GAO Issues Report: Abusive Tax Schemes – IRS Could Improve Its Reviews of Offshore Insurance Audits and Investigations

WASHINGTON, April 23 -- The Government Accountability Office has issued a report (GAONUMBER) entitled "Abusive Tax Schemes - IRS Could Improve Its Reviews of Offshore Insurance Audits and Investigations".

Here are excerpts of summaries associated with the report.

What GAO Found: "To encourage voluntary compliance with tax laws concerning offshore insurance arrangements, the Internal Revenue Service (IRS) uses feedback from internal stakeholders and the public to review and modify applicable guidance. Offshore insurance has legitimate uses but also can be structured to hide U.S. taxpayers' assets or falsely claim tax benefits. Treasury and IRS have opportunities to better solicit public input on certain guidance, including for offshore insurance, as GAO recommended in its April 2021 report. Treasury neither agreed nor disagreed with the recommendation, but GAO maintains that the recommendation remains valid.

One offshore insurance issue that IRS has prioritized with enforcement is micro-captive insurance arrangements--that is, when small insurance companies insure related business entities. For example, micro-captive insurance has been included on IRS's "Dirty Dozen" tax schemes list. To ensure micro-captive insurance audits are conducted properly, IRS generally uses two approaches:

* Managerial reviews: These consist of various types of written reviews, including in-process case reviews and workload reviews, among others, performed by the managers overseeing the audit.

* Quality reviews: These are conducted by independent reviewers outside of the audit work-stream to ensure that all processes meet IRS's standards.

IRS officials said that current oversight practices were sufficient to ensure that micro-captive audits were conducted accurately. For example, IRS cited that from fiscal years 2016 through 2020, the Small Business and Self Employed Division's (SB/SE) managerial reviews found that performance on attributes of micro-captive insurance audits were conducted appropriately about 97 percent of the time, compared to about 92 percent for all audits in general.

However, IRS's application of its review approaches could be enhanced. For example, SB/SE's managers have little guidance in the Internal Revenue Manual for when an audit should be subjected to managerial review and Large Business and International Division (LB&I) managers lack systems through which to record and analyze certain managerial reviews. By clarifying guidance and establishing a formal review system, SB/SE and LB&I would have better assurance that they are effectively auditing micro-captive insurance.

IRS also investigates whether promoters of micro-captive insurance schemes violate tax law. IRS's oversight of promoter investigations has no systematic method that would enable IRS to evaluate the effectiveness of its micro-captive promoter investigation program. For example, SB/SE lacks a systematic method to identify micro-captive promoter investigations for quality review. From fiscal years 2016 through 2020, LB&I did not apply quality reviews to any micro-captive insurance promoter investigations. Conducting formal reviews more systematically would better assure the quality of IRS's promoter investigations on micro-captive arrangements."

Why GAO Did This Study: "Tax evasion schemes involving offshore insurance are complex and resource-intensive for IRS to pursue, making it important for IRS to conduct compliance programs effectively.

GAO was asked to review how IRS conducts enforcement on offshore insurance compliance issues. This report evaluates to what extent IRS (1) reviews its guidance on offshore insurance to ensure that the guidance has its intended effect; (2) aligns oversight of its audit activities on taxpayers who may be abusing micro-captive insurance tax shelters with IRS audit policies and guidance; and (3) reviews its investigation activities on promoters who market abuses of offshore insurance tax shelters.

GAO reviewed IRS procedures on issuing guidance and on reviews of audits and promoter investigations, reviewed files on audits related to micro-captive insurance tax schemes, interviewed IRS officials, and compared IRS procedures with IRS policies and selected federal standards for internal control."

What GAO Recommends: "GAO is making seven recommendations to improve how IRS oversees, through managerial reviews and independent quality reviews, its taxpayer audits and promoter investigations involving micro-captive insurance arrangements. IRS disagreed with the recommendations, stating that its current procedures are sufficient and citing resource constraints. However, GAO maintains that IRS's procedures should be refined and can be done so with minimal use of resources."

