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The IRS has released their 2022 “Dirty Dozen” list of allegedly abusive tax transactions by way of IR-2022-113, June 1, 2022. Among the other transactions on this list is the so-called “Puerto Rico Captive Deal”, which I first warned about four years ago in my article, Beware The Puerto Rico Captive Insurance Tax Shelter (1/27/2018). The IRS itself first warned about these deals in IR-2020-226 (10/10/2020), as follows: “Also, as part of IRS’s continued focus in this area, the IRS has become aware of variations of the abusive micro-captive insurance transactions. Examples of these variations include certain Puerto Rico and offshore captive insurance arrangements that do not involve section 831(b) elections.”

Nonetheless, even after these warnings, certain promoters have continued to hawk the Puerto Rico Captive Deal with the usual representations that their deal has been fully vetted by top-notch tax lawyers, the IRS is overreaching, etc., and in fact not much seemed to happen with these deals as the IRS was throwing its limited manpower against the more straightforward microcaptive transactions and of course the COVID pandemic slowed down enforcement action.

Now, with COVID mostly out of the way and the IRS having worked its way through the bulk of the microcaptive transactions, the Service appears to be ready to start taking down the Puerto Rico Captive Deal as well. This is how the IRS describes the transaction in its Dirty Dozen list:

Puerto Rican and Other Foreign Captive Insurance. In these transactions, U.S owners of closely held entities participate in a purported insurance arrangement with a Puerto Rican or other foreign corporation with cell arrangements or segregated asset plans in which the U.S. owner has a financial interest. The U.S. based individual or entity claims deductions for the cost of ‘insurance coverage’ provided by a fronting carrier, which reinsures the ‘coverage’ with the foreign corporation. The characteristics of the purported insurance arrangements typically will include one or more of the following: implausible risks covered, non-arm’s-length pricing, and lack of business purpose for entering into the arrangement.”

There are of course many variants to the Puerto Rico Captive Deal, but probably the most typical way this deal is structured is as follows. The promoter first arranges for a non-captive property/casualty (“p/c”) insurance company with a Class “A” license allowing it to sell p/c insurance to anybody. This company will act as the “fronting company” from which the taxpayer’s operating business will purchase insurance. This fronting company takes on no real insurance risk, or at best a very thin sliver of risk, and is basically just renting out its license to the promoter. The taxpayer’s operating business makes a premium payment for insurance coverage to the fronting company, and takes a business deduction for that insurance.

The next step is for the promoter to set up a captive insurance company owned by the taxpayer. This captive insurance company will enter into a reinsurance deal with the fronting company such that the fronting company passes (“cedes”) all or most of its risk to the taxpayer’s captive, thus removing from the fronting captive any significant risk of loss, and in exchange for which the fronting company pays nearly all the premium that it received from the taxpayer’s operating business to the taxpayer’s captive.

It is important to note that such fronting relationships are not per se wrong, immoral, illegal, or even fattening, but instead they occur quite a bit in the legitimate insurance world, and particularly in the captive insurance world. This usually occurs because a captive insurance company has a limited insurance license that restricts the captive to only underwriting the risks of companies affiliated with the captive owner, or selling reinsurance to a fully-licensed carrier. Thus, if a business owner wishes to use a captive to cover workers compensation liability the captive cannot do so directly because the employees are third-parties not affiliated (at least in the captive sense) with the owner of the captive. Thus, the captive cannot offer workers compensation insurance directly. However, the captive cut a deal with a fronting carrier which has a license permitting it to offer workers compensation insurance, so that the fronting carrier issues the certificates of insurance on the front end, but the captive retains all or most of the risks through a reinsurance treaty. However, even in these situations, for the premiums to be deductible by the operating business, the captive still must satisfy risk distribution requirements for tax law purposes.

Thus, the fronting relationship itself is not the problem with the Puerto Rico Captive Deal. The problem is that, just as with microcaptives, there is no risk distribution going on since the fronting company acts as no more than a passthrough of the liability and premiums of the taxpayer’s operating business. The promoters try to claim that the fronting company provides the risk distribution, although this is demonstrably false. This by itself makes the deal an abusive tax transaction.

