. All other factors to qualify as insurance for federal tax purposes must also be
met.
Offshore Micro-
captive Insurance
Products: Business
Benefits of Proper
Use and
Characteristics of
Abuse
Page 10 GAO-20-589 Abusive Tax Schemes
Figure 1: Description of Insurance Arrangement between a Parent U.S. Business and its Offshore Micro-Captive Insurance
Subsidiary
When micro-captive insurance products are located offshore, they may
provide additional benefits to the business, such as less onerous
insurance regulations. One industry professional told us that offshore
jurisdictions may have a simpler or faster process for establishing a
micro-captive insurance company or they may have lower taxes.
Additionally, some countries have laws that may provide protection for the
micro-captive’s funds and assets in cases involving large claims or
lawsuits against the micro-captive or its parent U.S. business. Finally,
some businesses may benefit from their micro-captive’s ability to
accumulate offshore assets.
Page 11 GAO-20-589 Abusive Tax Schemes
Sometimes micro-captives are established purely for tax reasons, which
generally courts have ruled is improper.
23
Indicators that businesses have
established a micro-captive in an abusive tax scheme include artificially
high premiums that do not make economic sense or that are not
supported by actuarial science.
IRS enforcement officials told us they first came across abusive micro-
captive insurance schemes in the mid-2000s. Following many years of
enforcement action, IRS determined that some micro-captive insurance
transactions have the potential for abuse. Subsequently, IRS required
U.S. taxpayers to disclose their involvement in micro-captive insurance
transactions, based on certain criteria, through IRS Notice 2016-66,
Transaction of Interest: Section 831(b) Micro-Captive Transactions.
24
Between November 1, 2016, and December 31, 2019, IRS processed
disclosures on thousands of micro-captive insurance transactions.
25
IRS
has said that the majority of micro-captive cases examined have been
determined to be abusive. IRS officials told us that as the result of various
enforcement actions, including a 2016 enforcement campaign, IRS
offered settlements to 156 taxpayers who participated in abusive micro-
captive transactions. Of those taxpayers, 76 percent had elected to
accept the settlement terms as of June 2020.
Since 2017, IRS has won three micro-captive cases before the Tax Court,
which supported IRS’s increased enforcement actions against abusive
micro-captive insurance products. At issue in these cases was whether
the micro-captive or related businesses could claim various deductions
and tax benefits.
23
In the Avrahami and Syzygy cases, the intent established by the taxpayer’s
contemporaneous email record contributed to the Tax Court’s holding that the captive did
not provide genuine insurance. Avrahami v. Comm’r, 149 T.C. 144 163 (2017); Syzygy
Ins. Co. v. Comm’r, 117 T.C.M. (CCH) 115 24, 33, 36, (2019).
24
Notice 2016-66 references 2016-47 I.R.B. 745. Taxpayers who engage in these or
substantially similar transactions are required to report them to IRS. 26 U.S.C. § 6111; 26
C.F.R. § 1.6011-4(b)(6). A legal challenge to this requirement is before the U.S. Supreme
Court, as described in greater detail in appendix I.
25
Based on our analysis of IRS data from individual filers of Form 8886, which were
processed by IRS’s Office of Tax Shelter Analysis staff between November 1, 2016, and
December 31, 2019.
Page 12 GAO-20-589 Abusive Tax Schemes
Below are the criteria the Tax Court used in its analyses when
determining the micro-captive products were not genuine insurance.
Although these criteria are not independent or exclusive, they establish a
framework for determining whether insurance exists under the federal tax
law.
26
In some cases, the courts have considered whether the insurer is a
bona fide or sham insurance company.
27
Courts have also emphasized
the need to consider all facts and circumstances in each case.
28
When determining whether some captive insurance products were
insurance for federal income tax purposes, IRS and the courts have
considered whether insurance products involve actual and insurable
risks.
29
Actual risks are those that are truly faced by the insured, and
insurable risks are those that can only result in a loss if the event
occurred.
While most speculative risks could result in either a loss or a gain,
insurable risks can only result in a loss. For example, whether a business
will recuperate its investment in new equipment is a type of speculative
risk because the businesses could experience either a financial loss or
gain. In contrast, the risk that a building will catch fire is an insurance risk.
IRS has warned that some abusive micro-captive insurance tax shelters
involve insurance of implausible risks. While some such risks are clearly
unlikely, others require careful analysis to determine whether the insured
did not truly face the risks covered under their policy.
30
In Reserve
Mechanical Corp. v. Commissioner, the court determined that loss events
26
AMERCO, Inc. v. Comm’r, 96 T.C. 18, 38 (1991), aff’d 979 F.2d 162 (1992).
27
Courts have generally considered this separately from applying the other criteria. Rent-
a-Center, Inc. v. Comm’r, 142 T.C. 1 (2014); United Parcel Service of America v. Comm’r,
254 F.3d 1014 (11th Cir. 2001); Malone & Hyde Inc. v. Comm’r, 62 F.3d 835 (6th Cir.
1995).
28
Rent-a-Center, 142 T.C. at 13–14; Sears, Roebuck, and Co. v. Comm’r, 96 T.C. 61, 96
(1991).
29
See Harper Group and Includible Subsidiaries v. Comm’r, 96 T.C. 45, 58 (1991). See
also Notice 2016-66 § 1.02(c)–(f).
30
For example, one industry professional told us they had heard of a micro-captive
providing insurance specifically against damages caused by satellites falling out of Earth’s
orbit. While technically possible, such an event is extremely unlikely.
Criterion 1: Is There an
Actual or Insurable Risk?
