By
Beckett G. Cantley
Attorney. Author. Professor.
Teaching international Taxation at Northeastern University,
Shareholder | Cantley Dietrich, P.C
bgcantley@cantleydietrich.com
and
Geoffrey C. Dietrich.
Shareholder | Cantley Dietrich, P.C
gcdietrich@cantleydietrich.com
Our prior articles on Internal Revenue Code (IRC) section 831(b) captive insurance company (CIC) transactions indicated the likely future would be littered with the corpses of certain promoter groups who had run “roughshod” over the codified doctrines of economic substance and business purpose. (Most of our prior articles on the topic are available at www.cantleydietrich.com.)
This article addresses the recently filed class-action lawsuit against certain captive insurance promoters and captive managers—Phoenix 2010 Revocable Trust v. Artex Risk Solutions Inc., No. 2:18-cv-04514-GMS (D. Ariz. Dec. 6, 2018) (hereafter “Phoenix Trust”). Counsel for plaintiffs is David R. Deary, Esq., of Loewinsohn Flegle Deary & Simon LLP, of Dallas, Texas—and then provides analysis on the prospective court case. Given that the attorneys involved in the lawsuit plan to file more such class action suits (see below), it is important for the 831(b) captive insurance community to understand this initial case.
A "captive insurer" is generally defined as an insurance company that is wholly owned and controlled by its insureds; its primary purpose is to insure the risks of its owners, and its insureds benefit from the captive insurer's underwriting profits.
captive.com
The current advice of certain Captive Insurance Company managers and promoters is to cast doubt that mean what these cases clearly articulate and that the future is far brighter than the rapidly setting sun of promoter-led CIC transactions indicates. Avrahami v. Commissioner, 149 T.C. 7 (Aug. 21,2017) https://www.ustaxcourt.gov/opinions/2017/149_TC_No_7.pdf, and Reserve Mechanical Corp. v. Commissioner, 115 T.C.M. (CCH) 1475, T.C. Memo. 2018-86, https://www.ustaxcourt.gov/opinions/2018/TCMemo_2018-86.pdf
The vast number of CIC promoter articles that decry the vagaries of the Tax Court decisions buoys our assessment of this trend. Certain unscrupulous promoters peddle the belief that Tax Court decisions are momentary setbacks in the industry, rather than warning signals of the impending storm. Recent CIC transaction audit reports illustrate that despite promoter belief to the contrary, the direction of the Internal Revenue Service (IRS) appears to travel down the well-worn path of anti-abuse compliance.
In Phoenix Trust, there are numerous representative plaintiff groups, all of whom had a similar experience and—for the sake of brevity—will be hereafter referred to as the Phoenix Plaintiffs. The following discussion is on the allegations of the complaint.
Similar to the taxpayers in Avrahami and Reserve Mechanical, a trusted adviser of the Phoenix Plaintiffs had been approached about providing tax strategies to their clients. As the Phoenix Plaintiffs entered into the CIC arrangements, none had a completed feasibility study explaining why the CIC was necessary or that there were risks their commercial insurance could not prevent.
Across the board, the actuary and captive manager/promoter (Artex) worked together to determine rates, tables, and premiums based on the anticipated tax deduction requested. Further sweetening the deal for the proposed CIC, Artex structured the transactions so the Phoenix Plaintiffs could “borrow back” excess funds used in the insurance arrangements. In a final masterstroke, Artex purported to provide “estate planning captives” where ownership of the CIC was held by trusts for the benefit of the owners' children.
Artex, for its part, used the façade of experience to “assist” owners of closely held companies to form multiple CICs. Artex would further disguise their collusive activities through a false risk distribution platform, Provincial Insurance, PCC. The complaint claims that Karl Huish, the prior owner of Tribeca Risk Advisors and now Artex, and a family member, are the indirect owners of Provincial. The agreements between Artex and the insureds required the insured entities purchase insurance policies from Provincial, which would then flow premium dollars back into the client captives, less any losses, of which there were practically none.
The IRS concluded that all of the Phoenix Plaintiffs’ diverse transactions lacked economic substance sufficient to pass muster and further determined, like Avrahami and Reserve Mechanical, that the arrangement was not insurance for tax purposes. The IRS concluded that the premiums were not deductible and assessed back taxes, penalties for underreporting and underpayment, and interest. The complaint further asserts that the Artex-promoted transactions were actually the result of a conspiracy involving the named defendants and “other participants.” These “other participants” included other professionals such as tax attorneys, certified public accountants, and financial advisers who steered their clients into the Artex scheme in exchange for referral fees paid by Artex or another defendant.
As we have consistently warned, professionals who have the knowledge and/or ability to research and conduct due diligence into these types of transactions are now being roped into litigation because they should have known or were willfully ignorant of the Artex scheme.