But even worse, the promoters then try to use arbitrage the difference in Puerto Rico tax rates and ordinary U.S. tax rates to supercharge the tax benefits to the taxpayer. This would be fine if the taxpayer actually lived in Puerto Rico, but of course they usually do not. In that regard, the Puerto Rico Captive Deal is very similar to the U.S. Virgin Islands Economic Development Program (“USVI-EDP”) shelters that went around shortly after the turn of the century. So what you’re really talking about here is a shelter built upon a shelter.


If all this isn’t abusive enough, some of the Puerto Rico Captive Deals then cross the line from the merely abusive (or “avoision” as it is sometimes jokingly called) to flat-out tax evasion. This is where the promoters try to use offshore captives to bury the taxpayer’s money in a tax haven so that it is never taxed, or have the captive owned by an offshore private-placement life insurance product so that the taxpayer can then borrow the never-taxed moneys back tax-free. This variant is pretty much the same as another USVI tax shelter, which involved a company called Caduceus Life Insurance and is described in the opinion in U.S. v. Rozin where one of the taxpayers was convicted, and the promoters were indicted for tax fraud (after being convicted, the brainchild of this scheme, Peter J. Peggs, and his wife later committed suicide shortly before he was to report to prison). An almost identical scheme played out a few years later as I wrote about in my articles, Foster and Dunhill Scheme Ends In Denial Of Deductions And Indictments For Bogus Insurance Tax Shelter (6/23/2013) and Foster & Dunhill Saga Ends With Convictions And Donaldson Claiming To Be Too Fat To Jail (10/19/2017). Notably, both the Caduceus Life and Foster & Dunhill deals had thick opinion letters from tax law firms stating that those transactions were 100% kosher, but in the end those opinion letters proved not to be worth the paper they were written on.

In these instances, the Puerto Rico Captive Deal is a shelter built upon a shelter built upon a shelter built upon a shelter, or shelter3 if you prefer. The most abusive Puerto Rico Captive Deals may have crossed the line into Caduceus Life and Foster & Dunhill territory, but even the basic Puerto Rico Captive Deals which purport to rely upon more favorable Puerto Rico tax rates — when the taxpayer doesn’t actually reside in Puerto Rico — are abusive enough for the worst of penalties to apply to taxpayers who get caught in those deals.

This is not to say that all captive insurance companies that are domiciled in Puerto Rico are all tax shelters. There may indeed be legitimate Puerto Rico captives there which are basically tax-neutral (or at least no worse than traditional microcaptives) which provide workers compensation and other mundane insurance. But there are certainly some promoters in Puerto Rico who are pitching deals that range from the merely abusive to outright evasion, and the IRS has indicated that it is aware of at least some of these promoters and what they are doing.

Suffice it to say that folks who are involved in a captive insurance arrangement in Puerto Rico had been have their transactions reviewed by a truly independent tax lawyer who is familiar with captive insurance taxation, with truly independent meaning somebody that the taxpayer finds on their own and who isn’t recommended to them by promoters (promoters almost always have shill tax attorneys lined up with whom they have a solid relationship and will of course always advise the promoter’s clients that “all is well” even if it isn’t.

As I have previously written many times, and the IRS has similarly advised on many occasions, getting a truly independent opinion from a tax shelter is the singularly best way for a taxpayer to avoid getting caught of in one of these deals and the severe financial pain that can come with them. But, as I have personally seen on many occasions, some taxpayers really don’t want to know that a transaction is sketchy, focused as they are on saving a few bucks. And of course, these are the very same taxpayers who later are indignant about being caught in a tax shelter that they claim, only after the fact, that they would never have gotten into had they just known. The real truth is that there were red flags all around, but the taxpayers and their advisors willingly turned Nelson’s blind eye to them out of their desire to shave some dollars from their tax bills.

Same with the Puerto Rico Captive Deal, the warnings are out there and taxpayers have a chance to know that these deals are rotten to the core. Whether they take heed is a completely different matter of course.


IR-2022-113, June 1, 2022. https://www.irs.gov/newsroom/irs-warns-taxpayers-of-dirty-dozen-tax-scams-for-2022


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