SURVIVING THE IRS AUDIT

September 28, 2011

PresenterDaniel J. Kusaila, Tax PartnerSaslow Lufkin & Buggy, LLP

Agenda What taxes should a captive be

concerned with? How do you get to be lucky

enough to be chosen for audit? Types of Audits Which tax returns can they audit? The audit process FET initiative Best practices to avoid negative

outcomes2

Types of Taxes

--Income tax exams

--Excise tax exams

Both are increasing but for different reasons

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Types of Taxes (cont’d) Income tax exams – increasing due to

the bad economic times as Companies are reporting net operating losses or capital losses

Companies are carrying back losses and the size of the refund causes the IRS to review the tax return

Any refund claim in excess of two million requires Joint Committee sign-off

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The Chosen One

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There are Only Two IRS Audit Projects Directly Targeted at Captive Insurance

Section 501(c)(15) insurersExcise Tax (cascading tax)

Most Other Captive Audits Arise During the Audits of the Operating Companies

How Does One Get Selected for Audit?

The Chosen One (cont’d)

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Large Case Computer Selection

The Future is in the Technology Collateral Audits

Affiliates Partners /Members / S-Corp Shareholder Officers / Directors Party to same transaction Trust / Beneficiary

Referrals Prior Audit Informant

Which Tax Years?

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3 years – Normally, the Federal income tax statute of limitations is open for three years from the filing of the tax return ( or its original due date if longer)

6 years – The statute of limitations is 6 years if there is a 25% omission of gross income shown on the return and negligence

Forever – There is no statute of limitations if a false or fraudulent return with intent to evade tax is filed, or if no return is filed

Can extend by agreement to a fixed date or indefinitely (revocable on 90-days’ NOTICE)

All issues vs. restricted

Audit

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AuditFormal letter starting an audit

• Years• Taxpayer

Cannot audit the same year twice without approval

If there were two successive “no change” audits, the third audit should not be conducted

Types of Audits

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Mail-In AuditOffice Audit (IRS Office)

Informal Needed items specific in letter One sitting Can reschedule if needed

Field Audit Taxpayer or representative’s office? Off premises? One coordinator? Multiple meetings Large taxpayers – every day for two years

The IRS Audit Process

The Audit Process

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“Initial Contact”

First contact with the taxpayer generally to set up the “initial interview”

The IRS will contact either: The corporate officer who signed the

return, or If valid POA for the type of tax and

year, then the representative with a copy of all correspondence to the taxpayer.

Phone Call followed by a letter

The Audit Process (cont’d)

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The purpose of the initial contact is to:

Schedule the initial appointment, Establish a reasonable time and place for

the initial appointment and for conducting the examination,

Identify the person(s) to be present at the initial interview,

Discuss the examination process, Identify the initial issues to be examined,Discuss records needed, andAnswer the taxpayer's questions or

concerns regarding the audit process.

The Audit Process (cont’d)

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Who Represents the Taxpayer

Internal accountant?External CPALawyer (usually in background, if at all)

The Audit Process (cont’d)

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I recommend treating the agents with courtesy, professionally and offering them nice accommodations rather than a basement or closet.

The Audit Process (cont’d)

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Power of Attorney (Form 2848)Powers Granted/RestrictedAgreeing to IRS adjustmentsNegotiating refund checks

Information Documentation Request (IDR)

Written questions from IRS and request for supporting documentation

Reply in writing

Form 4564

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Potential IRS ConcernsThe agents many times will have

little or no knowledge of captive operations

They look to find a checklist indicating the types of information they should look at and will tend to focus on information that is treated as fact in many rulings

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Potential IRS Concerns (cont’d)

The feasibility study – the agent is going to want to review the study to determine why the Captive was established; be sure to have a discussion of the business merits and not tax benefits

They will look to determine if we are operating the captive as we indicated we would in the study

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Potential IRS Concerns (cont’d)

What type of risks are being insured in the captive?

accepted and common types of coverage or are we insuring other types of risks;

is there a fortuitous event that must occur before the insurance coverage pays a claim;

is it business risk

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Potential IRS Concerns (cont’d)

What’s the difference and why should it matter?

IRS takes the position that a business risk cannot be transferred to another party,

whereas insurance can be

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Potential IRS Concerns (cont’d)

Who are the insureds and what is their relationship to the Captive?

The IRS is looking to make sure that there is adequate risk shifting and distribution in the plan;

Generally this is looked at on an entity number basis

Also looking to concentration of risk.

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Potential IRS Concerns (cont’d)Is the Captive performing any non

insurance activities?

Is the Captive loaning money back to the parent or a related corporation?

Are there any related party guarantees?

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If parent premiums are deducted, determine whether there is a sufficient amount of unrelated risk assumed by the Captive

Is there a loss portfolio transfer and is there a significant chance of a significant loss as required for GAAP under FASB 113?

Is the taxpayer taking a consistent position by paying excise tax for risk ceded to an offshore insurance company that is not taxed as a U.S. taxpayer?

Potential IRS Concerns (cont’d)

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Potential IRS Concerns (cont’d)

Tax Exempt interest

Foreign affiliated entities

Policyholder dividends

Alternative Minimum Tax

Potential IRS Concerns (cont’d)

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Did the Captive enter into a finite risk contract with an offshore reinsurance company that is a non-Controlled Foreign Corporation? If so, review the transaction to determine whether there is significant tax avoidance.

Are Captive assets used as security or as compensating balance for the liabilities of another entity?

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IRS Exam Activity What is the reserving practice of

the Captive?

Is the Captive using an actuary to establish reserves and is the Company setting its reserves within the actuary’s expected range;

What kind of reserves is the Captive establishing?