Page 13 GAO-20-589 Abusive Tax Schemes
experienced in the past do not necessarily translate to current actual
risks.
31
The case. Peak Casualty Holdings, LLC (Peak) created an Anguilla-
based micro-captive insurance company, Reserve Mechanical Corp
(Reserve). The agreements between Peak and Reserve purported to
insure Peak against large financial losses not covered by Peak’s other
commercial insurance policies. These agreements identified PoolRe
Insurance Corp (PoolRe) as a stop loss insurer. Reserve also entered
into agreements to reinsure a share of PoolRe’s risk pool. The taxpayer
argued, in part, that these reinsurance agreements achieved risk
distribution.
In evaluating this argument, the court analyzed whether the agreement
between Reserve and PoolRe constituted bona fide insurance. Among
the factors the court considered in the analysis was whether PoolRe
faced actual and insurable risks. Reserve was able to point to one
financial loss event in the past 10 years, which was not fully covered by
Peak’s commercial insurers, but the full amount of the claim was
significantly below the threshold that would have triggered PoolRe’s
liability as a stop loss insurer.
32
In this case, the Tax Court determined that Peak was unlikely to
experience similar events in the future that could ever justify its policies’
premiums.
33
As a result, PoolRe did not truly face risk under its stop loss
agreement and therefore Reserve’s reinsurance agreement with PoolRe
was not insurance for federal income tax purposes. Since the reinsurance
agreement was not bona fide insurance, the taxpayer’s argument that
Reserve distributed risk through them failed.
The court held that Reserve itself was not an insurance company for
federal income tax purposes and was not eligible for its insurance
company income tax exemption under section 501(c)(15). Therefore, it
31
Reserve Mechanical Corp v. Comm’r, 115 T.C.M. 1475, 43-44 (2018), appeal docketed
No. 18-9011 (10th Cir. Dec. 27, 2018).
32
The taxpayer also argued that taxes owed after Peak’s returns were reviewed by an
accounting firm were the type of losses covered by Reserve and the stop loss agreements
with PoolRe, but the court found no evidence of the amounts of the purported loss or the
likelihood that something like that would happen again.
33
This analysis was part of a broader discussion of whether the micro-captive properly
distributed risk. We have focused on this part of the analysis to illustrate the Tax Court’s
application of this criterion.
Page 14 GAO-20-589 Abusive Tax Schemes
was not eligible to make an election to be treated as a domestic
insurance corporation under section 953(d), and as a result, was liable for
a 30 percent withholding tax on income received from affiliated insured
businesses.
Generally, the courts have determined that risk shifting occurs when the
insured transfers the financial consequences of an insurable loss to the
insurer. The risk is typically offset by premium payments. Risk
distribution, also referred to as risk pooling, allows the insurer to reduce
the possibility that a single costly claim will exceed the amount paid in
premiums by the insured.
In one 1991 Tax Court case, the judge noted that captive insurance
products, including micro-captive products, “straddle the fence” between
self-insurance and insurance for federal income tax purposes.
34
The key
distinctions between these two types of arrangements include the
presence of risk shifting and risk distribution, and the court’s
consideration of captive insurance arrangements often revolves around
analysis of risk shifting and risk distribution.
Risk shifting and risk distribution do not occur when a captive insurance
company only insures the risks of its parent.
35
For risk shifting, courts
noted that when the captives paid out claims, these financial losses
impacted their parent corporations’ balance sheets, so the economic
impact of these risks was not truly transferred away from the parent.
Further, since risk distribution involves pooling many small independent
risks, captives that only insured their parents’ risks could not properly
distribute risk. However, captives can shift and distribute risk by insuring
sibling corporations, which are business entities owned by the same
parent corporation, or by insuring or reinsuring unrelated entities.
36
The
cases below illustrate taxpayers and their advisors crafting insurance
products with this legal framework in mind; however, they were ultimately
held to have failed to distribute risk.
34
Harper Group and Includible Subsidiaries, 96 T.C. at 46.
35
Carnation Co. v. Comm’r, 640 F.2d 1010, 1013 (9
th
Cir. 1981); Stearns-Roger Corp., Inc.
v. U.S., 577 F.Supp 833, 838 (D. Colo. 1984); see also Anesthesia Service Med. Group,
Inc. v. Comm’r 85 T.C. 1031, 1041-1042 (1985).
36
Crawford Fitting Co. v. U.S., 606 F.Supp. 136, 148 (N.D. Ohio 1985); Humana Inc. v.
Comm’r, 881 F.2d 247, 257 (6th Cir. 1989).
Criterion 2: Are Both Risk
Shifting and Risk
Distribution Present?
Page 15 GAO-20-589 Abusive Tax Schemes
The cases. All three of IRS’s recent victories involved the determination
that risk distribution did not occur. In Avrahami v. Commissioner, Reserve
Mechanical Co. v. Commissioner, and Syzygy v. Commissioner, the
taxpayers argued their captive distributed risk, in part, because the
captive entered into agreements under which, the taxpayers argued, the
captive provided reinsurance to unrelated insurance companies.
However, in all three cases, the Tax Court held that these unrelated
entities were not bona fide insurance companies; therefore, the captive
did not effectively distribute risk.
37
Secondary question. Throughout the case law, IRS and courts have
sometimes considered whether an insurer or reinsurer was a sham
company when determining whether a captive insurance product was
insurance for federal tax purposes. In some cases, the court makes this
determination independently from other characteristics of the
arrangement, because a sham insurance company cannot provide
insurance for federal income tax purposes.
