Tax Fraud Tuesdays: The Dirty Dozen #11

Each year, the Internal Revenue Service compiles a list of the 12 most common, dangerous or costly tax scams. They call this list their “dirty dozen” and recommend that taxpayers stay vigilant during tax season. We will summarize these twelve scams for you, and highlight the steps you should take to protect yourself.

Abusive tax shelters are a slightly more sophisticated tax scam than much of what we have covered so far in this series, and one of the most common ways to create an abusive tax shelter is through micro-captive insurance schemes. Captive insurance companies are entirely legal schemes in which a business sets up an insurance subsidiary to protect other parts of the company or other subsidiaries—the insured owns the insurance structure. For example, many Fortune 500 corporations have created captive subsidiaries that accumulate assets used in case of disaster. British Petroleum’s use of a captive environmental insurance policy proved to be a smart decision after the Gulf oil spill.

Because the captive insurance shelter allows the owning entity to claim deductions for premiums paid, there is a tax benefit to the owning entity of the captive structure. Additionally, micro-captive shelters (captives with annual written premiums of under $2.2 million) only pay tax on investment income, creating even more incentive for some taxpayers or tax preparers to abuse this structure. This leads to shady tax preparers suggesting that clients use these insurance structures to save taxes, which is generally unethical. If the captive subsidiary does not serve a real insurance purpose, it is tax fraud. In general, if the captive’s policy is not as fully structured as a real insurance policy would be—with a clear purpose, contracts, realistic risks that are not covered by another policy, reasonable premiums—then it should be avoided.