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Beware The Puerto Rico Captive Insurance Tax Shelter

By newadmin / Published on Sunday, 28 Jan 2018 04:55 AM / No Comments / 8 views


Department of Justice press release. Sadly, the night before he was supposed to report for prison, Peggs and his wife committed suicide. Suffice it to say that all the business owner participants in the deal got slammed with steep penalties.

But the DOJ wasn’t even through with the Caduceus Life prosecutions before a nearly identical tax shelter started, known the Foster Dunhill shelter after the company which prolifically marketed the shelter. The Foster Dunhill shelter was run by Stephen Donaldson, who controlled Fidelity Insurance Company. As with Caduceus Life, business owners caused their business to make large premium payments to Fidelity Insurance for vague “business protection policies” and took a corresponding deduction. Fidelity Insurance Company internally segregated the premiums received from each business, and later funneled them into so-called “private placement life insurance” (PPLI) policies for the benefit of the business owners, who could then borrow against the cash-value of those policies, ostensibly tax-free. After the IRS figured out this scheme, the DOJ indicted Donaldson and his sidekick, Duane Crithfield; you can read all about it in my article Foster and Dunhill Scheme Ends In Denial Of Deductions And Indictments For Bogus Insurance Tax Shelter. Donaldson and Crithfield will be spending this and several future Christmas holidays with their new friends at the U.S. Bureau of Prisons. Oh, and the business owner participants in this deal got slammed with severe penalties too.

If you think that a thick opinion letter will protect you, then you’d better consider that in the Foster Dunhill shelter, they had several opinion letters, including from the belated very large tax firm of Jenkins & Gilchrist. This didn’t save the principals of Foster Dunhill, or their clients.

There have been other nearly-identical deals, but by now you should get the point: Arrangements whereby a business takes a deduction for payments to somebody else’s insurance company and the money circulates back to the business owner is not a new shelter, and once the IRS finds out about it, the business owners will see their deductions denied and penalties imposed — and the promoters have a very good chance of being indicted. At best, it is a shelter; at worst, criminal tax fraud.

Jay Adkisson

The Puerto Rico Captive Tax Shelter

Which brings me to the latest wave of these shelters, which all seem to be based in Puerto Rico. This is the tax shelter du jour, being aggressively marketed to take advantage of the demise of abusive 831(b) captive insurance companies that were likewise marketed as tax shelters. (It is here that I must point out that not all, or even most, 831(b) captive insurance companies are invalid, but largely only those which had dubious coverages, ridiculous premiums, and participated in low-risk risk pools, which is still a lot of them — well into the thousands).

Worse, it seems that these new Puerto Rico shelters are being marketed mostly (but not all) by groups that the IRS were already looking at in regard to abusive 831(b) captive insurance companies, including some that were believed to be under so-called “promoter audits”, i.e., audits where the IRS has subpoenaed the client lists of the promoters and subjected all the clients to examination — and usually ending in the mass-denial of deductions and assessment of penalties against those clients.

In other words, if you have been an 831(b) promoter and the IRS has come a’calling for those deals, you now take your existing and prospective clients and slam them into this new Puerto Rico deal instead.

How does it work? There are several variations, but they largely follow the same base theme: The promoter sets up an insurance company that is owned (mostly just in name) by a Puerto Rico local. Just like in the Caduceus Life and Foster Dunhill deals, the businesses of their clients purchase vague insurance coverages from the insurance company, paying absurdly high premiums.

The insurance company is usually set up as a Puerto Rico “segregated asset plan” which allows the insurance company to, essentially, create little pockets of assets to back the insurance policies of particular businesses being insured. Really, this is self-insurance — and thus not “insurance” at all for U.S. tax purposes — but it facially appears to outsiders to be an arm’s length third-party insurance relationship.

The promoter then makes the claim that because no individual business owner holds 10% or more of the insurance company as a whole, the arrangement is not a “controlled foreign corporation” (CFC), such as would create a bunch of nasty tax issues. Usually, a Puerto Rico citizen will own the company, at least on paper, but stock warrants or stock options are given to business owners so that when the time comes they can cash out, i.e., the business owner has what amounts to a springing interest in the company.

One of the tax law requirements for “insurance” is that it have risk distribution. The promoters of this deal claim that because the insurance company is issuing policies to numerous businesses, this ipso facto means that risk distribution is present. But hold on: Because the insurance company is internally segregating risks among the protected cells owned by each business owner, it is really just the individual protected cell of the business owner which is actually doing the insuring, and this isn’t risk-distribution at all. To try to obfuscate this issue, the promoter will have the individual protected cells of the business owners appear to take on the risk of the entire insurance company, but usually with a very high self-insurance retention, i.e., the “pooled” coverage doesn’t kick in until the claim hits $250,000 or some number.

In other words, the arrangement facially appears to provide for risk pooling, and therefore risk distribution, but in actuality there is little or no actual risk pooling going on. It appears at first to be a single insurance company, but under the hood it is actually a bunch of little captive insurance companies, none of which meet the risk distribution requirements to be considered insurance companies. It is a charade; Kabuki theatre at its finest.

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Old tax shelters never die. They just get a new acronym and a thicker opinion letter.

I’ve seen this happen time after time. The failure of 412(i) plans begat 419A(f)(6) plans, which themselves failed and begat 419(e) plans. The idea was the same: A business gets a deduction for a payment to an employee plan, which was then used to purchase life insurance which the business owner could borrow against, such that the business owner would later get the money back tax-free. But as the IRS started chasing one, the promoters moved on to the next one, and so forth and so on.