The report was sent to Sen. Charles Grassley, R-Iowa, ranking member of the Senate Judiciary Committee, on April 22, 2022.

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March 23, 2022

To: The Honorable Charles Grassley, Ranking Member, Committee on the Judiciary, United States Senate

Dear Senator Grassley:

Federal law generally allows U.S. taxpayers to enter into insurance policies with offshore entities and provides certain tax benefits, such as income-tax deductions for insurance premiums, for genuine offshore insurance transactions./1 Our 2020 report on offshore insurance discusses examples of ways that taxpayers may legitimately claim these tax benefits, for example by acquiring offshore life insurance./2

However, when structured in abusive ways, offshore insurance products can be designed to hide U.S. taxpayers' assets or falsely claim federal income tax benefits. Furthermore, the Internal Revenue Service (IRS) has identified instances where taxpayers have used offshore insurance products in abusive tax schemes to improperly claim reduced tax liabilities. Our 2020 report also describes examples of how offshore insurance can be abused for tax purposes.

These abusive tax schemes can involve sophisticated tax shelters, devised and marketed to taxpayers by accountants, estate planners, and attorneys. These arrangements also may be constructed or recommended by professionals who have established relationships with taxpayers.

IRS officials have said that when insurance is held offshore, it can be more resource intensive to identify abusive insurance tax schemes and take enforcement action. Consequently, it is important that IRS properly manages its methods for encouraging and enforcing compliance on offshore insurance.

The federal government has lost significant amounts of revenue to abuse of insurance products. For example, in 2016, IRS estimated that hundreds of millions of dollars of certain insurance premiums have been used by taxpayers and promoters to improperly claim tax deductions./3 When taxpayers abuse insurance products, they threaten our tax system's integrity and fairness and contribute to the tax gap, which is the difference between the taxes people and businesses owe and what they annually pay voluntarily and on time in the United States.

You asked us to review what guidance IRS provides about complying with laws related to offshore insurance accounts and how IRS conducts enforcement on offshore insurance-related non-compliance. This report assesses the extent to which IRS:

* reviews its guidance on offshore insurance to ensure that the guidance has its intended effect;

* aligns oversight of its audit activities on taxpayers who may be abusing micro-captive insurance tax shelters with its audit policies and guidance;/4 and

* reviews its investigation activities on promoters who market abuses of micro-captive insurance tax shelters./5

In addition to these objectives, in appendix I of this report, we describe available data sources on offshore insurance companies and related transactions and discuss whether IRS could use such data in its audit selection.

To assess the extent to which IRS reviews its guidance on offshore insurance, we first identified relevant guidance. We included guidance that IRS officials considered non-regulatory guidance relating to offshore insurance. We compared IRS activities on developing and reviewing these types of guidance with IRS's Internal Revenue Manual (IRM), relevant best practices from the Office of Management and Budget (OMB), and relevant principles of federal internal control standards on risk assessment and control activities./6 We also interviewed relevant agency officials on IRS's guidance development process as it pertains to offshore insurance.

To assess the extent to which IRS aligns oversight of its audit activities on taxpayers who may be abusing micro-captive insurance tax shelters with IRS policies and guidance, we reviewed documentation describing objectives, procedures, and standards for IRS audits of potentially abusive offshore insurance tax arrangements. We focused our review on micro-captive tax shelters because IRS has publicly prioritized its efforts to reign in abusive micro-captive tax shelters and has data on these enforcement efforts. We reviewed the IRM; documentation and guidance specific to the IRS business operating divisions; previous GAO and Treasury Inspector General for Tax Administration reports, and IRS micro-captive insurance audit data. We also interviewed IRS staff.

Based on the findings of our initial review, we obtained the relevant criteria to evaluate IRS examinations of micro-captive insurance tax shelters. These criteria consisted of a list of required or recommended documents or activities that should be documented in an audit case file.

