Myth #10 - Captives Are an Audit Target
Every year, hundreds (maybe thousands) of business owners that would benefit immensely from the risk management, asset protection and tax saving benefits of owning their own captive insurance company (CIC) are frightened away by advisors or so-called experts who suggest that, "captives are an audit target."
Myth # 10 is characterized by both injustice and disservice.
Let's start with injustice. First, it is reasonable and fair to state that captives are audited by the I.R.S. It is also reasonable and fair to state that if the I.R.S. audits a business and finds a captive insurance company, the captive will almost certainly be audited as well. It is also reasonable to note that from time to time, the I.R.S. performs audit sweeps of captives to assess industry-wide compliance with captive law, tax law and I.R.S. safe harbor guidelines. While there isn't clear evidence to this effect, let's assume captives increase the risk of being audited. Should that stop you from doing what is right for you and your business? By the way, 401(k) and 403(b) qualified retirement plans were subjected to an audit sweep by the I.R.S. in the early 2000's. No one suggested stopping or suspending their installation as a result.
The injustice occurs because the risk of an audit is over-hyped, which is functionally disingenuous. Suppose I wrote an article about the grave dangers of travelling by airplane. My article might say, "If you fly, and if the plane is old or poorly constructed, and if the maintenance crew did a poor job, and if the pilot is sleep-deprived or drunk, you could die a horrible death." I could go on to say, "people die in airplane crashes every year." Well, these statements are technically true, but I am really overstating the dangers of flying. I'm also failing to note that flying is statistically far safer than automobile travel.
What if you own a captive insurance company and your captive is audited? A well-structured and well-run CIC should pass an audit in the same way well-structured 401(k) and 403(b) qualified retirement plans weathered their audits by the I.R.S. Considering the illustration in the preceding paragraph, your captive should be well-structured (similar to flying in a well-built airplane), operated correctly (similar to flying in a well-maintained airplane), and managed by a proven and experienced captive manager (similar to flying with a professional and responsible pilot). Furthermore, the I.R.S. has fared poorly in its attacks against captive insurance companies. Captives that follow the plain reading of the law, precedents set in case law and comply with I.R.S. safe harbor guidelines should not only be well prepared to weather an audit, should an audit occur, but they should also be solidly positioned to defeat the I.R.S. in U.S. Tax Court, if the Service won't relent. Recent cases including Rent-A-Center and a captive managed by Capstone attest to the defensibility of well-structured captives.
Let's address the "disservice" aspect of Captive Myth # 10. Imagine the harm that would be done by steering passengers away from flying to other forms of transportation. Think of all the time wasted. And, statistically speaking, accidents and fatalities would increase. Erroneously steering business owners away from captive ownership deprives them and their businesses of tremendous benefits. Captive insurance companies can form the chassis of a small or mid-size business' Enterprise Risk Management (ERM) Strategy, resulting in a more robust company with far better prospects for long term viability.
The decision to form or expand or maintain a captive insurance company should be a business decision like any other. Consider the risks versus the reward of acting or not acting, remembering that the risk of NOT pursuing a captive strategy is often the permanent forgoing of a very large tax deduction and loss of all the non-tax benefits as well. The out of pocket cost can never be recovered. But, not only do you lose the tax deduction, but all future growth, earnings and interest on that money as well. Millions of dollars are at stake. The opportunity cost of failing to act is definite and significant.
For a great many businesses it's worth the risk of an audit to reap the significant tax and non-tax benefits of a captive. Potential downside risk can be managed by setting up and running the captive well and being prepared to defend your CIC all the way to court if necessary - where the IRS has an abysmal record.