Internal Revenue Service (IRS)

In a case of first impression, the Tax Court held that the U.S.–Canada Tax Treaty (Treaty) did not exempt a Canadian citizen from U.S. income tax on the unemployment compensation she received from the State of Ohio. Pei Fang Guo v. Commissioner, 149 T.C. No. 14. The taxpayer came to the U.S. in 2010 as a post-doctoral fellow at the University of Cincinnati. She worked at UC from 2010 through 2011 on a nonimmigrant professional visa. When her employment contract ended in November 2011, she returned to Canada after she was unable to find other work in the U.S., where she stayed through 2012. When her UC employment contract ended, the taxpayer applied to the State of Ohio for unemployment compensation, which she received in 2012. When the taxpayer filed her 2012 U.S. tax return, she took the position that her unemployment compensation was exemption from income tax under Article XV of the Treaty. Instead, she reported the unemployment compensation on her Canadian tax return. The IRS disagreed, and the taxpayer filed a petition in Tax Court.

Tax Court SealThe Tax Court said that the taxpayer was a nonresident alien in 2012, which means she was neither a U.S. citizen nor resident. Generally, nonresident aliens must pay U.S. tax on their U.S.–source income. Everyone agreed that the taxpayer’s unemployment compensation was U.S.–source income. As a result, the only question left for the Tax Court to decide was whether the taxpayer’s unemployment compensation was exempt from U.S. income tax under the Treaty. But the Treaty does not mention unemployment compensation, except to say it does not count as social security.

The taxpayer focused her argument on the term “remunerations” in Article XV of the Treaty. Article XV governs the treatment of “salaries, wages, and other similar remunerations derived . . . in respect of an employment.” But the Treaty does not define “remunerations” either, so the Tax Court turned to the Code. “Remuneration” appears twice in the Code. Section 3401(a) says that “the term ‘wages’ means all remunerations . . . for services performed by an employee for his employer,” and section 3121(b) says that the “term ‘wages’ means all remuneration for employment.”

The Tax Court held that, just as unemployment compensation is not the same thing as “wages,” unemployment compensation does not constitute “similar remuneration derived. . . in respect to employment” under Article XV. The taxpayer wasn’t employed by UC when she received her unemployment compensation. And she did not receive it from her former employer.  She received it from the State of Ohio. As a result, the Tax Court concluded she was required to pay U.S. taxes on her unemployment compensation.

TIGTA recently released a report discusses their audit of the IRS’s estate and gift tax examination procedures.  TIGTA made eight recommendations of changes to the estate and gift tax examination process.  The bulk of TIGTA’s recommendations address the informal processes, lack of consistency, and unknown effectiveness of the estate and gift tax examination procedures.

One of the more significant findings of the report is that while the examination division proposed over $577 million of estate and gift tax deficiencies for FY 2016, only $98 million of those deficiencies were sustained after cases were considered by IRS Appeals.  The Examination division attributed this statistic to the fact that the Examination division proposes alternative deficiencies in order to prevent being whipsawed.  However, the Examination division could not separately identify the amount of deficiencies that were attributable to these alternative positions.  TIGTA highlighted that the Government could be subject to suits for attorneys’ fees pursuant to Section 7430 if the positions set forth in the notices of deficiency were not substantially justified.  TIGTA recommended that Examination division develop written guidance “on the circumstances in which it is advisable to propose and issue notices of deficiency in estate and gift tax examinations that contain alternative positions.”

Other highlights from the report include:

  • there is one gatekeeper who decides whether or not to route a case for examination and how to prioritize cases;
  • there is no quality review process;
  • unlike the process for selecting income tax returns for examination, the process of selecting estate and gift tax examinations for examination is based minimal written guidance and involves almost no objective procedures, but instead relies on human involvement and judgment; and
  • procedures for documenting case selection, examination documentation and managerial review either did not exist or if they did exist were not followed as closely as they should be.

