SURVIVING THE IRS AUDIT September 28, 2011

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

2. 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 Agenda 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 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

6. 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

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 Which Tax Years?

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 Audit

9. 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

10. The IRS 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 The Audit Process

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. The Audit Process (cont’d)

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

14. The Audit Process (cont’d) • 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) • 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. 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. 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. 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. 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. 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. 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. 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?

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

25. 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?

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

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

29. 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)

30. 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

31. 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

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 Appeals Conference

33. Taking it to Court *Judge travels from DC ** Option Judge or Jury

34. Interest – Second Quarter 2011 – Prepay? Penalties & Interest **Underpayment of $100,000 beginning 30 days after 30-day or 90-day letter

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 Penalties & Interest (cont’d)

36. Federal Excise Taxes

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. 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.

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. 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. 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. 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).

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? Best Practices (cont’d)

45. 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.

46. 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