38
However, in other cases, the
court examines whether an arrangement involved a bona fide insurer as
part of a more detailed analysis of risk distribution. In a 2017 Tax Court
case, the court considered as part of its analysis of risk distribution
whether an entity to whom the micro-captive was providing reinsurance
was a bona fide insurance company.
The case. In Avrahami v. Commissioner, the court considered many
characteristics of the company purchasing the reinsurance. It concluded
that the third-party insurer was not a bona fide insurance company
because the reinsurance premiums were excessively large and of a
circular nature, and there was an ultralow probability of a claim ever being
paid and an atypical fee structure.
39
While there are many ways in which a micro-captive insurance product
may be structured, the product still must conform to commonly accepted
notions of insurance for it to be considered insurance for federal income
tax purposes. Courts have considered a variety of questions for this part
of the test, including whether the insurer is regulated under the insurance
laws of its jurisdiction, whether it is adequately capitalized, whether
37
Syzygy, 117 T.C.M. at 36–37; Reserve Mech. Co., 115 T.C.M. at 45–46, 47–48;
Avrahami, 149 T.C. at 190.
38
Malone & Hyde, Inc. v. Comm’r 62 F.3d 835, 842—843 (6th Cir. 1995); United Parcel
Service of America, Inc. v. Comm’r, 254 F.3d 1014, 1020 (11th Cir. 2001); Ocean Drilling
& Exploration Co. v. U.S., 988 F.2d 1135, 1157 (Fed. Cir. 1993).
39
Avrahami, 149 T.C. at 190.
Criterion 3: Does the
Product Fit Commonly
Accepted Notions of
Insurance?
Page 16 GAO-20-589 Abusive Tax Schemes
premiums charged were reasonable and the result of arm’s length
transactions, and whether the insurer has paid any claims.
In Syzygy v. Commissioner, the court considered many of these factors
when determining that the agreement among Syzygy, its owner, and its
fronting carriers was not insurance in the commonly accepted sense. In
this case, the court considered the legitimacy of agreements between a
business and its domestic micro-captive, which was incorporated and
regulated in Delaware.
The case. A group of related taxpayers had financial interests in a group
of corporate entities collectively referred to as HT&A. HT&A created a
micro-captive insurance company, Syzygy, which operated in a complex
structure as a second insurer of HT&A’s risks. HT&A’s insurance policies
were with fronting carriers, who then passed along all of HT&A’s risk to
Syzygy, but kept a percentage of HT&A’s premiums as a fee. The court
held that although Syzygy was organized and regulated as an insurance
company, met Delaware’s minimum capitalization requirements, and paid
a claim, these insurance-like traits did not overcome the arrangement’s
other failings. The court gave greater weight to its findings that Syzygy
was not operated like an insurance company and that the fronting carriers
charged unreasonable premiums and late-issued policies with conflicting
and ambiguous terms. The court held that the agreements at issue were
not insurance in the commonly accepted sense.
40
40
Syzygy, 117 T.C.M. at 45.
Page 17 GAO-20-589 Abusive Tax Schemes
IRS has also determined that offshore life insurance arrangements have
the potential for tax abuse.
41
One IRS official told us that offshore variable
life insurance products have been used to conceal assets from the U.S.
government, including undeclared assets at risk of being discovered
during investigations of foreign banks. Further, some taxpayers closely
control how their premiums are invested and may direct premium funds
toward illiquid assets they currently own in an attempt to convert taxable
income to tax exempt income that is eventually passed on to their
beneficiaries tax-free.
However, IRS also acknowledged that there are many legitimate uses of
offshore life insurance products and that when used properly these
products offer important benefits to taxpayers. In addition to the various
tax benefits discussed in the background section, offshore policies may
also offer taxpayers certain legal benefits, depending on the jurisdiction.
For example, individuals or other entities wishing to sue the policyholder
for assets held in an offshore life insurance policy must file the lawsuit
with the offshore jurisdiction’s legal authority.
Offshore life insurers and U.S. policyholders must ensure they meet the
taxpayer responsibilities described in the background section. For
variable life insurance policies, the net premium funds in the separate
asset account are invested among a variety of investment products
offered by the insurance company (such as stocks, bonds, and mutual
funds). While policyholders are permitted to allocate the funds in the
separate asset account among these investment products as they wish,
courts have indicated that in order to maintain tax benefits, the
policyholders must not exercise significant control over the account, so
the frequency of transfers and reallocations may be limited by the
insurance company. For example, IRS officials told us that policyholders
should not be allowed to select specific individual investments (e.g.,
Apple common stock).
Figure 2 depicts how offshore variable life insurance arrangements may
operate to comply with these responsibilities and identifies an example of
41
Since 2013, the U.S. Department of Justice has taken significant actions against
abusive offshore life insurance products. The agency established the Swiss Bank
Program, which is directed at the financial institutions themselves, and allows the banks to
resolve issues related to U.S. clients with undeclared accounts. The agency’s
investigations have turned up abuses of life insurance products.
Offshore Life
Insurance Products:
Individual Taxpayer
Benefits of Proper
Use and
Characteristics of
Abuse
Page 18 GAO-20-589 Abusive Tax Schemes
how a taxpayer’s actions could lead to the abuse of this type of tax
shelter–either intentionally or unintentionally.
Figure 2: Description of U.S Individual’s Offshore Variable Life Insurance Product and an Example of How Abuse Could Occur
Below are the two major questions that courts have raised in deciding
whether taxpayers fulfilled their responsibilities related to holding offshore
life insurance products, including whether the taxpayer properly reported
insurance accounts to the U.S. government and whether the taxpayer
paid all required taxes based on the true type of financial vehicle.