TIGTA’s report can be accessed here.

On September 11, 2017, the Treasury Inspector General for Tax Administration (TIGTA) issued its final report discussing IRS compliance activities through fiscal year 2016 (the federal government’s fiscal year begins on October 1 and ends on September 30). TIGTA compiles statistical information reported by the IRS and issues the report annually in response to continuing stakeholder interest in the analysis and trends in IRS Collection and Examination function activities. Here are the highlights:

  • IRS Budget Increased, but Staffing Declined. Although the IRS budget increased in 2016, IRS staffing continued to decline. The budget increase was intended to improve customer service, prevent fraud and identity theft, and enhance cybersecurity to safeguard taxpayer data.
  • The Number of Tax Returns Examined Declined. The number of tax returns examined in 2016 decreased approximately nine percent compared to 2015. The number of examinations conducted in 2016 is approximately 32 percent lower than the number conducted during 2012. The report attributes the significant reduction in the number of examinations over that time period to a continued decline in examination staffing, which reached a 20-year low in 2016.

Percentage Change in the Number of Field Examiners and Examinations Since FY 2012

Source: IRS Data Book and Table 37 Examination Program Monitoring

 

  • IRS Issued Fewer Liens and Levies. The number of liens and levies issued continued to decline in 2016. The IRS issued its fewest amount of liens and levies since 2002.
  • Payment Alternatives – Increase in Direct Debit Installment Agreements. The number of direct debit installment agreements (a payment option available to certain taxpayers who cannot fully pay their tax obligations on time) has increased by 128 percent since 2012. The increased use of this payment option is likely attributable to reductions in enforcement personnel and the need to efficiently and effectively collect outstanding tax liabilities.
  • Legislative Initiatives. In December 2015, Congress enacted the Fixing America’s Surface Transportation Act. The law contains two measures designed to assist the IRS in collecting delinquent taxes: (1) authorizing the use of private debt collectors for the collection of outstanding inactive tax receivables, and (2) authorizing the State Department to revoke, or deny, passports to taxpayers with seriously delinquent tax debt. The IRS began assigning cases to private debt collection agencies in April 2017. The IRS also worked to coordinate with the State Department to implement the passport revocation program. You can read more about the passport revocation program here and here.

You can read the full report here.

Two members of Congress have introduced a bill that would exempt from income tax transactions under $600 conducted using Bitcoin or other digital currencies. Currently, the Internal Revenue Service treats digital currencies like Bitcoin as property, meaning that on every transaction using Bitcoin, the taxpayer must recognize either a gain or loss for tax purposes depending on his or her basis in the digital currency and report such gain or loss on an income tax return. The IRS does not recognize any de minimus transaction amount, meaning that a taxpayer using Bitcoin to purchase a cup of coffee must recognize gain or loss on the transaction. Representatives Jared Polis (D-Colo.) and David Schweikert (R-Ariz.), co-chairs of the Congressional Blockchain Caucus, have introduced the Crytocurrency Tax Fairness Act of 2017 to exempt small purchases with digital currency up to $600 from tax reporting and burdensome recordkeeping requirements.

In a press release announcing the bill, Rep. Polis said that “[c]ryptocurrencies can be used for anything from buying a cup of coffee to paying for a car, to crowdfunding a new startup and more and more consumers are choosing to use this type of payment. To keep up with modern technology, we need to remove outdated restrictions on cryptocurrencies, like Bitcoin, and other methods of digital payment. By cutting red tape and eliminating onerous reporting requirements, it will allow cryptocurrencies to further benefit consumers and help create good jobs.”

Rep. Schweikert added that “[i]ndividuals all over the world are starting to use cryptocurrencies for small every day transactions, yet here in the States we have fallen behind and make cryptocurrency use more of a challenge than it needs to be. “With this simple legislative change, anyone can make digital payments to buy a newspaper or a bike without worrying about tax code challenges.”

