1. SURVIVING THE IRS AUDIT September 28, 2011 Presenter Daniel J. Kusaila, Tax Partner Saslow Lufkin & Buggy, LLP

2. 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

3. Types of Taxes   --Income tax exams  --Excise tax exams  Both are increasing but for different reasons 3

4. 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

5. The Chosen One 5  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 How Does One Get Selected for Audit?

6. The Chosen One (cont’d) 6  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

7. Which Tax Years? 7  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

8. Audit 8  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

9. Types of Audits 9  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

10. The IRS Audit Process

11. The Audit Process 11 “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

12. The Audit Process (cont’d) 12 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.

13. The Audit Process (cont’d) 13 Who Represents the Taxpayer  Internal accountant?  External CPA  Lawyer (usually in background, if at all)

14. The Audit Process (cont’d) 14 I recommend treating the agents with courtesy, professionally and offering them nice accommodations rather than a basement or closet.

15. The Audit Process (cont’d) 15  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

16. Form 4564 16

17. 17 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

18. 18 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

19. 19 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

20. 20 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

21. 21 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.

22. 22 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?

23. 23  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)

24. 24 Potential IRS Concerns (cont’d)  Tax Exempt interest  Foreign affiliated entities  Policyholder dividends  Alternative Minimum Tax

25. Potential IRS Concerns (cont’d) 25  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?

26. 26 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?

27. Audit Process 27  What we all hope for: A “No change Letter”

28. Audit Process (cont’d) 28  IRS Proposed Adjustments  Form 5701 used to communicate proposed adjustment by the IRS  Form 886-A explanation of adjustment accompanies

29. Agreed Issues 29  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)

30. Unagreed Issues 30  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

31. Unagreed issues when the audit is over 31  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

32. Appeals Conference 32  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

33. Taking it to Court 33 TAX COURTDISTRICT COURTCT. OF FED CLAIMS Pay FirstNoYes Judge / JuryJudgeOption**Judge Place of TrialLocal*LocalLocal* % Tax Cases100%2%50% Government Lawyer IRSDOJ * Judge travels from DC ** Option Judge or Jury

34. Penalties & Interest 34 InterestOverpaymentUnderpaymentDeduct Corporate3%4%Yes Large Corporate1.5%6%**Yes Interest – Second Quarter 2011 – Prepay? **Underpayment of $100,000 beginning 30 days after 30-day or 90-day letter

35. Penalties & Interest (cont’d) 35  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

36. Federal Excise Taxes

37. 37 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

38. 38 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) 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.

39. 39 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.

40. 40 Interim Guidance Memo SBSE-04- 0909-045 (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

41. 41 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

42. Best Practices

43. 43  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).

44. Best Practices (cont’d) 44  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?

45. Best Practices (cont’d) 45 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.

46. Best Practices (cont’d) 46 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