In what may come as a surprise to some—and may verify what others have known all along—the complaint alleges violations of federal and Arizona Racketeer Influenced and Corrupt Organizations Act (RICO) statutes. The complaint alleges the collusion and conspiracy of both the named defendants and the other participants. Simply put, Artex and named defendants are alleged to have colluded with the other participants to sell a tax shelter arrangement to obtain substantial fees. In addition to the RICO claims, the complaint alleges a host of others including breach of fiduciary duty, professional negligence, negligent misrepresentation by the defendants, breach of contract, fraud, aiding and abetting, and civil conspiracy. Included among named defendants are underwriters, actuaries, and their firms.
The class-action lawsuit seeks the return of penalties assessed against taxpayers and disgorgement of the management fees and other costs expended by the taxpayer during the life of the CIC.
The authors want to make it very clear that not all CIC promoters/managers are among the bad actors targeted in the complaint and the complaints to follow. There are many CIC promoters/managers who are conservative in practice and seek to strictly follow IRS and state insurance law guidance. The bad actors that are (or will be) the targets of these class-action complaints are those that created “too good to be true” structures with specific defects, most of which are described in Avrahami and Reserve Mechanical.
The Phoenix Trust case represents the first opportunity taxpayers have had a chance to stand against the rising tide of bad actor promoter misrepresentations. Until recently, taxpayers have largely not been informed of the landscape of reality in CIC transactions.
Over the last decade, the IRS has targeted CIC promoters first with forensic audits, then promoter/risk pool audits, and now the bad actors with tax shelter captive shops are facing class-action litigation. These bad actor promoters appear to have done very little to prepare their clients for the deluge of IRS and civil litigation that is now upon them.
The storm we predicted in prior articles has reached shore.1 Now that the IRS is in full stride in its section 831(b) CIC enforcement activities, taxpayers, promoters, and advisers need to take account of the aftermath. The IRS is unlikely to alter its current course of enforcement as reports indicate the current Tax Court docket includes no less than 280 and, perhaps, as many as 500 pending 831(b) CIC cases.
Imposition of penalties for reportable transactions falls under the statutory, non-appealable penalty sections of 6707 and 6707A.2 As we have seen, the IRS often expands reporting requirements retroactively and seeks to enforce penalties back to the retroactive date.3 It is possible for a business owner to be assessed penalties that date back to their first year of participation in the abusive CIC captive shelter, provided the income tax return statute of limitations has not run out.
The IRS now seems to be adopting a rule-of-thumb in assessments, where tax years up to and including 2010 are being hit with 20 percent penalties, and those after 2010 are being assessed penalties at the 40 percent rate.4 Attorney David R. Deary, who is leading the Artex class-action litigation team, recently commented that “the Service has become increasingly aggressive in audits and in public statements about imposing penalties ranging from 20 to 40 percent on these transactions; we will be seeking to recover these as an element of damage in all our cases.”
The Artex class-action case is only the first of several similar CIC-based class-action complaints that are being drafted for filing in the near future. The law firm that brought the Artex case has numerous clients in tow that participated in CICs with the bad actors of the industry. He recently confirmed this when he stated,
“We anticipate the filing of additional class actions in the near future against other major promoters of these transactions.”
Mr. Deary also confirmed that these actions are being brought only against the truly noncompliant CIC promoters/managers and not a witch hunt being brought against the entire CIC industry.
Phoenix Trust is the first in a series of anti-promoter class-action lawsuits that will be filed against the worst offenders in the captive industry. Concerned attorneys, accountants, and wealth managers should carefully consider the needs of their clients involved in CIC transactions.
Certainly, not every promoter/ captive manager is in the position of Artex. Artex has been, after all, in a promoter audit, and their clients have had the IRS deny premium deductions and assess penalties. This makes it the most likely and an easy target of opportunity for the initial class action. The prudent adviser's concerns should increase as a client's captive manager starts to look more and more like Artex.
Editor’s Note: This article is provided by Beckett G. Cantley, who teaches international taxation at Northeastern, and Geoffrey C. Dietrich. Both are shareholders in Cantley Dietrich, P.C., and they can be reached at bgcantley@cantleydietrich.com and gcdietrich@cantleydietrich.com, respectively.
This article is discussing the same lawsuit discussed elsewhere in this issue, Shivkov v. Artex Risk Solutions, Inc., Case No. 2:18-cv04514-GMS (D. Ariz. Dec. 6, 2018), but references a different plaintiff. It should be noted that Mr. Cantley has a co-counsel arrangement with the tax shelter practice of Loewinsohn Flegle Deary Simon LLP, counsel for the plaintiffs.