According to their press release, Polis and Schweikert relaunched the Congressional Blockchain Caucus in February. The caucus educates, engages, and provides research to help policymakers implement smart regulatory approaches to the issues raised by blockchain-based technologies and networks. Blockchain is a decentralized distributed ledger that is the main technology powering cryptocurrencies such as Bitcoin and Ethereum. By using math and cryptography, blockchain supplies a decentralized database of every transaction involving value. This creates a record of authenticity that is verifiable by a user community, increasing transparency and reducing fraud. Crytocurrencies, like Bitcoin and Ethereum, are used for purchases, trade, and payment across the globe. The estimated value of the cryptocurrecy economy is $162 billion.

Meanwhile, the IRS is continuing its aggressive efforts to identify the users of digital currency through litigation involving a “John Doe summons” on Coinbase Inc., a leading virtual currency exchanger. The IRS believes that because virtual currency transactions are difficult to trace, offer relative anonymity, and lack third-party information reporting, taxpayers may be using them to hide taxable income.  In a press release announcing the John Doe summons, then-Principal Deputy Assistant Attorney General Caroline D. Ciraolo, head of the Justice Department’s Tax Division, said that “[a]s the use of virtual currencies has grown exponentially, some have raised questions about tax compliance.  Tools like the John Doe summons authorized today send the clear message to U.S. taxpayers that whatever form of currency they use – bitcoin or traditional dollars and cents – we will work to ensure that they are fully reporting their income and paying their fair share of taxes.”  According to the IRS, there is a significant reporting gap between the number of virtual currency users reported by Coinbase during the period 2013 through 2015 and the total number of taxpayers reporting gains or losses to the IRS during that same period (807, 893, and 802, respectively). In addition, it has been reported that the IRS is utilizing Chainanalysis software to identify owners of virtual currencies.

The President has declared a major disaster in the State of Texas. The declaration permits the IRS to postpone certain deadlines for taxpayers who reside or have a business in the disaster area.

Individuals who reside or have a business in the following counties may qualify for tax relief: Aransas, Austin, Batrop, Bee, Brazoria, Calhoun, Chambers, Colorado, DeWitt, Fayette, Fort Bend, Galveston, Goliad, Gonzales, Hardin, Harris, Jackson, Jasper, Jefferson, Karnes, Kleberg, Lavaca, Lee, Liberty, Matagorda, Montgomery, Newton, Nueces, Orange, Polk, Refugio, Sabine, San Jacinto, San Patricio, Tyler, Victoria, Walker, Waller and Wharton.

Taxpayers not in the covered disaster area, but whose records necessary to meet a deadline are in the disaster area are also entitled to relief. In addition, all relief workers affiliated with a recognized government or philanthropic organization assisting in the relief activities in the disaster area and any individual visiting the covered disaster area who was killed or injured as a result of the disaster are entitled to relief.

The IRS gives the affected taxpayers until January 30, 2018 to file most tax returns (including individual, corporate, and estate and trust income tax returns; partnership returns, S corporation returns, and trust returns; estate, gift, and generation-skipping transfer tax returns; and employment and certain excise tax returns), that have either an original or extended due date occurring on or after August 23, 2017, and before January 31, 2018. This includes taxpayers who had a valid extension to file their 2016 return that was due to run out on October 16, 2017. It also includes the quarterly estimated income tax payments originally due on September 15, 2017 and January 16, 2018, and the quarterly payroll and excise tax returns normally due on October 31, 2017. In addition, penalties on payroll and excise tax deposits due on or after August 23, 2017, and before September 7, 2017, will be abated as long as the deposits were made by September 7, 2017.

If an affected taxpayer receives a late filing or late payment penalty notice from the IRS that has an original or extended filing, payment or deposit due date that falls within the postponement period, the taxpayer should call the telephone number on the notice to have the IRS abate the penalty.