We selected these criteria based on the IRM and other agency guidance documents for conducting micro-captive insurance audits. We then identified and requested a non-generalizable sample of 30 IRS micro-captive insurance audit case files that closed in fiscal year 2019 and compared the case files to our criteria./7 We recorded where case files were missing supporting documentation of required or recommended examiner activities and aggregated our results.

In addition, we reviewed IRS documentation of internal managerial and quality reviews of micro-captive insurance audits conducted in fiscal year 2019 to describe how the agency evaluated its audits. We collected data from IRS on both the number and score of managerial and quality reviews conducted from fiscal years 2016 through 2020. We reviewed the data for accuracy by confirming that IRS's data sets matched data reported in managerial and quality review documents. We interviewed agency officials to determine how the quality scores were determined. We found the data sufficiently reliable to report both the number and quality scores of such reviews. We also compared IRS managerial review procedures listed in the IRM and described by agency officials to relevant federal internal control standards on control activities, monitoring controls, and documentation of the internal control system.

To assess the extent to which IRS reviews its investigations of promoters who market abuses of micro-captive tax shelters, we identified relevant procedures that were in place for identifying, investigating, and reviewing investigations of promoters of potentially abusive tax schemes. Again, we focused our review on micro-captive tax shelters to provide a more detailed analysis of IRS's related enforcement activities and to reflect IRS's publicly stated priority of enforcing tax laws on promotion of abusive micro-captive tax shelters. We also assessed the extent to which these procedures align with relevant federal internal control standards on control activities, information and communication, and monitoring.

For a more detailed discussion of our methodology, see appendix II.

We conducted this performance audit from April 2020 to March 2022 in accordance with generally accepted government auditing standards.

Those standards require that we plan and perform the audit to obtain sufficient, appropriate evidence to provide a reasonable basis for our findings and conclusions based on our audit objectives. We believe that the evidence obtained provides a reasonable basis for our findings and conclusions based on our audit objectives.

See footnotes here: https://www.gao.gov/assets/gao-22-104180.pdf

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Conclusions

Tax arrangements involving micro-captive offshore insurance can be complex and contribute to the tax gap when abused. To better ensure taxpayer and promoter compliance with the laws governing offshore insurance arrangements, while at the same time ensuring the best use of existing IRS resources, it is important for IRS to properly conduct enforcement activities, such as audits and investigations.

To this end, SB/SE has opportunities to better target micro-captive audits with managerial reviews, while LB&I could benefit from formally documenting managerial reviews of audits and using such documentation to resolve detected deficiencies. Additionally, IRS has opportunities to better leverage its quality review program concerning audits of micro-captive insurance tax arrangements by more precisely targeting micro-captive insurance.

Similar opportunities exist for investigations concerning promoters of micro-captive insurance tax schemes. As with audits, IRS has opportunities to more rigorously target micro-captive promoter investigations for formal managerial and quality review, begin to track and document managerial and quality reviews with data, and establish metrics that would help IRS better determine how well it conducts investigations of promoters.

By taking actions to ensure the quality of audits and promoter investigations, IRS would be more confident that its audits and promoter investigations were being conducted properly and using its resources effectively.

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Recommendations for Executive Action

We are making the following seven recommendations to IRS:

The Commissioner of Internal Revenue should have SB/SE provide more specific guidance on when SB/SE should use various managerial review tools and the frequency with which such reviews should be conducted on high-priority matters such as those surrounding micro-captive insurance arrangements. (Recommendation 1)

The Commissioner of Internal Revenue should have LB&I adopt formal managerial reviews of its audits and establish methods and procedures for recording and analyzing managerial review data that allow it to isolate high-priority cases, including micro-captive insurance audits, and use the data to assess the quality of its audits. (Recommendation 2)

The Commissioner of Internal Revenue should have SB/SE and LB&I subject a sample of their micro-captive insurance audits to a formal quality review process. Based on the findings of this review, SB/SE and LB&I should take corrective action to remedy any deficiencies. (Recommendation 3)

