Transcript When the IRS Knocks August 2011

SURVIVING THE IRS AUDIT
September 28, 2011
Presenter
Daniel J. Kusaila, Tax Partner
Saslow 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 outcomes

2
Types of Taxes

--Income tax exams

--Excise tax exams
Both are increasing but for different reasons
3
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
4
The Chosen One
How Does One Get Selected for Audit?

There are Only Two IRS Audit Projects Directly
Targeted at Captive Insurance
 Section 501(c)(15) insurers
 Excise Tax (cascading tax)

Most Other Captive Audits Arise During the Audits of
the Operating Companies
5
The Chosen One (cont’d)
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

6
Which Tax Years?
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

7
Audit

Audit
 Formal 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
8
Types of Audits
Mail-In Audit
 Office 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

9
The IRS Audit Process
The Audit Process
“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
11
The Audit Process (cont’d)
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, and
 Answer the taxpayer's questions or concerns regarding the
audit process.
12
The Audit Process (cont’d)
Who Represents the Taxpayer
Internal accountant?
 External CPA
 Lawyer (usually in background, if at all)

13
The Audit Process (cont’d)
I recommend treating the agents with courtesy,
professionally and offering them nice
accommodations rather than a basement or closet.
14
The Audit Process (cont’d)

Power of Attorney (Form 2848)
 Powers Granted/Restricted
 Agreeing to IRS adjustments
 Negotiating refund checks

Information Documentation Request (IDR)
 Written questions from IRS and request for
supporting documentation
 Reply in writing
15
Form 4564
16
Potential IRS Concerns
 The 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
17
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
18
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
19
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
20
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.
21
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?
22
Potential IRS Concerns (cont’d)

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?
23
Potential IRS Concerns (cont’d)
Tax Exempt interest
Foreign affiliated entities
Policyholder dividends
Alternative Minimum Tax
24
Potential IRS Concerns (cont’d)

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?
25
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?
26
Audit Process

What we all hope for:
A “No change Letter”
27
Audit Process (cont’d)

IRS Proposed Adjustments

Form 5701 used to communicate proposed
adjustment by the IRS

Form 886-A explanation of adjustment
accompanies
28
Agreed Issues

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)
29
Unagreed Issues
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

30
Unagreed issues when the audit is
over
30-day letter
 Taxpayer’s Protest
 Agent’s Rebuttal
 Ex Parte Meeting – Appeals and Examiners
 One or more meetings with the Appeals Officer
 Control of the Statute of Limitations

31
Appeals Conference
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

32
Taking it to Court
TAX COURT
DISTRICT COURT
CT. OF FED CLAIMS
No
Yes
Yes
Judge / Jury
Judge
Option**
Judge
Place of Trial
Local*
Local
Local*
% Tax Cases
100%
2%
50%
Government
Lawyer
IRS
DOJ
DOJ
Pay First
*Judge
travels from DC ** Option Judge or Jury
33
Penalties & Interest
Interest – Second Quarter 2011 – Prepay?
Interest
Corporate
Large Corporate
Overpayment
Underpayment
Deduct
3%
4%
Yes
1.5%
6%**
Yes
**Underpayment of $100,000 beginning 30 days after 30-day or 90-day letter
34
Penalties & Interest (cont’d)
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

35
Federal Excise Taxes
FET Exam Activity
 Federal 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
37
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:
1) 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.
38
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.
39
Interim Guidance Memo SBSE-040909-045 (Excise Taxes)
 Procedures for excise tax examiners
 IRS indicated it will be auditing foreign captive subsidiaries
 Forward 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
40
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
41
Best Practices
Best Practices

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).

43
Best Practices (cont’d)

Feasibility Study
 Non-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?
44
Best Practices (cont’d)
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.

45
Best Practices (cont’d)
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

46