Casualty Losses

Affected taxpayers in a federally declared disaster area have the option of claiming disaster-related casualty losses on their federal income tax return for either the year in which the event occurred, or the prior year. Individuals may deduct personal property losses that are not covered by insurance or other reimbursements.

August brought three wins for taxpayers who donated conservation easements that were challenged by the IRS.  In all of the cases, terms of the conservation easement deed document carried the day. 

  • In BC Ranch II, L.P. v. Comm’r, No. 16-60068, 2017 BL 282040 (5th Cir. Aug. 11, 2017), the Fifth Circuit overturned a Tax Court decision finding that an easement deed allowing for small boundary adjustments violated the perpetuity requirement of Section 170(h)(2)(C).  The perpetuity requirement provides that, in order to qualify for a charitable contribution deduction for a conservation easement donation, a taxpayer must restrict, in perpetuity, the use which may be made of the real property.  The Fifth Circuit held that the Tax Court’s reliance in Belk  v. Comm’r, 140 T.C 1 (2013), aff’d 774 F.3d 2210 (4th Cir. 2014), to hold that the conservation easement restrictions violated the perpetuity requirement was misplaced because Belk involved a provision where the easement land could be substituted in its entirety for a new parcel of land.  The Fifth Circuit looked at similar cases where small adjustments to the easement were permitted to promote the underlying conservation purpose.  Because that was the case here, the court found that the perpetuity requirement was met.  Addressing the IRS alternative theory that the partners entered into disguised sales for partnership property, the court also determined that the portions of capital contributions made by partners, other than those attributable to the parcels that were distributed to them, were not disguised sales of partnership assets.  
  • Next, in 310 Retail, LLC, v. Comm’r, T.C. Memo 2017-164, and Big River Development, L.P. v. Comm’r, T.C. Memo 2017-166, the Tax Court held that the conservation easement deeds at issue met the contemporary written acknowledgement requirement set forth in Section 170(f)(8)(B).  The contemporary written acknowledgement provision requires that, in order to claim a charitable contribution deduction, the donor is required to obtain from the charity a written statement that describes the donation, states whether the charity provides goods and services in exchange for the donation, and, if goods and services were provided, the fair market value of those goods and service.  This documentation must be obtained before the earlier of the due date of the return or the date the return in filed.  In both cases, the donor did not obtain from the charity separate documentation that is traditionally sent to donees with this specific language.  However, because the conservation easement deeds contained language discussing the consideration given and stating that the deed was the complete agreement of the parties (known as a merger clause), the deed itself acknowledged that the charity did not provide goods and services to the donor and therefore satisfied the contemporaneous written acknowledgement requirements. 
  • In all three cases, while the taxpayers now presumably have established the right to claim the charitable contribution deduction, the next step of determining the value of the conservation easement will be a separate battle.

August 29, 2017Law360

An unusual feature of this latest bank resolution is what the Justice Department characterizes as Prime Partners’ “voluntary and extraordinary cooperation” with the U.S. government. In early 2009, Prime Partners voluntarily implemented a series of remedial measures to stop assisting U.S. taxpayers in evading federal income taxes, before the initiation of any investigation by the U.S. government. The timing of these corrective actions is particularly notable, as the Justice Department announced its landmark deferred prosecution agreement with UBS AG, the largest bank in Switzerland, in February 2009, and the Internal Revenue Service unveiled its Offshore Voluntary Disclosure Program approximately 30 days later. In the midst of the announcement of the UBS resolution, many other Swiss banks were advising their U.S. clients to transfer their account holdings to other, smaller Swiss banks in order to avoid detection by U.S. authorities, thereby creating a class of U.S. taxpayers now labeled by authorities as “leavers.” In stark contrast, it appears that Prime Partners embarked on a different course of conduct, implementing corrective action to avoid further violations of U.S. law.