The Commissioner of Internal Revenue should have SB/SE design and implement an identification and tracking method in EQRS to allow agency officials to readily identify and compare managerial reviews of micro-captive promoter investigations, both to other micro-captive promoter investigations, and promoter investigations generally, and use the data to assess the quality of its promoter investigations. (Recommendation 4)

The Commissioner of Internal Revenue should have LB&I adopt formal managerial reviews of micro-captive insurance promoter investigations, establish a reliable way to store and track managerial review data of promoter investigations that allows it to isolate high priority cases, issue guidance on how often and by what method such investigations should be subjected to managerial review, and use the data to assess the quality of its promoter investigations. (Recommendation 5)

The Commissioner of Internal Revenue should have SB/SE develop a method to assess the quality of promoter investigations and apply this method to micro-captive promoter investigations. Based on these reviews, SB/SE should take corrective action to remedy any deficiencies uncovered in its analysis. (Recommendation 6)

The Commissioner of Internal Revenue should have LB&I establish and implement metrics on promoter investigation quality and subject a set of micro-captive promoter penalty investigations to formal quality review procedures to establish a baseline measure of micro-captive promoter investigation quality. Based on these reviews, LB&I should take corrective action to remedy any deficiencies uncovered in its analysis. (Recommendation 7)

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Agency Comments and Our Evaluation

We provided a draft of this report to IRS for review and comment. In its comments, which are reproduced in appendix IV, IRS disagreed with our recommendations. IRS also provided technical comments, which we incorporated as appropriate.

In its letter, IRS stated that micro-captive insurance audits are subject to further oversight beyond the managerial and formal quality reviews, and that this additional oversight helps ensure case quality and consistency.

IRS also said it has been effective in addressing abuses involving micro-captive insurance arrangements and that expending additional resources to address our recommendations is not warranted and would come at the expense of other organizational priorities.

We respect IRS's concern about allocating resources, and agree that IRS consider its resources and the possible effects on other programs when responding to our recommendations. However, we maintain that IRS's current procedures should be further refined to help it address this highpriority compliance issues, and we believe IRS can do so with minimal use of resources.

We summarize IRS's comments and our response for each recommendation below.

* Recommendation 1: After receiving our draft report, IRS stated in its letter that SB/SE area directors annually issue guidance on requirements for minimum review and documentation to their managers, and provided examples of such guidance. However, none of the information IRS provided fully addresses the specifics of our recommendation. First, the annual guidance examples do not consistently provide managers with expectations for reviews of priority work and types of cases to be reviewed. Second, while SB/SE states that the annual guidance documents are consistent with the IRM, the IRM does not provide direction or guidance as to how or when high-priority cases should be subject to managerial review. Finally, the IRM does not clearly state that all types of managerial review will be conducted according to the SB/SE area director's annual guidance. SB/SE could implement our recommendation by, for example, documenting in the IRM specifically what the area director's responsibilities are concerning guidance to managers on conducting reviews and stating whether there is priority work that requires additional managerial scrutiny.

* Recommendation 2: IRS stated in its letter that LB&I audit managers use a checklist to ensure quality and that subject matter experts and IRS Chief Counsel staff assist in ensuring the quality of individual audits on micro-captive cases. However, our recommendation concerns how LB&I assesses audit quality more broadly, not only during the conduct of each audit. The checklists IRS described in its letter (referred to as "check sheets" in this report) do not address the part of our recommendation calling for establishing a method to track or evaluate managerial reviews of high-priority audits. As stated in our report, LB&I does not have a means to record and compare written assessments of audits in an electronic system. Furthermore, there is no indication of how frequently or at what point in the audit managerial reviews occur specifically on micro-captive audits. LB&I did not provide any examples of staff using the checklist. IRS could implement this recommendation by, for example, electronically compiling a sample of LB&I managerial reviews and use that electronic data to analyze quality. This would help assure IRS that LB&I maintains quality in its reviews moving forward.