Page 19 GAO-20-589 Abusive Tax Schemes
Federal regulations require that U.S. taxpayers with certain foreign life
insurance accounts report this information to IRS and the Financial
Crimes Enforcement Network. However, because of the intricacies of
the foreign financial system, it can be difficult for the U.S. government
to ensure that its taxpayers have declared their foreign financial
accounts and related income. Failure to file the appropriate
information returns has been considered abusive by the courts.
The case. In United States v. John Blandi, the taxpayer pleaded guilty
to charges related to failing to report the foreign financial account
associated with his Swiss private placement life insurance policy, a
type of variable life insurance policy.
42
The U.S. Department of Justice
detailed that the taxpayer intentionally took precautions to prevent
financial transactions that would alert U.S. government officials to his
foreign financial account. The taxpayer also withheld information
about the account’s existence from his tax preparer.
This concealment resulted in the tax preparer filing false income tax
returns, which stated that the taxpayer had no reportable foreign
financial accounts. Additionally, by concealing the private placement
life insurance separate asset account he held offshore, the taxpayer
underreported his income by more than $1 million and understated his
tax due by more than $500,000.
As discussed above, when taxpayers display significant control over
assets held offshore in separate asset accounts of their life insurance
policies, they can be considered the owners of such accounts for tax
purposes. Having significant control but not paying certain taxes has
been considered an abuse by the courts.
The case. In Webber v. Commissioner, the court determined that the
taxpayer had significant control over the assets held in the foreign
financial account associated with his offshore private placement
variable life insurance policies. As a result, the court held that the
taxpayer was the owner of that account for federal income tax
purposes, and any income from the assets was includable in the
taxpayer’s gross income.
43
In this case, the taxpayer directed the insurance policies’ assets
toward various start-ups and other companies in which he had a
42
Plea Agreement at 4–7, U.S. v. Blandi, No. 2:19-cr-0161-WFN (E.D. Wash. Oct. 22,
2019).
43
Webber v. Comm’r, 144 T.C. 324, 368 (2015).
Taxpayer Responsibility 1:
Did the Taxpayer Properly
Report Insurance
Accounts to the U.S.
Government?
Taxpayer Responsibility 2:
Did the Taxpayer Pay All
Required Taxes Based on
the True Type of Financial
Vehicle?
Page 20 GAO-20-589 Abusive Tax Schemes
financial interest. More than 70,000 emails were sent between the
taxpayer, investment manager, and the insurer regarding the
investment strategy for the private placement life insurance policies’
accounts.
We provided a draft of this report to IRS. IRS provided technical
comments but did not provide a letter.
As agreed with your offices, unless you publicly announce the contents of
this report earlier, we plan no further distribution until 30 days from the
report date. At that time, we will send copies of this report to the
appropriate congressional committees, the Secretary of the Department
of the Treasury, the Commissioner of Internal Revenue, and other
interested parties. In addition, the report is available at no charge on the
GAO website at http://www.gao.gov.
If you or your staff have any questions about this report, please contact
points for our Offices of Congressional Relations and Public Affairs are on
the last page of this report. GAO staff who made key contributions to this
report are listed in appendix III.
Sincerely yours,
Jessica Lucas-Judy
Director, Tax Issues
Strategic Issues
Agency Comments
Appendix I: Guidance That IRS Has Issued
about Offshore Insurance
Page 21 GAO-20-589 Abusive Tax Schemes
The Internal Revenue Bulletin (IRB) is one of the main ways the Internal
Revenue Service (IRS) communicates official guidance to taxpayers.
Through the IRB, IRS has issued four notices directly relating to abusive
tax schemes involving insurance that also apply to offshore insurance
accounts.
Most recently, IRS issued Notice 2016-66, Transaction of Interest:
Section 831(b) Micro-Captive Transactions. As previously discussed, this
notice outlines circumstances in which taxpayers may improperly claim
deductions for premiums paid to a micro-captive insurance company.
Micro-captive insurance is one type of insurance sometimes held
offshore.
Three other IRS notices describe transactions that may involve offshore
insurance accounts but are not restricted to offshore insurance:
• Notice 2002-70, Certain Reinsurance Arrangements, describes when
certain income shifting among related companies to insurance
companies may be noncompliant with federal income-tax laws.
1
• Notice 2005-49, Qualification of Certain Arrangements as Insurance,
briefly summarizes existing related revenue rulings and solicits
comments on the following:
• The factors to determine whether cell captive arrangements
constitute insurance.
• The circumstances under which related parties as insurance may
be affected by a loan-back of amounts paid as premiums.
• Whether certain aspects of risk are relevant in determining
whether risks are adequately distributed for an arrangement to
qualify as insurance.
• Federal income tax issues raised by transactions involving finite
risk.
• Notice 2008-19, Cell Captive Insurance Arrangements: Insurance
Company Characterization and Certain Federal Tax Elections, sought
1
The transaction described by Notice 2002-70 was removed as a listed transaction by
Notice 2004-65.
Appendix I: Guidance That IRS Has Issued
about Offshore Insurance
Appendix I: Guidance That IRS Has Issued
about Offshore Insurance
Page 22 GAO-20-589 Abusive Tax Schemes
comments about when protected cell company arrangements
constitute legitimate insurance.