The Justice Department appears to have taken great care to describe publicly the extent of Prime Partners’ extensive cooperation, which included the following:

  • Prime Partners’ voluntary production of approximately 175 client files for noncompliant U.S. taxpayers, which included the identities of those U.S. taxpayers;
  • Prime Partners’ willingness to continue to cooperate to the extent permitted by applicable law; and
  • Prime Partners’ representation — based on an investigation by outside counsel, the results of which have been reviewed by the Justice Department — that the misconduct under investigation did not, and does not, extend beyond that described in a statement of facts accompanying the non-prosecution agreement.

Another notable aspect of this case is that while Prime Partners is a Swiss institution, it did not take advantage of the popular yet now-closed “Swiss Bank Program,” which essentially offered amnesty to any Swiss financial institution willing to come forward and make full disclosure of its cross-border activities involving U.S. citizens. Nearly 80 Swiss institutions enrolled in the Swiss Bank Program and successfully resolved their potential exposure under U.S. tax laws by paying steep financial penalties and agreeing to fully cooperate with the U.S. government’s ongoing investigations of offshore tax evasion. Instead of enrolling in the Swiss Bank Program, Prime Partners appears to have conducted an internal investigation, voluntarily disclosed its misconduct to the Justice Department, cooperated with the subsequent government investigation, and attempted to negotiate the best possible deal it could. Prime Partners may have been prompted to undertake such action based upon what the Justice Department has publicly stated is its “willingness to reach fair and appropriate resolutions with entities that come forward in a timely manner, disclose all relevant information regarding their illegal activities and cooperate fully and completely, including naming the individuals engaged in criminal conduct.”

The Justice Department’s announcement that it agreed to a nonprosecution agreement with Prime Partners is no doubt a signal to other financial institutions (both Swiss and non-Swiss) that the voluntary disclosure “window” remains open (notwithstanding the termination of the Swiss Bank Program), and that institutions voluntarily disclosing their wrongdoing and demonstrating substantial cooperation — like that of Prime Partners — will be treated leniently.

Indeed, in a press release announcing the resolution Acting Manhattan U.S. Attorney Joon H. Kim stated that “[t]he resolution of this matter through a non-prosecution agreement, along with forfeiture and restitution, reflects the extraordinary cooperation provided by Prime Partners to our investigation. It should serve as proof that cooperation has tangible benefits.” In the same vein, Acting Deputy Assistant Attorney General Stuart M. Goldberg said that “[i]n our ongoing investigations, we will continue to draw on information from a variety of sources and to provide substantial credit to those around the globe who provide full and timely cooperation regarding the identity of U.S. tax cheats and the phony trusts and shell companies they seek to hide behind.” At the same time, the Justice Department will undoubtedly seek to punish — to the fullest extent possible under U.S. laws — financial institutions that have aided and abetted tax evasion by their U.S. customers and that fail to come forward voluntarily and cooperatively.

Finally, the Justice Department’s resolution with Prime Partners stands as yet another stern warning to taxpayers with undisclosed foreign accounts that they must take corrective action immediately or face harsh consequences. In the press release, Acting Deputy Assistant Attorney General Stuart M. Goldberg said “[t]he message is clear to those using foreign bank accounts to engage in schemes to evade U.S. taxes – you can no longer assume your ‘secret’ accounts will remain concealed, no matter where they are located. In our ongoing investigations, we will continue to draw on information from a variety of sources and to provide substantial credit to those around the globe who provide full and timely cooperation regarding the identity of U.S. tax cheats and the phony trusts and shell companies they seek to hide behind.” The Internal Revenue Service’s Offshore Voluntary Disclosure Program remains available to taxpayers with undisclosed foreign assets, although the penalty for account holders at Prime Partners will now increase from 27.5 percent to 50 percent.

Reprinted with permission from Law360. (c) 2017 Portfolio Media. Further duplication without permission is prohibited. All rights reserved.

For more up-to-date coverage from Tax Controversy Sentinel, please subscribe by clicking here.