Audit Process

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What we all hope for: A “No change Letter”

Audit Process (cont’d)

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IRS Proposed Adjustments

Form 5701 used to communicate proposed adjustment by the IRS

Form 886-A explanation of adjustment accompanies

Agreed Issues

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If an audit, one or more issues may be settled, even if other issues are not

Form 870 is used to agree to the settled issues

While in practice this ends the audit of agreed issues, technically the Taxpayer can file a claim for refund and the IRS can reopen (if it gets internal permission for the second audit)

Unagreed Issues

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Notice of Proposed Adjustment (NOPA) Response to NOPA Lawyer in Background? Factual differences – auditors can resolve Legal differences – auditors cannot resolve “Hazards of Litigation” – auditors cannot take

into account Technical Advice Request – IRS National Office Advanced Issue Resolution – early Appeals for

an issue Fast Track – mediation with the IRS auditors,

mediated by an Appeals Officer

Unagreed issues when the audit is over

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30-day letterTaxpayer’s ProtestAgent’s RebuttalEx Parte Meeting – Appeals and Examiners

One or more meetings with the Appeals Officer

Control of the Statute of Limitations

Appeals Conference

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Appeals’ mission is to settle cases Very informal

1 to 3 Appeals Officers No court reporters or other third parties Client? / Experts?

First conference – make a good first impression Settlement – every case has its time

Be prepared to settle when it is time Don’t make an offer when the other side is

not in a position to evaluate the offer 870-AD - normally neither side is to reopen Closing Agreement Post Appeals Mediation

Taking it to Court

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TAX COURT DISTRICT COURT

CT. OF FED CLAIMS

Pay First No Yes Yes

Judge / Jury Judge Option** Judge

Place of Trial

Local* Local Local*

% Tax Cases

100% 2% 50%

Government Lawyer

IRS DOJ DOJ

*Judge travels from DC ** Option Judge or Jury

Penalties & Interest

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Interest Overpayment

Underpayment

Deduct

Corporate 3% 4% Yes

Large Corporate

1.5% 6%** Yes

Interest – Second Quarter 2011 – Prepay?

**Underpayment of $100,000 beginning 30 days after 30-day or 90-day letter

Penalties & Interest (cont’d)

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20%• Disregard of Rules or Regulations• Negligence• Substantial Understatement (without

Substantial Authority) 40%

• No economic Substance (20% if disclosed)• Involves Undisclosed Foreign Financial Asset• 75% Fraud

Exception for Certain Penalties• Reasonable Cause and • Taxpayer Acted with Good Faith

Additional Penalties for Reportable Transactions Potential Disclosure on Form UTP

Federal Excise Taxes

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FET Exam ActivityFederal excise tax examinations are

increasing due to an enforcement initiative regarding the excise tax.

FET is due whenever a US premium is transferred offshore and is due again when the foreign insurer transfers it again

FET rates are 4% for direct business and 1% for reinsurance

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FET Exam Activity (cont’d)

The exam will involve a review of the reinsurance treaties placed by the Captive

The examiner is looking for primarily two things:

11) ) does the placement involve a foreign insurance company, and,

2) was the form 720 filed and the tax paid.

The tax and form are due quarterly.

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FET Exam Activity (cont’d)

Most US income tax treaties contain a clause exempting the excise from having to be reported.

If relying on the income tax treaty exemption, be sure that the foreign company has a valid “closing agreement” with the IRS in place.

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Interim Guidance Memo SBSE-04-0909-045 (Excise Taxes)Procedures for excise tax examinersIRS indicated it will be auditing foreign captive subsidiariesForward all information to International excise tax group

Name and employer identification number (EIN) of the parent company; Full name and EIN of the captive subsidiary; Location or country of the captive subsidiary; Amount of premiums insured with the captive subsidiary; and Amount of premiums reinsured by the captive subsidiary to reinsurance companies (if known).

Looking to enforce “cascading theory” under Rev. Rul. 2008-15

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Rev. Rul. 2008-15 – Federal Excise Tax

Excise tax under § 4371 has a “cascading” effect

Tax applies to premiums paid to cover U.S. risks regardless of the nationality of the insuring and/or reinsuring entities Applies to payments from one foreign insurance

company to another foreign insurance company if the underlying risks are U.S. situs risks

Ann. 2008-18 sets out a voluntary compliance initiative for foreign insurers and reinsurers that owe FET on foreign-to-foreign reinsurance transactions Applies to FET on premiums received on or after October 1,

2008 IRS will not examine cascading tax liabilities from prior

periods

Best Practices

Best Practices

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To limit the potential to an unsuccessful IRS audit, the most important thing is:

To have a knowledgeable team devoted to the industry (Captive Manager, Attorney, CPA and Auditor).

Best Practices (cont’d)

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Feasibility StudyNon-Tax Business Purpose

Good Structure, Adequate Capital, Etc.Strong Team (Captive Manager,

Attorney, CPA)• Good advice

Tax Opinion• Why consider? FIN 48 or ASC Topic

740, Uncertain Tax Positions or just Comfort

• IRS Private Ruling?

Best Practices (cont’d)

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Good Records

Documentation Why a Captive? Why the Coverages? Why the Pricing? Why the Domicile, etc.?

Application Actuarial Reports Financial Projections Corporate Records – Articles, Bylaws, Minutes,

etc.

Best Practices (cont’d)

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As the Captive Matures

Update of Business Plan Review of Structure, Operation, Coverage,

Agreements, Pricing, Capitalization, etc. Continued Education Keep Corporate Formalities CICA Best Practices Book Periodic Review of Legal, Regulatory and Tax Document Everything