GAO Issues Report on Tax Schemes

WASHINGTON, Sept. 3 -- The Government Accountability Office has issued a report (GAO-20-589) entitled "Abusive Tax Schemes: Offshore Insurance Products and Associated Compliance Risks".

The report was sent to Sen. Charles Grassley, R-Iowa, chairman of the Senate Finance Committee, on Aug. 31, 2020. Here are excerpts of summaries associated with the report.

What GAO Found: "Federal law provides certain tax benefits for transactions involving genuine insurance products, including insurance products held offshore. While taxpayers may lawfully hold offshore insurance products, they contain features that make them vulnerable for use in abusive tax schemes. For example, offshore insurance products can be highly technical and individualized, making enforcement challenging, according to Internal Revenue Service (IRS) officials. Furthermore, insurance is not defined by federal statute, potentially making a determination of what constitutes genuine insurance for federal tax purposes unclear.

Offshore micro-captive insurance products, which are made by small insurance companies owned by the businesses they insure, may be abused if the corporate taxpayer improperly claims deductions for payments made to a micro-captive for federal tax purposes. Courts have applied certain considerations to determine whether these deductions can be claimed. For example, one consideration is whether the insurance legitimately distributes risk across participating entities. IRS officials said they expend significant resources reviewing these schemes because of the varied ways insurance companies may work.

Offshore variable life insurance products, which are insurance policies with investment components over which the insured has certain control, may be abused if the individual taxpayer fails to meet IRS reporting requirements or pay appropriate federal income taxes. Federal regulations require that taxpayers with certain foreign life insurance accounts report this information to IRS and the Financial Crimes Enforcement Network. The structure of life insurance products may vary and taxpayers are required to pay taxes based on the underlying type of financial product the policy represents.

The figure below shows how noncompliance may occur when taxpayers use life insurance and micro-captive insurance in abusive tax schemes."

Why GAO Did This Study: "When structured in abusive ways, insurance products held offshore can be designed to aid in unlawful tax evasion by U.S. taxpayers. Two products that IRS has recently warned have the potential for such abuse include micro-captive insurance and variable life insurance policies.

GAO was asked to review how taxpayers may abuse offshore insurance products. This report describes (1) how offshore insurance tax shelters provide opportunities for income tax abuse; (2) how offshore micro-captive insurance is used and how it is used in abusive tax schemes; and (3) how offshore variable life insurance is used and how it is used in abusive tax schemes.

GAO reviewed IRS tax and information return forms, relevant U.S. case law and IRS guidance, academic and trade publications, and applicable statutes and regulations. GAO also interviewed IRS officials and professionals in the tax preparation and insurance industries."

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July 30, 2020

To: The Honorable Charles E. Grassley, Chairman, Committee on Finance, United States Senate

Dear Chairman Grassley:

When structured in abusive ways, offshore insurance products can be designed to hide U.S taxpayers' assets or falsely claim federal income tax benefits./1 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./2

However, when taxpayers abuse these products, they threaten our tax system's integrity and fairness. This is in part because taxpayers may believe that individuals and businesses are not paying their fair share of taxes and instead are contributing 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. In 2019, the Internal Revenue Service (IRS) estimated the average annual gross tax gap for tax years 2011 through 2013 to be $441 billion. After taking into account its enforcement activities and late payments, IRS calculated that the average net tax gap was $381 billion per year.

While taxpayers can hold offshore insurance for a number of legitimate reasons, IRS has identified instances where taxpayers have used offshore insurance products to improperly reduce their tax liabilities.

These abusive offshore insurance tax schemes can involve sophisticated tax shelters, devised and marketed to taxpayers by accountants, estate planners, and attorneys. These shelters may also be constructed or recommended by professionals that 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.

You asked us to review how taxpayers may abuse offshore insurance products and what guidance IRS provides about complying with laws related to offshore insurance accounts. This report describes (1) how offshore insurance tax shelters provide opportunities for income tax abuse; (2) how offshore micro-captive insurance is used and how it is used in abusive tax schemes; and (3) how offshore life insurance is used and how it is used in abusive tax schemes.

To describe how offshore insurance tax shelters provide opportunities for income tax abuse, we reviewed academic and trade publications; reviewed IRS guidance on its website; summarized applicable statutes, regulations, and case law; and interviewed IRS officials and industry professionals, whom we identified from referrals from professional associations and our own literature searches. Specifically for IRS guidance, we confirmed with IRS officials what they considered to be key guidance on helping ensure compliance with offshore insurance products.

We summarized this information and categorized the guidance according to our previous work, which defined types of guidance and reviewed guidance IRS communicates publicly./3

Additionally, to describe micro-captive insurance and life insurance tax shelters and any non-tax benefits these shelters offer and to determine how they are used in abusive tax schemes, we reviewed relevant case law and industry websites and interviewed industry professionals and IRS officials.

We conducted this performance audit from October 2019 to July 2020 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/710/708520.pdf

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Agency Comments

We provided a draft of this report to IRS. IRS provided technical comments but did not provide a letter.

As agreed with your offices, unless you publicly announce the contents of this report earlier, we plan no further distribution until 30 days from the report date. At that time, we will send copies of this report to the appropriate congressional committees, the Secretary of the Department of the Treasury, the Commissioner of Internal Revenue, and other interested parties. In addition, the report is available at no charge on the GAO website at http://www.gao.gov.

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The text of the GAO report is available at https://www.gao.gov/products/GAO-20-589

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