The Tax Court has issued its long-awaited decision addressing captive insurance arrangements. In Avrahami v. Commissioner, 149 T.C. No. 7 (2017), the Tax Court held that payments made from a number of businesses owned by the Avrahamis to a microcaptive insurance company that was wholly-owned by Mrs. Avrahami were not for “insurance,” and thus were not deductible as insurance premiums paid. Here is what you need to know.

Captive Insurance Generally

Amounts paid for insurance are deductible as ordinary and necessary business expenses. Insurance companies are generally taxed on the insurance premiums they receive. However, small insurance companies that satisfy certain requirements are eligible to make a section 831(b) election, in which case they are only taxed on their taxable investment income (which does not include premiums received). For 2009 and 2010, an insurance company other than a life insurance company that had written premiums that did not exceed $1.2 million could elect to be taxed under section 831(b) as long as they met all other requirements.

A pure captive insurance company is one that only insures the risks of companies related to it by ownership. A captive insurance company that is eligible to make a section 831(b) election (referred to as a “microcaptive”) does not pay tax on the premiums it receives. Thus, if a business owner creates a microcaptive that insures only the risks of the business owner’s business, the business is able to deduct up to $1.2 million for insurance premiums paid to the related microcaptive while the microcaptive does not pay tax on the premiums received. However, the premiums are only deductible if the payments are for “insurance,” which begs the question: what is “insurance”? This is the question Avrahami addressed in the context of payments made to microcaptives.

Case Background

The Avrahamis owned jewelry stores and commercial real estate companies (the “Avrahami Entities”). In November 2007, they created an insurance company (the “Captive”) to insure the risks of the Avrahami entities. The Captive was wholly-owned by Mrs. Avrahami. In 2009 and 2010 – the years at issue in this case – the Avrahami entities paid the Captive premiums for direct insurance policies of approximately $730,000 and $810,000, respectively, for policies covering seven types of risk including: administrative actions, business risk indemnity, business income protection, employee fidelity, litigation expense, loss of key employee, and tax indemnity. In addition to its direct policies, the Captive participated in a risk distribution program with other small captive insurance companies through Pan American. Through Pan American’s risk distribution program, the Avrahami Entities paid approximately $360,000 to Pan American for terrorism coverage only. Pan American then reinsured all of the risk it had assumed and would make sure that the Captive received reinsurance premiums equal to the amount paid by the Avrahami Entities to Pan American ($360,000), and in exchange the Captive would reinsure a small percentage of Pan American’s total losses. In total, the Avrahamis deducted approximately $1.1 million and $1.3 million in 2009 and 2010, respectively, for insurance premiums paid from the Avrahami Entities to the Captive or Pan American for both direct policies and for the terrorism coverage obtained through the risk distribution program. Only the Avrahami Entities were covered by the direct policies while over 100 insureds were included in the risk distribution program.

The IRS argued that neither the Captive nor Pan American sold “insurance”, meaning the premiums paid by the Avrahami Entities were not deductible as ordinary and necessary business expenses. The Tax Court agreed.

The Court’s Analysis

To be considered insurance, the arrangement must: (1) involve risk-shifting; (2) involve risk-distribution; (3) involve insurance risk; and (4) meet commonly accepted notions of insurance. The Tax Court analyzed only two of these elements: risk distribution and commonly accepted notions of insurance.

Risk distribution occurs when the insurer pools a large enough collection of unrelated risks. The Tax Court looked to the number of companies the Captive insured and the “number of independent risk exposures” (i.e., how many policies does the Captive issue and what do those policies cover). Ultimately, the Court determined that insuring 3 companies in 2009 and 4 in 2010, issuing 7 direct policies that covered 3 jewelry stores, 3 commercial real estate companies, 2 key employees, and 35 other employees did not cover a sufficient number of risk exposures to achieve risk distribution through the affiliated entities. The Court distinguished the facts present in this case from other cases where they have determined that insurers adequately distributed risk.