2
In May 2020, the U.S. Supreme Court announced it would hear a case in
which a captive insurance management company challenged the legality
of Notice 2016-66. Specifically, the Court will consider whether the Anti-
Injunction Act—which, in general, bars lawsuits for the purposes of
restraining the assessment or collection of tax—required the dismissal of
a lawsuit seeking to enjoin IRS’s enforcement of the requirement to report
transactions described in Notice 2016-66. The case is on appeal from the
Sixth Circuit, which upheld the district court’s dismissal of the case under
the Anti-Injunction Act.
3
In addition to the notices, officials from the IRS Office of Chief Counsel
identified 10 revenue rulings that were released through the IRB as being
relevant to abusive offshore insurance tax schemes. Table 1 shows the
10 rulings IRS identified, with a brief summary of the rulings’ contents.
Table 1: Revenue Rulings Relating to Abusive Offshore Insurance Tax Schemes
Revenue ruling
What the ruling addresses
Rev. Rul. 78-338
Whether amounts paid by a domestic corporation to a foreign insurance company are deductible.
Rev. Rul. 89-96
Whether a casualty insurance company is entitled to claim a deduction under Internal Revenue Code
section 832(b)(5) for losses incurred during the taxable year on insurance contracts.
Rev. Rul. 2001-31
That the Internal Revenue Service will no longer invoke the economic family theory with respect to captive
insurance transactions.
Rev. Rul. 2002-89
Whether amounts paid by a domestic parent corporation to its wholly owned insurance subsidiary are
deductible.
Rev. Rul. 2002-90
Whether amounts paid for professional liability coverage by domestic operating subsidiaries to an
insurance subsidiary of a common parent are deductible as insurance premiums under the law.
Rev. Rul. 2002-91
Whether a group captive formed by a relatively small group of unrelated businesses involved in a highly
concentrated industry to provide insurance coverage is an insurance company within the meaning of
federal law.
Rev. Rul. 2005-40
Whether certain situations constitute insurance for federal income tax purposes and if so, whether amounts
paid to the insurer are deductible as insurance premiums.
Rev. Rul. 2007-47
Whether a certain business arrangement may deduct insurance premiums under federal law and whether
the arrangement may be accounted as an insurance contract under federal law.
2
Generally, a protected cell company is a special legal entity granted by local jurisdictions
in which a core company has a number of cell companies. The entire group is treated as a
single entity for tax purposes but the cells are treated independently for other purposes,
such as liability purposes.
3
CIC Services, LLC v. Internal Revenue Service, 925 F.3d 247 (6th Cir. 2019).
Appendix I: Guidance That IRS Has Issued
about Offshore Insurance
Page 23 GAO-20-589 Abusive Tax Schemes
Revenue ruling
What the ruling addresses
Rev. Rul. 2008-8
Whether the relationship among various entities constitutes insurance for federal income tax purposes.
Rev. Rul. 2009-26
Presents two situations to illustrate the application of insurance principles as to whether a reinsurance
arrangement is sufficient for the assuming company to qualify as an insurance company under federal law.
Source: GAO analysis of Internal Revenue Service data. | GAO-20-589
Officials from the IRS Office of Chief Counsel also identified a series of
determinations they said may be relevant to offshore insurance issues,
which can be found on the IRS Written Determinations website.
4
Table 2
provides summaries of these determinations. These rulings are non-
precedential in nature, and should not be interpreted as addressing
existing noncompliance, only responding to facts and circumstances
raised by taxpayers.
Table 2: Written Determinations That the Internal Revenue Service Identified as Relating to Offshore Insurance Tax Planning
Written
determinations number
What the ruling addresses
PLR 201746022
Corporate taxpayers’ proposed reorganization of a foreign insurance business.
PLR 201314020
Whether the taxpayer’s second-level domestic subsidiaries and contracts issued by them can be treated
as insurance for federal income tax purposes.
PLR 201219011
Whether a foreign company that is taxed as a domestic corporation may be considered an insurance
company for federal tax purposes.
PLR 201219010
Whether a foreign company that is taxed as a domestic corporation may be considered an insurance
company for federal tax purposes.
PLR 201219009
Whether a foreign company that is taxed as a domestic corporation may be considered an insurance
company for federal tax purposes.
PLR 201030014
Whether a foreign company that is taxed as a domestic corporation under 953(d) election may be
considered an insurance company for federal tax purposes.
PLR 200703007
Whether a corporate taxpayer’s transaction selling a contract covering decommissioning costs for nuclear
power plants can be treated as insurance for federal income tax purposes.
PLR 200629029
Whether a corporate taxpayer’s transaction by a wholly owned subsidiary to sell a contract covering
decommissioning costs can be treated as insurance for federal income tax purposes.
PLR 200629028
Whether a corporate taxpayer’s transaction by a wholly owned subsidiary to sell a contract covering
decommissioning costs can be treated as insurance for federal income tax purposes.
PLR 200628018
Whether a corporate taxpayer’s express limited warranty provided to consumers upon purchase of
taxpayer’s manufactured products can be considered insurable risks for federal income tax purposes.
CCA 201702037
Whether a corporate taxpayer can qualify as an insurance company other than a life insurance company
under the law.
CCA 200202002
Whether a corporate taxpayer could deduct premiums paid to a foreign but related insurance company.
4
https://apps.irs.gov/app/picklist/list/writtenDeterminations.html.
Appendix I: Guidance That IRS Has Issued
about Offshore Insurance
Page 24 GAO-20-589 Abusive Tax Schemes
Written
determinations number What the ruling addresses
CCA 201802014
Whether an arrangement between affiliated operating entities and a captive insurance affiliate concerning
the fluctuation in the value of specified foreign currencies is insurance for federal income tax purposes.
