If you are running a business or engaging in transactions that the IRS doesn’t like – even if they are legal – then the IRS may take steps to investigate you or the business. And the IRS has included various types of captive insurance arrangements on its annual “Dirty Dozen” list of potentially abusive transactions since, at least, 2015.
One of the first things the IRS may do is issue Information Document Requests (“IDR”) for various documents and business records regarding the captive insurance arrangement; such as tax returns and corporate governance documents. The IRS may then issue a summons to the business or its principals, seeking books and records related to tax liability, documents related to corporate officers and directors, documents related to the risks covered by commercial insurance versus captive insurance, documents related to any uncovered risks, copies of all insurance policies and riders, and generally all documents related to the captive insurance arrangements. If the taxpayer or other target of the IRS summons refuses to produce documents – or the IRS believes the production was incomplete – it can enforce the summons in federal court. But there are some defenses. Maybe the IRS agent is acting in bad faith? But this requires the business to point to specific facts or circumstances raising an inference of bad faith.
The courts set the burden on the IRS low. Under U.S. v. Clarke, 573 U.S. 248, 254 (2014), the IRS can meet its burden with a simple affidavit from its agent that it doesn’t think it received enough information. And Courts are loathe to referee what they perceive as a pre-litigation or third-party discovery dispute. But some taxpayers think the IRS issues overly broad, burdensome, and oppressive discovery in order to create settlement leverage. Or to “extract revenge” when a captive insurer does not accept a settlement offer. Those are roughly the facts of a recent captive insurance tax dispute case. Michele Almeleh v. U.S., 2022 WL 7033677 (D. Ariz, October 12, 2022).
Ms. Almeleh is the treasurer of Arc Tech and a related company, C&M Insurance Partners Protected Cell (presumably, a protected cell captive insurer). The IRS is investigating Arc Tec and C&M, and even though Almeleh served over 3,000 pages of documents, the IRS sought additional information. The key takeaway from the opinion is that the Court did not believe Almeleh developed her bad faith challenge to the summons. “Naked allegations of improper purpose are not enough: the taxpayer must offer some credible evidence supporting [bad faith]. But circumstantial evidence can suffice to meet that burden; after all, direct evidence of another person’s bad faith, at this threshold stage, will rarely if ever be available.” Id. at *6.
Almeleh’s argument was that Arc Tec was offered a settlement agreement of its tax liabilities by the IRS, but it was rejected. She testified that “I am being targeted, pressured and harassed for not signing . . . the settlement agreement.” Id. And the Court summarized that: “Almeleh's theory is that the IRS is angry that Arc Tec didn't accept the settlement offer, and thus has decided to burden Arc Tec with overbroad document requests in an attempt to force a settlement or extract revenge, but that theory is poorly articulated and not compelling.” Id. This theory was not enough.
The Court went on to say that, rather than conclusory opinions, the target of a summons needs to articulate “a showing of facts that give rise to a plausible inference of improper motive.” Id. Once a taxpayer or target makes a sufficient showing of bad faith, the taxpayer is entitled to a limited evidentiary hearing on the issue of bad faith or improper purpose. Id. at *7.