One such tax shelterinvolves an insurance company, usually offshore. The business owner client of the promoter will cause his business to make an oversized insurance premium payment to the promoter’s insurance company, and the business will take a large deduction for that insurance expense. The promoter will then internally segregate the premiums that are earned from that particular business, so that each set of premiums that are earned from each business are attributed to the particular business owner client. The premium moneys build up in the account over a period of years, and then the premiums come back to the business owner by some backdoor method.

This particular shelter is not new. The first scam (at least that I have ever heard of) was Caduceus Life Insurance Company (later renamed “Security Trust Insurance Company”), which was run by a promoter by the name of Peter J. Peggs. Security Trust was based in a U.S. territory, being the U.S. Virgin Islands, and sold vague “loss of income” policies to U.S. businesses. The businesses got a nice deduction, and the money was later recirculated back to the business owners. When the IRS figured out this scheme, Peggs and bunch of other folks were indicted, and several spent time in federal prison. You can read more about this shelter in the later Department of Justice press release. Sadly, the night before he was supposed to report for prison, Peggs and his wife committed suicide. Suffice it to say that all the business owner participants in the deal got slammed with steep penalties.

But the DOJ wasn’t even through with the Caduceus Life prosecutions before a nearly identical tax shelter started, known the Foster Dunhill shelter after the company which prolifically marketed the shelter. The Foster Dunhill shelter was run by Stephen Donaldson, who controlled Fidelity Insurance Company. As with Caduceus Life, business owners caused their business to make large premium payments to Fidelity Insurance for vague “business protection policies” and took a corresponding deduction. Fidelity Insurance Company internally segregated the premiums received from each business, and later funneled them into so-called “private placement life insurance” (PPLI) policies for the benefit of the business owners, who could then borrow against the cash-value of those policies, ostensibly tax-free. After the IRS figured out this scheme, the DOJ indicted Donaldson and his sidekick, Duane Crithfield; you can read all about it in my article Foster and Dunhill Scheme Ends In Denial Of Deductions And Indictments For Bogus Insurance Tax Shelter. Donaldson and Crithfield will be spending this and several future Christmas holidays with their new friends at the U.S. Bureau of Prisons. Oh, and the business owner participants in this deal got slammed with severe penalties too.

If you think that a thick opinion letter will protect you, then you’d better consider that in the Foster Dunhill shelter, they had several opinion letters, including from the belated very large tax firm of Jenkins & Gilchrist. This didn’t save the principals of Foster Dunhill, or their clients.

There have been other nearly-identical deals, but by now you should get the point: Arrangements whereby a business takes a deduction for payments to somebody else’s insurance company and the money circulates back to the business owner is not a new shelter, and once the IRS finds out about it, the business owners will see their deductions denied and penalties imposed — and the promoters have a very good chance of being indicted. At best, it is a shelter; at worst, criminal tax fraud.

Jay Adkisson

The Puerto Rico Captive Tax Shelter

Which brings me to the latest wave of these shelters, which all seem to be based in Puerto Rico. This is the tax shelter du jour, being aggressively marketed to take advantage of the demise of abusive 831(b) captive insurance companies that were likewise marketed as tax shelters. (It is here that I must point out that not all, or even most, 831(b) captive insurance companies are invalid, but largely only those which had dubious coverages, ridiculous premiums, and participated in low-risk risk pools, which is still a lot of them — well into the thousands).

Worse, it seems that these new Puerto Rico shelters are being marketed mostly (but not all) by groups that the IRS were already looking at in regard to abusive 831(b) captive insurance companies, including some that were believed to be under so-called “promoter audits”, i.e., audits where the IRS has subpoenaed the client lists of the promoters and subjected all the clients to examination — and usually ending in the mass-denial of deductions and assessment of penalties against those clients.

In other words, if you have been an 831(b) promoter and the IRS has come a’calling for those deals, you now take your existing and prospective clients and slam them into this new Puerto Rico deal instead.

How does it work? There are several variations, but they largely follow the same base theme: The promoter sets up an insurance company that is owned (mostly just in name) by a Puerto Rico local. Just like in the Caduceus Life and Foster Dunhill deals, the businesses of their clients purchase vague insurance coverages from the insurance company, paying absurdly high premiums.

The insurance company is usually set up as a Puerto Rico “segregated asset plan” which allows the insurance company to, essentially, create little pockets of assets to back the insurance policies of particular businesses being insured. Really, this is self-insurance — and thus not “insurance” at all for U.S. tax purposes — but it facially appears to outsiders to be an arm’s length third-party insurance relationship.

The promoter then makes the claim that because no individual business owner holds 10% or more of the insurance company as a whole, the arrangement is not a “controlled foreign corporation” (CFC), such as would create a bunch of nasty tax issues. Usually, a Puerto Rico citizen will own the company, at least on paper, but stock warrants or stock options are given to business owners so that when the time comes they can cash out, i.e., the business owner has what amounts to a springing interest in the company.

One of the tax law requirements for “insurance” is that it have risk distribution. The promoters of this deal claim that because the insurance company is issuing policies to numerous businesses, this ipso facto means that risk distribution is present. But hold on: Because the insurance company is internally segregating risks among the protected cells owned by each business owner, it is really just the individual protected cell of the business owner which is actually doing the insuring, and this isn’t risk-distribution at all. To try to obfuscate this issue, the promoter will have the individual protected cells of the business owners appear to take on the risk of the entire insurance company, but usually with a very high self-insurance retention, i.e., the “pooled” coverage doesn’t kick in until the claim hits $250,000 or some number.

In other words, the arrangement facially appears to provide for risk pooling, and therefore risk distribution, but in actuality there is little or no actual risk pooling going on. It appears at first to be a single insurance company, but under the hood it is actually a bunch of little captive insurance companies, none of which meet the risk distribution requirements to be considered insurance companies. It is a charade; Kabuki theatre at its finest.

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