The Avrahamis argued that they adequately distributed risk because, in addition to the Captive insuring the Avrahami Entities, the Captive participated in the Pan American risk distribution program and reinsured third-party risk. The Court determined that Pan American was not a bona fide insurance company in the first place, meaning the policies it issued were not “insurance” and the Captive could not have distributed risk by reinsuring policies that were not insurance to begin with. The Court looked to a number of factors to determine whether Pan American was a bona fide insurance company, ultimately concluding that it was not for the following reasons:

  • There was a circular flow of funds. Avrahami Entities paid Pan American, Pan American turned around and reinsured all of the risk it had assumed, making sure that the Captive received reinsurance premiums equal to those paid by the Avrahami Entities. Thus, money was effectively transferred from an entity owned by the Avrahamis (one of the Avrahami Entities) to an entity wholly-owned by Mrs. Avrahami (the Captive).
  • The premiums charged for terrorism coverage were “grossly excessive”. The only policy Pan American issued was for terrorism coverage, and the policy was worded in a way that it was highly unlikely that the triggering event would ever occur.
  • Pan American charged high premiums for an event that was unlikely to ever occur (and had never occurred in the past), and if the event did occur Pan American may have not been able to pay the claims.
  • Because the risk distribution program was not recognized by the Court, when the Court reviewed the direct policies it determined that on a stand-alone basis they also did not adequately distribute risk because the direct policies only covered the Avrahami Entities and the combination of risks and entities covered by the direct policies did not distribute risk among an adequate number of independent insurance risks.

For these reasons, the Court concluded that the Captive did not adequately distribute risk.

The Tax Court then analyzed whether the Captive met commonly accepted notions of insurance, which required the Court to work through a number of factors. The Court determined that the Captive was not selling insurance in the commonly accepted sense. The Court explained:

  • The Captive did not operate like an insurance company. No claims were filed until the IRS began its audit. The Captive only invested in illiquid, long-term loans to related parties and failed to get regulatory approval before transferring funds to them.
  • The Captive returned substantial portions of its surpluses to the insureds and owners of the insured through various loans and distributions.
  • The Captive policies were questionable because they were unclear and contradictory.
  • The Captive charged unreasonable premiums even though an actuary priced the policies. The Court did not find the actuary’s pricing methodology at all persuasive, noting that the actuary consistently chose inputs that would generate higher premiums. The Court noted that before creating the Captive, the Avrahami Entities paid $150,000 for commercial insurance policies. After creating the Captive, the Avrahami Entities paid $1.1 million and $1.3 million in 2009 and 2010, and paid $90,000 for a commercial insurance policy.

As a result, the Court concluded that payments made from the Avrahami Entities to the Captive and Pan American were not for insurance, and thus were not deductible as ordinary and necessary business expenses.

It is worth noting that the Captive was incorporated under the laws of the Caribbean nation of Saint Christopher and Nevis (St. Kitts). The Captive made a section 953(d) election to be treated as a domestic corporation for federal income tax purposes, and also made an election to be taxed as a small insurance company under section 831(b). However, since the Captive’s policies were not for “insurance”, both elections were invalid, and it was thus treated as a foreign corporation for federal income tax purposes. The parties stipulated that the taxable premiums earned by the Captive were not subject to U.S. Federal income tax.

Impact on Continuing IRS Scrutiny of Captive Insurance Arrangements

For several years, the IRS has devoted significant resources to examinations of captive insurance arrangements and numerous cases are the subject of Tax Court petitions.  There are several cases pending in the Tax Court post-trial.  The IRS increased its scrutiny of microcaptives when it issued Notice 2016-66, requiring self-reporting by taxpayers engaging in captive insurance arrangements where there has been a low incidence of claims or where significant loans have been made to related parties. In light of the Avrahami decision, the IRS is likely to continue devoting resources to scrutinizing and challenging captive insurance arrangements it believes are abusive.

