Back in 2017, I wrote about the prolific microcaptive promoter Celia Clark who decided to terminate her law firm\’s captive insurance practice after her captive insurance risk pool failed rather spectacularly in the Avrahami case. Today brings us to an interesting complaint filed by Ms. Clark in the U.S. District Court of the Southern District of Florida against the U.S. Internal Revenue Service, in which Ms. Clark is seeking to avoid \more than $11 million in penalties that the IRS has assessed against attorney Celia Clark for her role in advising and assisting with the establishment of so-called “microcaptive” insurance companies for her clients.\
Here the caveat must be given that captive insurance companies generally are entirely legitimate risk management tools from the viewpoint of both the IRS and state insurance regulatory law, and there are even many captive insurance companies qualifying under Internal Revenue Code 831(b), from which the microcaptive transaction derives, that are completely legitimate. When a reference is made to a microcaptive transaction, that refers to a particular type of captive insurance vehicle which is not intended to be a real risk management vehicle, but rather a tax shelter to avoid taxes through phony premium payments, and which almost always has as its hallmark that the tax requirement of risk distribution was met through a risk-mixing device called a risk pool that doesn\’t actually mix much risk, if indeed any. This article concerns only the tax shelter that is now commonly referred to as microcaptives.
I\’m not going to spend much time going through the particulars of Ms. Clark\’s complaint, which you can read for yourself here. The Cliff Notes summary is that the IRS has assessed promoter penalties in excess of $11 million against Ms. Clark, and she has so far actually paid the IRS the amount of $1,745,544 in penalties for which she seeks a refund. Ms. Clark alleges that the IRS began a civil examination of her back in August, 2012, but did not assess her any penalties at that time, and instead essentially lulled her in continuing her captive insurance practice through 2017. There are also allegations that Ms. Clark could not have known in advance that the IRS would have such success as it ultimately did against microcaptive transactions in later years before the U.S. Tax Court, that the IRS engaged in all sorts of technical errors in assessing the penalties, and that fundamentally the penalties are unfair because she\’s now retired and has no ability to rebuild herself financially should the penalties stick.
Again, I strongly encourage you to read the complaint itself, and if anything that I have said above is the even least bit inaccurate then of course the text of the complaint itself controls. On the other hand, allegations found in a complaint are just that ⸺ allegations ⸺ and one can rather safely presume that when the IRS files its inevitable answer that it will substantially disagree with many of Ms. Clark\’s points.
The story here is not Ms. Clark\’s complaint but rather that the IRS has finally started dropping promoter penalties, known as \section 6700 penalties\ for that provision of the U.S. Internal Revenue Code, on at least the most prolific of the promoters of microcaptive transactions. While I don\’t have any inside information on the subject, one can probably safely presume that Ms. Clark is not the only microcaptive promoter to get dinged with penalties.
Congress beefed up the section 6700 penalties after the tsunami of tax shelters that swept the nation in the late 1990s and early 2000s, and which culminated in the criminal prosecutions of those involved with the KPMG tax shelters. Certainly, KPMG wasn\’t the only major accounting or law firm selling tax shelters at the time, Ernst & Young paid a $123 million fine and that tax shelter drive-through known as the Jenkins & Gilchrist law firm went out of business entirely, but KPMG was the most high-profile of the bunch and ended up agreeing to a deferred prosecution agreements whereby it also paid $456 million in fines and restitution to the IRS. Anyway, Congress was totally fed up with tax shelters and eventually amended section 6700(a)(2) such that for promoters of tax shelters, \the amount of the penalty shall be equal to 50 percent of the gross income derived (or to be derived) from such activity by the person on which the penalty is imposed.\
Note the term \gross income\, which in this context means that the promoter cannot deduct as expenses what it paid others. As applied to microcaptive transactions, this means that the promoter cannot deduct what it may have paid to actuaries, underwriters, and others to put these transactions together. Rather, the IRS simply looks at what was paid to the promoter in fees, and 50% of that is the penalty. Also, for determining this amount, the IRS can go back in time to the very first transaction being sold, so that if, say, a promoter of microcaptives started selling transactions back in 2007, then the gross income will be calculated from 2007.