CCA 201511021 (as
reconsidered in CCA
201802014)
Whether the arrangement between related companies and their affiliated insurance company involving
foreign currency fluctuations constitutes insurance for federal tax purposes.
TAM 201015030
Whether provisional indemnification receivables for incurred but not reported loss reserves are includable
in the calculation of insurance income of a foreign insurer and its earnings and profits, and if so, whether
the subsequent changes to the foreign insurer’s income and earnings and profits are included in its
income on a pro-rata basis.
TAM 200453013
Whether a corporate taxpayer domesticated outside the United States (1) would have qualified as an
insurance company if it was a domestic corporation, (2) whether it was eligible to elect to be treated as a
domestic corporation, and if not, how should its income be taxed, and (3) whether certain arrangements
were a sham for federal income tax purposes.
TAM 200453012
Whether a corporate taxpayer domesticated outside the United States (1) would have qualified as an
insurance company if it was a domestic corporation, (2) whether it was eligible to elect to be treated as a
domestic corporation, and if not, how its income should be taxed, and (3) whether certain arrangements
were a sham for federal income tax purposes.
TAM 200824029
A number of items related to a corporate taxpayer that is a foreign company, such as whether the
company qualified as a certain type of insurance company and, if not, whether it continues to qualify for a
voluntary legal election.
TAM 200824028
A number of items related to a corporate taxpayer that is a foreign company, such as whether the
company qualified as a certain type of insurance company and, if not, whether it continues to qualify for its
voluntary legal election.
TAM 200520035
A number of items related to a corporate taxpayer that is a foreign corporation, such as whether the
company qualified as a certain type of insurance company and, if it did not and its voluntary election is
invalid, how it should be taxed.
Legend: The table’s abbreviations refer to Private Letter Rulings (PLR); Chief Counsel Advice (CCA); and Technical Advice Memorandum (TAM).
Source: GAO analysis of Internal Revenue Service data. | GAO-20-589
Our own search of IRS’s Written Determinations website database
returned more than 600 results involving the term “insurance.” The issues
include instances related to captive insurance tax shelters. However, we
did not determine the relevancy of all these rulings to offshore insurance
tax schemes.
For many years, IRS has emphasized abusive tax schemes involving
insurance in various internet postings, particularly press releases and
summaries of information. More recently, IRS detailed its program for
settlement offers relating to micro-captive insurance schemes and plans
for new audit efforts related to micro-captive insurance compliance. For
example, in January 2020, IRS said in a press release that “nearly 80
percent of taxpayers who received offer letters elected to accept the
settlement terms. In addition, IRS is establishing 12 new examination
Appendix I: Guidance That IRS Has Issued
about Offshore Insurance
Page 25 GAO-20-589 Abusive Tax Schemes
teams that are expected to open audits related to thousands of taxpayers
in coming months.”
Additionally, in a public release, IRS said it has identified abusive tax
schemes involving micro-captive insurance as part of its “Dirty Dozen” list
of the most prominent abusive tax schemes since 2014. IRS included
abusive micro-captive insurance tax shelters most recently on its March
2019 list. The release said, “Micro-captives are on the Dirty Dozen list
again, reflecting IRS’s commitment to curbing abusive arrangements
through audits, investigations, and litigation.” The release also identifies
court cases where, it says, “IRS has been successful in litigating these
transactions,” and identifies Notice 2016-66 reporting requirements. In a
July 2020 announcement, IRS did not include micro-captives on its 2020
Dirty Dozen list due to a focus on aggressive and evolving schemes
related to coronavirus tax relief. Instead, the announcement said a new
series of press releases would emphasize illegal schemes and
techniques and include such scams as abusive micro-captives and
fraudulent conservation easements.
IRS has posted other types of guidance on its website. Two examples
include the following:
• A Q&A on life insurance, which briefly describes how to report life
insurance proceeds.
• A fact sheet from May 2019 on abusive offshore tax avoidance
schemes, which generally describes abusive insurance arrangements
in which premiums are improperly reported and income is shifted
using offshore private annuities.
IRS also provides guidance on insurance compliance in various
publications. Most directly, IRS Publication 535, Business Expenses,
addresses insurance deductibility. Topics covered in this publication
include deductible premiums, nondeductible premiums, capitalized
premiums, and when to deduct premiums and are all related to the
abusive schemes covered earlier in this report. However, this publication
does not directly discuss issues relating to abusive offshore insurance tax
shelters.
IRS Office of Chief Counsel officials also cited a series of court cases as
potential guidance on how to make offshore insurance arrangements
properly; however, legal determinations are specific to the facts and
Appendix I: Guidance That IRS Has Issued
about Offshore Insurance
Page 26 GAO-20-589 Abusive Tax Schemes
circumstances of the litigated cases and are not prepared by IRS, like the
other guidance in our review.
Appendix II: Tax Forms and Information
Returns Related to Offshore Insurance
Page 27 GAO-20-589 Abusive Tax Schemes
When required, taxpayers often have the choice to report their offshore
insurance accounts and any associated tax benefits in a way that is most
convenient for them. Tables 3 and 4 describe these requirements. The
exact nature and combination of forms that taxpayers must file depends
on the exact nature of the insurance product and the associated tax
benefits, and as a result may vary with each taxpayer. Therefore, this is
not an exhaustive list of the forms taxpayers may use to report offshore
insurance.