* Recommendation 3: IRS stated that program results indicate that current quality review processes are sufficient for micro-captive audits. However, our recommendation addresses quality assurance at a higher level than the conduct of the audit itself and would provide greater assurance of audit quality on micro-captive audits moving forward. Furthermore, as we indicated in our report, only a small portion of micro-captive audits have been subjected to formal quality review. For example, in fiscal year 2019, none of the micro-captive insurance cases that LB&I closed were reviewed through LQMS. IRS already has the ability to identify micro-captive audits electronically. It could fulfill this recommendation by, for example, reviewing a statistically valid sample of micro-captive cases every 2 or 3 years as long as the issue remains a high priority for IRS.

* Recommendation 4: IRS stated that SB/SE officials can use project codes in EQRS to identify, track, and compare managerial reviews of micro-captive cases. However, as noted in our report, officials relied on a manual process to distinguish micro-captive investigations from micro-captive audits. This makes comparison across audits and investigations labor intensive. IRS could address this recommendation first by showing whether the cost of implementing a new code exceeds the cost of manually sorting cases. If the cost of implementing the code exceeds the manual process, SB/SE could instead, for example, conduct its analysis only as long as micro-captive arrangements remains a high priority. In addition, in response to the IRS comments, we changed the wording of our recommendation from "assess the effectiveness of its promoter investigations" to "assess the quality of its promoter investigations," which more accurately reflects the intent of this recommendation.

* Recommendation 5: IRS stated that LB&I promoter investigations already are subject to 100 percent managerial review. However, as mentioned in our report, these reviews are not all documented in a way that LB&I could compile and analyze. The IRM requires that managers evaluate and recommend changes to their penalty program, which includes micro-captive promoter investigations. However, LB&I lacks an electronic method to identify, document, and analyze managerial reviews of such investigations for trends, anomalies, or potential deficiencies.

IRS could address this recommendation by, for example, electronically compiling a narrow sample of reviews, issuing guidance that corresponds with the sample scope, and analyzing the sample. Such analysis could be conducted semi-annually for only as long as micro-captive insurance arrangements remain a high priority. IRS also noted that we did not review investigations as part of our review, but this observation is not relevant to our recommendation to help assess the procedures for ensuring the quality of high-priority investigations. Instead, our recommendation addresses oversight procedures that did not require a review of the investigation case files. In addition, in response to the IRS comments, we changed the wording of our recommendation from "assess the effectiveness of its promoter investigations" to "assess the quality of its promoter investigations," which more accurately reflects the intent of this recommendation.

* Recommendation 6: IRS stated that SB/SE already has a method to assure investigation quality and that the success of these investigations shows that the quality assurance methods in place are sufficient. However, as described in our report, SB/SE managerial reviews are only made during the investigation process. IRS would be better assured of the overall quality of its micro-captive investigations more broadly with higher-level, independent reviews. IRS could implement this recommendation by, for example, leveraging existing quality reviews it already uses for audits and conducting the analysis semi-annually for only as long as micro-captive insurance arrangements remain a high priority. IRS again noted that we did not review investigations as part of our work. This observation is not relevant to this recommendation to help assess the procedures for ensuring the quality of high-priority investigations.

* Recommendation 7: IRS stated that LB&I promoter investigations are subject to managerial review and that developing metrics would not provide meaningful insight because each case is "so unique that setting metrics applicable to the entire population would not provide meaningful insight." We believe that if IRS can create quality standards for LB&I audits, it can do so for LB&I investigations and perhaps can look to its LQMS quality review procedures as a model for possible metrics in fulfilling this recommendation. IRS noted that we did not review investigations as part of our work. This observation is not relevant to this recommendation to help assess the procedures for ensuring the quality of high-priority investigations.

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The text of the GAO report is available at https://www.gao.gov/products/gao-22-104180

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