One way to consider the situation is this, and we\’ll take Ms. Clark\’s situation by way of example: If the IRS assessed an $11 million penalty constituting 50% of her gross fees derived from selling microcaptive transactions, then we can infer that the IRS calculated the total fees she received to be $22 million. Some of that $22 million was doubtless paid for expenses in putting the transactions together, and so that money is permanently lost. Of the balance, constituting profits, federal and state taxes were paid on those moneys as well, so probably at least 50% was eaten up at the time. Now, the 50% section 6700 penalties kick in and eat up the other half. The net result is that a promoter probably ends up making very little profit for their labors, and in fact might come out net behind. So if you think that only a 50% promoter penalty lets a promoter get away with way too much money, that\’s probably not the case at all.
I have utterly no idea how many microcaptives that Ms. Clark was involved with, but in her defense I don\’t think that she was the most active of the promoters. Other captive managers at times boasted that they had sold microcaptive transactions into the many hundreds, and so their own promoter penalties should be correspondingly higher.
This is not to say that every manager of microcaptives out there is going to be hit with promoter penalties, because I seriously doubt that is the case. In targeting promoters, the IRS typically looks for those who are also giving tax advice when they set up the transaction, so lawyers and accountants who gave tax advice in relation to these transactions will fall much closer to the bullseye ⸺ but some of the largest sellers of microcaptive transactions were captive managers that were owned or controlled by lawyers or accountants.
Also, the IRS will typically look at who kept selling microcaptive transactions when they either knew, or should have realized, that the transaction didn\’t work. This too describes a number of firms that kept right on blissfully selling microcaptive transactions past the 2012-2013 period when they started getting the word from the IRS that maybe things were not all rosy in microcaptive land. Gosh, there are still a few firms out there today who keep selling, at least trying to sell, microcaptive transactions, telling their clients quite falsely that their programs are somehow technically superior to those which have blown up in the past (they aren\’t).
If you think that those who get hit with promoter penalties can simply declare bankruptcy and wash out the liability, think again: Promoter penalties are extremely difficult to ever discharge in bankruptcy, if at all. With the penalties being so large, promoters can expect to have IRS collections personnel involved for their rest of their lives, and even afterwards in making claims against their estates should they have any upon death.
So, you can see why Ms. Clark is suing the IRS to try to avoid the promoter penalties. When you\’ve only got one card left, and you\’ve not only gone all in but also signed an $11 million marker, you\’re going to play that card.
Another question goes to the degree to which the IRS may seek to assert penalties to others who were involved in microcaptive transactions, particularly the actuaries who improperly reversed their analysis so as to back-in numbers to justify the tax deductions that the captive owners wanted to take by way of paying premiums, and which actuaries would come up with pretty much any number so long as the checks that they themselves were receiving cleared. In terms of promoter culpability, it is difficult to see that these folks were any better than those selling the microcaptive transactions. Others who might on the hook include accountants who were preparing tax returns knowing these deals had nothing in the way of real economic substance. The IRS cannot, however, touch yet another group who facilitated microcaptive transactions, which were the insurance regulators of a few states who sought to build their captive numbers by openly welcoming the licensing of captive insurance companies that made little to no sense from an insurance perspective ⸺ those insurance regulators are every bit as culpable as everybody else in the microcaptive food chain, yet they are immune to IRS censure.
One silver lining to be found in this dark cloud, not for the promoters but for the rest of the captive industry which wants to be rid of all this microcaptive stuff, is that the assessment of promoter penalties usually means that the IRS is starting to wind down its activities in a particular area. Certainly, the IRS still has considerable cleaning up to do with U.S. Tax Court cases that are lingering, and, as mentioned, there are still the foolish out there who are still running their microcaptive programs. But still, when promoter penalties are assessed it usually means that the IRS is starting to turn its attention elsewhere to some other transactions being sold that it doesn\’t like.
As a curiosity, if nothing else, it will be interesting to see in the coming days what other high-profile promoters of microcaptive transactions are also assessed the section 6700 penalties, and in what amounts.
Complaint filed in Clark v. U.S., S.D.Fla. Case No. 21-CV-82056, Doc# 001 (Nov. 11, 2021). https://captiveinsurancecompanies.com/cases/clark/20211111_Clark_001_Complaint.pdf