We have learned from discussions with IRS Representatives that the IRS is now opening a large number of captive audits.
If you are a taxpayer who has come under audit by the IRS with respect to a captive insurance company, here are some things you should know.
- Type of Audit. For this purpose, we can divide the IRS audits into two types. The first is a random audit on an individual or business, and the second is a targeted audit. A random audit normally involves a local IRS Agent and considers on some level the totality of a return filed. In a targeted audit, the IRS obtained a customer list from the captive Promoter and is auditing you because you are one of the customers. In a random audit, the Agent has a checklist to review various items of your return and may spend little or no time scrutinizing the captive. In a targeted audit, the Agent is normally well trained in the captive area. Further, in a targeted audit, the Agent may already have been directed on an IRS position for all of the captives that relate to that Promoter. Accordingly, the method of dealing with the Agent is very different in random audits than in targeted audits.
- Your Representation. You need to be represented in an IRS audit. The very first thing you should do upon receiving notification of an audit is to engage tax counsel. You should not speak to the IRS, answer questions or participate in an interview without tax counsel.
- Choosing Tax Counsel. There is no right or wrong choice, but the options normally include the following:
- Local CPA. The local CPA is often a good choice because he or she knows your business and circumstances best. Hopefully, they also were very much involved in your decision to create a captive and can address questions with personal knowledge regarding the intent of the captive. The downside is that some CPAs do not have a lot of experience with IRS audits, and especially with targeted audits of captives. The CPA will normally be very frank in their assessment if they believe they are in over their head. We recommend that even in such cases, that the CPA stay on the power of attorney and work with other hired counsel.
- Promoter’s Counsel. Often, the Promoter will provide or refer Counsel to represent you in audit. The benefits of this are that the Promoter’s Counsel will most likely be extremely knowledgeable about captives in general and have inside knowledge of the IRS position with respect to the Promoter’s captive. Also, the Promoter’s Counsel is sometimes paid by the Promoter. The down side is that the Promoter’s Counsel may be conflicted and provide a conflicts waiver for you to sign prior to an engagement. Basically, the issue is whether the Promoter is representing your interests or the interests of the Counsel. You may feel that those interests are the same, and sometimes they are, but sometimes they are not.
- Outside IRS Counsel. We are often called upon to represent clients under audit and have represented more than 500 taxpayers in Promoter transactions in the last 8 years. We often work with the local CPAs, but also will coordinate efforts with the Promoter’s Counsel.
- Internal Audit. It is important at the very outset to review the issues involving the formation of the Captive and consider whether there are any red flags (see https://www.williamscoulson.com/irs-audits-captive-owners-know-the-red-flags/ ).
- Stop the Bleeding. Now that you know that you are under audit, you may want to reconsider any current premium payments and deductions that may not yet have been taken. It may be too late to address deductions already taken for years already under audit, but it may not be too late to address later years that are not under audit or have not yet been filed.
- Consider Your Due Diligence. When the IRS proposes adjustments, they also normally propose an accuracy related penalty of 20% of the adjustment. A taxpayer can often get the penalties waived at the Exam level by demonstrating good faith and due diligence from reliance on an independent tax counsel. At the beginning of the audit, you should review your file for that evidence. Sometimes, the guidance from tax professionals was not memorialized in writing. In such cases, you should seek to get the Counsel to put their guidance in writing. Also, recent cases have shown that reliance on the Counsel on any party related to the sale is not sufficient.
If you are under audit and would like to discuss your case, please call Mike Lloyd at (412) 454-0225 or email him at firstname.lastname@example.org.