Table 3: Tax Returns Used to Report Insurance and Claim Associated Tax Benefits, Including Offshore Insurance
Form number and title
Purpose of form
Location of offshore insurance information
Form 1065
U.S. Return of
Partnership Income
Business partnerships use this form to report:
• Income
• Gains and losses
• Deductions and other tax benefits
Business partnerships may report information related to
insurance costs on one of two places on this form. They
may either report deductions taken on premiums paid
for business insurance using Line 2, Cost of Goods
Sold, or Line 20, Other Deductions.
a
Form 1040 Schedule B
Interest and Ordinary
Dividends
Taxpayers use this form to report:
• Interest
• Ordinary dividends
• Interest in or ownership of foreign accounts
and trusts
Taxpayers should report financial interests or signature
authority over financial accounts, including insurance
policies with cash value (such as whole life insurance
policies), that are located in a foreign country.
Additionally, taxpayers are required to note whether
they are required to file the Financial Crimes
Enforcement Network Form 114.
Form 1040 Schedule C
Profit or Loss from
Business (Sole
Proprietorship)
Businesses that are sole proprietors use this
form to report:
• Income or loss from the business
• Statutory employee wages and expenses
• Certain other income and deductions
Sole proprietorships may report deductions taken for
insurance other than health insurance in one of two
places on this form. They may either report deductions
taken on premiums paid for insurance using Part II Line
15, Insurance (other than health), or using Part I Line 4,
Cost of Goods Sold.
Form 1120-PC
U.S. Property and
Casualty Insurance
Company Tax Return
Domestic and certain foreign non-life insurance
corporations, including Section 831(b) micro-
captives, use this form to report:
• Income
• Gains and losses
• Deductions and other tax benefits
Non-life insurance corporations may report premiums
earned on Schedule A Line 1. These corporations
indicate their elections under section 831(b) and 953(d)
elections on Section D of the form.
Form 1120
U.S. Corporation Income
Tax Return
Corporations use this form to report:
• Income
• Gains and losses
• Deductions and other tax benefits
Corporations may report deductions related to
insurance costs on one of two places on this form. They
may either report deductions taken on premiums paid
for business insurance using Line 2, Cost of Goods
Sold, or Line 26, Other Deductions.
b
Form 1120-S
U.S. Income Tax Return
for an S Corporation
S-Corporations use this form to report:
• Income
• Gains and losses
• Deductions and other tax benefits
S-Corporations may report deductions related to
insurance costs on one of two places on this form. They
may either report deductions taken on premiums paid
for business insurance using Line 2, Cost of Goods
Sold, or Line 19, Other Deductions.
c
Appendix II: Tax Forms and Information
Returns Related to Offshore Insurance
Appendix II: Tax Forms and Information
Returns Related to Offshore Insurance
Page 28 GAO-20-589 Abusive Tax Schemes
Form number and title
Purpose of form
Location of offshore insurance information
Form 1120-L
U.S. Life Insurance
Company Income Tax
Return
Every domestic life insurance company and
every foreign corporation that would qualify as a
life insurance company uses this form to report:
• Income
• Gains and losses
• Deductions and credits
Insurance companies report gross premiums on Line 1
and amount owed on Line 30.
Form 8865
Return of U.S. Persons
With Respect to Certain
Foreign Partnerships
A U.S. person qualifying under certain
conditions must complete and file Form 8865 to
report aspects of:
• Controlled foreign partnerships
• Transfers to foreign partnerships
• Acquisitions, dispositions, and changes in
foreign partnership interests
Filers report the name and address of foreign
partnerships on Line G1.
Form 8991
Tax on Base Erosion
Payments of Taxpayers
with Substantial Gross
Receipts
Certain corporate taxpayers use the form to
determine the base erosion minimum tax
amount for the year.
Insurance premiums are reported on the form under
Schedule A, Base Erosion Payments and Base Erosion
Tax Benefits, Line 8.
Source: GAO analysis of Internal Revenue Service data. | GAO-20-589
a
Form and instructions indicate that the taxpayer should attach a statement that lists the type and
amount of all allowable deductions that are not deductible on page 1 of Form 1065. Examples listed
include insurance premiums.
b
Form and instructions indicate that taxpayer should attach a statement that lists the type and amount
of all allowable deductions that are not deductible elsewhere on Form 1120. Examples listed include
insurance premiums.
c
Form and instructions indicate that taxpayer should attach a statement that lists the type and amount
of allowable trade or business deductions that are not deductible elsewhere on page 18 of Form 1120-S.
Appendix II: Tax Forms and Information
Returns Related to Offshore Insurance
Page 29 GAO-20-589 Abusive Tax Schemes
Table 4: Information Returns Used to Report Offshore Insurances
Form number and title
Purpose of form
Location of offshore insurance information
Form 8938
Statement of Specified
Foreign Financial
Assets
This form is filled out by individual taxpayers
and is used to report all foreign financial
assets (including cash-value insurance
accounts) in which they have a financial
interest and which are valued over the various
reporting thresholds ($50,000 for unmarried
taxpayers living inside the U.S.; $200,000 for
same living abroad).
Taxpayers use three parts of the Form 8938 to report
information on their offshore cash-value life insurance
accounts. First, they use Part II, Other Foreign Assets
Summary, to report basic information on their insurance
account. Second, taxpayers use Part III, Summary of Tax
Items Attributable to Specified Foreign Financial Assets,
Section 2, Other Foreign Assets, to report information
about tax benefits related to the insurance account. Finally,
taxpayers use Part VI, Detailed Information for Each “Other
Foreign Asset”, to show more detailed information about
the character, dollar value, and geographic location of the
insurance account.
Form 8966
Foreign Account Tax
Compliance Act Report
This form is filed by certain foreign financial
institutions, to report information on their
institutions’ various U.S. financial accounts
and U.S. financial account owners, including
certain cash value insurance accounts.
