These are difficult times for practitioners of creative tax strategies. During the past two years, Congress and the Internal Revenue Service have cracked the whip on accounting firms for abusive tax shelters. Earlier this year, the IRS issued a ruling that curbs the opinion letters lawyers use to bless a tax plan's legitimacy. It's all added up to an atmosphere in which many clients are too nervous to attempt even the most mildly inventive tax strategies.

What to do? The answer, according to some lawyers, brokers, insurance carriers and maybe even the IRS itself, is to buy tax insurance. A fairly new type of coverage provides taxpayers with seven years' worth of protection for strategies that involve large potential tax savings. It also carries an added dividend: the commendation of a generally conservative underwriter willing to put its money behind the legitimacy of a tax move. And the cost is just 5 percent to 12 percent of the client's potential liability in taxes and/or penalities.

“It's a way for an inherently conservative person to insure an aggressive position,” says Carlyn McCaffrey, a New York-based partner and co-head of the trusts and estates department in the law firm of Weil, Gotshal & Manges LLP.

Few brokers offer tax insurance to individuals. Risk Capital Management, a three-year old New York City newcomer, is probably the only firm to focus solely in this area. Marsh Inc., the world's largest insurance brokerage, also based in New York, has been offering individual tax insurance policies for six years, but has sold under 10 policies in the past six years, according to a company spokesperson.


The IRS crackdown started with investigations of highly unorthodox tax shelters that had been heavily marketed in the late 1990s by a number of the Big Four accounting firms, as well as some smaller firms. “They were being sold like commodities,” says Jay Gordon, chair of the tax department at the New York office of Greenberg Traurig, LLP. In 2003, after a Congressional hearing, Ernst & Young and PriceWaterhouseCoopers both settled with the government; another firm, KPMG, is still being investigated.

At the same time, there was an epidemic of opinion letters written by lawyers who were earning commissions on aggressive transactions or getting paid exorbitant fees, as much as $1 million, to produce the opinions. On Dec. 30 of last year, the IRS came out with a ruling meant to “quash the lucrative trade in opinion letters,” in the words of Commissioner Mark Everson. A lawyer's opinion letter used to automatically mitigate the penalties a taxpayer had to pay if the strategy was later found flawed by the IRS. The ruling suddenly made it impractical for advisors with a financial interest in a particular tax strategy to write a letter in support of a client pursuing that strategy. And it forbade what Gordon called “cookie cutter” opinions, mandating that letters analyze each client's situation to see whether the strategy is appropriate. What's more, if the IRS found an opinion letter unacceptable because an advisor was making money from the transaction, the taxpayer would not be able to escape paying penalties on taxes owed.

That's where tax insurance comes in. It's been around since the late 1990s, but those recent IRS and Congressional actions may make it particularly appealing now. “It will be more expensive and difficult to get opinion letters and that makes tax insurance all the more appropriate,” says David De Berry, a vice president at The Hartford Financial Services Group, which underwrites tax insurance for both corporations and individuals. What's more, as the IRS has grown increasingly aggressive in its tactics, taxpayers are becoming ever more wary of trying anything unusual, according to tax lawyers. “They're scaring people from doing what I would call plain vanilla tax planning,“ says Gordon. In this uncertain environment, tax insurance looks to be just what the doctor ordered.

At the same time, experts agree that the standards for obtaining tax insurance coverage are considerably more stringent than for opinion letters. “If the tax law is unclear, you're not going to get covered,” says Jared Kaplan, a partner in the law firm of McDermott, Will & Emery. In fact, the abusive tax shelters under investigation, Kaplan and other lawyers point out, would never have received coverage from insurers, anyway. Tax insurance brokers also say they won't touch anything the IRS deems a reportable transaction.

But it's just that higher level of security that makes tax insurance a likely purchase for many people. ”It's like a house,” says Lou Steinberg, a tax partner in the New York office of Cravath, Swaine & Moore LLP. “You can make it as fireproof as possible. But if you're concerned about what might happen, you still buy fire insurance.” That's particularly important for estate-planning purposes, where a wrong move can have disastrous results and multi-million dollar tax consequences down the line. “If an entire strategy is based on a particular tax advantage and three years later, it blows up, then your estate plan will completely unwind,” says Jonathan Legge, managing director of Marsh.

What kind of strategies are covered? Consider these examples: A client interested in retirement planning recently entered into a transaction in which a significant amount of income was placed in a non-qualified deferred compensation plan. The question remained: Did that money, with a tax liability of about $15 million, have to be included in the person's taxable income? To protect against the risk that the IRS might not allow that exclusion, the person bought a policy through Risk Capital Management. In another case, an individual created a personal investment corporation for conducting trades with interest rates and foreign currencies. He got coverage for the risk associated with deducting losses realized after becoming the sole shareholder of the company. Total tax liability: about $35 million.

How do the insurers determine what's kosher and what's not? Consider how Risk Capital does it. Three staff underwriters (all tax attorneys with experience working for carriers — one also an accountant) research the legal background of each case to determine what the likely IRS position would be. If they conclude there's a legitimate case, they draft a policy. At the same time, researchers will approach lawyers at one of five firms on retainer to see whether they can green light the policy. (Those firms are Cravath; Weil Gotshal; Latham & Watkins LLP; McDermott; and Skadden, Arps, Slate Meagher & Flom LLP.)

The process takes about four to six weeks. After all that, Risk Capital, for example, approaches an insurance carrier to see whether it is willing to back the policy. The carrier then goes through its own process to research the soundness of the strategy.

Coverage doesn't come cheap. Nemo Perera, a managing partner at Risk Capital, estimates you need at least a $2 million potential tax liability to make it worth the investment. The one-time premium, which covers the seven-year time limit in which the IRS can challenge a strategy, runs anywhere from 5 percent to 12 percent, depending on the level of risk and covers anything from the actual tax owed to fines, legal costs and penalties.

Even if a tax strategy passes muster with both the broker and insurance carrier, that doesn't mean a policy will be written. According to Marsh's Legge, in the past two to three years, the number of times clients and carriers have not been able to agree on a level of risk — or an appropriate price — has climbed. Indeed, according to De Berry, Hartford recently approved four coverage strategies, he says, “involving the value in a bargain sale and net gift transactions.” But they never underwrote the policies, because they weren't able to come to final terms with the clients.

What's more, it's possible to come close to having a strategy covered, only to have a broker or underwriter back out. Perera, for example, points to a strategy that involved a split dollar tax savings strategy. While the company initially decided to pursue coverage of the arrangement, more recently it reevaluated that decision after finding that the IRS had changed its position on split dollar plans. “We're constantly monitoring the IRS airwaves to get a sense of what direction they are taking,” says Perera.

Has anyone collected? With a three-year audit cycle, brokers say it's too soon to tell, as most of the policies are no more than five years old and many are considerably newer. Perera has three cases pending with the IRS, but the clients are still in negotiations. He's covered a total of about 25 individual tax transactions so far.

The really good news about tax insurance is that it has received a vote of confidence from the IRS itself. Two years ago, a Treasury committee found that tax insurance should be included in a list of reportable transactions. That's because regulators initially perceived them to be vehicles for supporting abusive tax shelters. But later testimony convinced regulators that, in reality, the opposite was true. “Tax insurance fosters a culture of compliance,” says De Berry, who presented the testimony that swayed committee members. “We are putting our capital behind the correctness of a tax position and, as a result, we have to approach it conservatively.” Final regulations that came out in April 2003 reversed the first decision. The bottom line: Tax insurance may be pricey, but its conservative nature might be right for the times.

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