The Internal Revenue Service has issued a renewed warning for tax professionals and businesses to beware of a recent increase in email scams targeting employee Forms W-2. According to the IRS, the W-2 scam – called business email compromise or “BEC” – is one of the most dangerous phishing email schemes trending nationwide from a tax administration perspective. The IRS saw a sharp increase in the number of incidents and victims during the 2017 filing season.

A business email compromise occurs when a cybercriminal is able to “spoof” or impersonate a company executive’s email address and target a payroll, financial, or human resources employee with a request. For example, fraudsters will try to trick an employee to transfer funds into a specified account or request a list of all employees and their Forms W-2.

“These are incredibly tricky schemes that can be devastating to a tax professional or business,” said IRS Commissioner John Koskinen. “Cybercriminals target people with access to sensitive information, and they cleverly disguise their effort through an official-looking email request.”

The Federal Bureau of Investigation reported earlier this year that there has been a 1,300 percent increase in identified losses – with more than $3 billion in wire transfers – since January 2015. The FBI found that the culprits behind these scams are national and international organized crime groups who have targeted businesses and organizations in all 50 states and 100 countries worldwide.

During the 2016 filing season, the IRS first warned businesses that the scam had migrated to tax administration and scammers were using business email compromise tactics to obtain employees’ Forms W-2. The criminals were immediately filing fraudulent tax returns that could mirror the actual income received by employees – making the fraud more difficult to detect.

In 2017, the IRS saw the number of businesses, public schools, universities, tribal governments and nonprofits victimized by the W-2 scam increase to 200 from 50 in 2016. Those 200 victims translated into several hundred thousand employees whose sensitive data was stolen. In some cases, the criminals requested both the W-2 information and a wire transfer.

The Form W-2 contains the employee’s name, address, Social Security number, income and withholdings. That information was used to file fraudulent tax returns, and it can be posted for sale on the Dark Net, where criminals also seek to profit from these thefts.

If the business or organization victimized by these attacks notifies the IRS, the IRS can take steps to help prevent employees from being victims of tax-related identity theft. However, because of the nature of these scams, many businesses and organizations did not realize for days, weeks, or months that they had been scammed.

The IRS has established a special email notification address specifically for businesses and organizations to report W-2 thefts: dataloss@irs.gov. Be sure to include “W-2 scam” in the subject line and information about a point of contact in the body of the email. Businesses and organizations that receive a suspect email but do not fall victim to the scam can forward it to the BEC to phishing@irs.gov, again with “W-2 scam” in the subject line.

The IRS urges tax professionals to both beware of business email compromises as a threat to their own systems and to educate their clients about the existence of BEC scams. Employers, including tax practitioners, should review their policies for sending sensitive data such as W-2s or making wire transfers based solely on an email request. The IRS also suggests that tax professionals should consider taking these steps:

  • Confirm requests for Forms W-2, wire transfers or any sensitive data exchanges verbally, using previously-known telephone numbers, not telephone numbers listed in the email.
  • Verify requests for location changes in vendor payments and require a secondary sign-off by company personnel.
  • Educate employees about this scam, particularly those with access to sensitive data such as W-2s or with authorization to make wire transfers.
  • Consult with an IT professional and follow these FBI recommended safeguards:
    • Create intrusion detection system rules that flag e-mails with extensions that are similar to company email. For example, legitimate e-mail of abc_company.com would flag fraudulent email of abc-company.com.
    • Create an email rule to flag email communications where the “reply” email address is different from the “from” email address shown.
    • Color code virtual correspondence so emails from employee/internal accounts are one color and emails from non-employee/external accounts are another.

If a BEC incident occurs, notify the IRS and file a complaint with the FBI at the Internet Crime Complaint Center.

For more up-to-date coverage from Tax Controversy Sentinel, please subscribe by clicking here.