Filers report various information about the cash-value
insurance account throughout Form 8966. For example,
filers report their own identifying information including their
global intermediary identification number (Line 4) and
country of origin (Line 3c) in Part I. In Parts II and III, filers
provide information on the owner of the account, including
country of origin (Line 3c) and Taxpayer Information
Number (Line 4). In Part IV, filers provide financial
information, including the cash-value insurance account’s
balance (Line 3a) and dividends (Line 4b).
Form 8886
Reportable Transaction
Disclosure Statement
This form is filed by taxpayers who participated
in a reportable transaction, including
transactions of interest such as that described
in Notice 2016-66. It is used to describe the
transaction in detail, including the expected tax
treatment and all potential tax benefits.
Filers report various information related to Section 831(b)
micro-captive insurance transactions of interest using Form
8886. For example, filers report their identifying number in
the header, the form number and year of the related tax
return (Line B); the reportable transaction number (Line
1c); and the type of entity they participated through (Line
5a). Taxpayers use Lines 7a and 7b to report the expected
tax treatment and benefits. They use Line 8a to describe
the character of related entities, including foreign entities.
Form 8918
Material Advisor
Disclosure Statement
This form is filed by material advisors to any
reportable transaction. A material advisor can
be an individual, trust, estate, partnership, or
corporation. They use the form to disclose
certain information about the reportable
transaction. Material advisors are those who
provide material aid, assistance, or advice with
any reportable transaction and directly or
indirectly receive or expect to receive gross
income in excess of the threshold amount for
this involvement.
Filers report various information related to one or more
reportable transaction(s). For example, filers report their
identifying number (Header block), the name of the
reportable transaction(s) (Line 1), a description of the type
of material aid provided (Line 6a), whether any foreign
entities or individuals were needed to achieve tax benefits
generated by the transaction and what their roles are
(Lines 7a-b), the types of financial instruments used in the
transaction (Line 9), the type of tax benefit(s) generated by
the transaction (Line 10), the Internal Revenue Code
section(s) used to claim tax benefits from the transaction
(Line 12), and a narrative description about the transaction
that includes some of the above components (Line 13).
Appendix II: Tax Forms and Information
Returns Related to Offshore Insurance
Page 30 GAO-20-589 Abusive Tax Schemes
Form number and title
Purpose of form
Location of offshore insurance information
Form 5471 Schedule M
Transactions Between
Controlled Foreign
Corporation and
Shareholders or Other
Related Persons
This form is used by certain U.S. persons who
are officers, directors, or shareholders in
certain foreign corporations. The form and
schedules are used to satisfy the reporting
requirements of Sections 6038 and 6046 and
the related regulations, as well as to report
amounts related to Section 965.
Filers report various information related to transactions
between controlled foreign corporations for which they are
an officer, director, or shareholder. For example, filers
report their identifying number (Header block), premiums
received and paid for insurance or reinsurance (Lines 12
and 25 respectively), the name of other U.S. persons who
are shareholders in the involved entities (Column b), and
the name of any other foreign corporations which the filer
controls or is a shareholder (Columns d-f).
Form 5472
Information Return of a
25% Foreign-Owned
U.S. Corporation or a
Foreign Corporation
Engaged in a U.S.
Trade or Business
Generally, a reporting corporation must file
Form 5472 if it had a reportable transaction
with a foreign or domestic related party.
Filers report premiums received for insurance or
reinsurance and premiums paid for insurance or
reinsurance on Lines 11 and 24 respectively.
Form 720
Quarterly Federal
Excise Tax Return
This form and its attachments are used to
report liability and pay the excise taxes listed
on the form. If a taxpayer reports a liability on
Part I or Part II, he or she may be eligible to
use Schedule C to claim a credit.
Among other things, filers report premiums paid for
insurance policies, such as life insurance policies, held by
foreign insurers (IRS No. 30). The form also requires filers
to report their identifying number (Header block).
Schedule A
(Form 8975)
Tax Jurisdiction and
Constituent Entity
Information
U.S. persons with multinational enterprises
with revenues of $850 million or more file the
form to report certain information about the
filer’s multinational enterprise group on a
country-by-country basis.
Filers use Part ll, Column 4 of the form to report constituent
entities’ main business activities.
FinCEN Form 114
Report of Foreign Bank
and Financial Accounts
This form is filed by U.S. persons to report a
financial interest in or signature authority over
a foreign financial account if its aggregate
value exceeds $10,000 at any point during the
calendar year.
Filers report various information related to foreign financial
accounts over which the filer has a financial interest or
signature authority. For example, filers must include their
Taxpayer Identification Number (Part 1 Line 3). In Part II,
for each account filers report the type of account (Line 16),
the maximum account value (Line 15), the account number
or other designation (Line 18), and the financial institution’s
name and address (Lines 17 and 19-23).
Source: GAO analysis of Internal Revenue Service and Financial Crimes and Enforcement Network data. | GAO-20-589
Appendix III: GAO Contact and Staff
Acknowledgments
Page 31 GAO-20-589 Abusive Tax Schemes
In addition to the contact named above, the following staff made key
contributions to the report: Tara Carter (Assistant Director), Eric Gorman
(Analyst-in-Charge), Steven Flint, Topher Hoffmann, Gina Hoover, Amalia
Konstas, Krista Loose, Scott E. McNulty, Ed Nannenhorn, Cynthia
Saunders, Andrew J. Stephens, Leanne Violette, and Alicia White.
Appendix III: GAO Contact and Staff
Acknowledgments
GAO Contact
Staff
Acknowledgments
(103843)
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