Insurance for Tax Shelters Targeted

California lawmakers, concerned about rampant use of questionable tax shelters, are infuriated that some insurance companies are offering to back these arrangements and pay any fines or penalties for taxpayers caught using plans that turn out to be illegal.

Some lawmakers want to ban the insurance policies, which they say serve little purpose other than to help millionaires cheat the tax system.

“I think this is outrageous,” said Assemblyman Dario Frommer (D-Los Angeles), who on Friday introduced a bill, AB 1297, to outlaw the policies. “The message I am hearing is, ‘Don’t worry about it. If you use a tax shelter that is illegal and you are caught, you won’t pay a dime.’ ”

“These insurance companies are probably betting that some of these people will never get caught,” Frommer said.

Industry officials, however, say the legislative effort is misguided. An executive from one company accused of selling such coverage said that while his firm does insure corporate tax returns, his firm would not put its money behind illegal strategies.

At issue are complicated transactions that corporations and affluent individuals use to cut their tax bills. They often involve taking advantage of provisions in the state and federal tax laws to make it appear that they have less income than they really do.

Experts say shelters can involve a wide variety of legal and illegal techniques that are often difficult to detect. Tax officials say they typically involve many kinds of investments intended to reduce tax liability. But under investigation are such techniques as moving money offshore and creating the false appearance of large donations to charity that can be reported as a tax deduction.

California, short of tax revenue, has been aggressively cracking down and looking for ways to recoup the estimated $1 billion a year lost as a result of the shelters. The state stepped up its effort in April with an investigation by the California Franchise Tax Board into companies it believes have insured taxpayers using abusive shelters.

The board has issued subpoenas to two insurance companies suspected of providing the policies, AIG and Hartford Financial Services Group, in the hope of locating tax evaders.

The latest bill stands a relatively good chance of approval, as many lawmakers who initially seemed unenthusiastic about the state’s getting tough on the shelters are now bragging about the success of the effort.

But there are plenty of critics of the state’s enforcement efforts.

Chris Micheli, a lobbyist for business groups, said the proposal is too heavy-handed and will make it harder for businesses to get insurance to cover legitimate needs.

“The Legislature ought to be cautioned about its overzealousness,” he said.

Insurance companies and some tax lawyers say the lawmakers have it all wrong -- that the companies would never provide back-up for risky schemes that carry huge penalties.

But critics of tax insurance -- which can cost hundreds of thousands of thousands dollars upfront -- charge there are documented cases where accounting firms offer it to rich taxpayers to lure them into buying shelters that flout tax laws.

Their evidence includes documents from KPMG, one of the country’s major accounting firms. In a list of selling points obtained by a U.S. Senate committee, the firm encouraged its sales staff to use the insurance policies to nudge reluctant clients into signing up for a questionable shelter. The IRS is now investigating the shelter’s legality.

The tax plan that KPMG was trying to sell used a series of complicated transactions to give taxpayers the appearance of having donated millions to a charity. The taxpayer would take the tax deduction, and get the money back later.

The list of selling points instructed staff as their “absolutely last resort” to tell wary potential buyers that “at least 3 insurance companies have stated they will insure the tax benefits of the transaction.”

KPMG staffers identified AIG and Hartford as two of those companies, according to the Senate report.

Spokespeople for AIG and KPMG declined to comment and officials with Hartford did not return phone calls.

But in an article published last month in the industry magazine Trusts & Estates, David Deberry, a vice president with Hartford, said the company will only insure tax returns it is confident are legal.

Others say a lot of tax law is a legally gray area, and making these insurance policies illegal would discourage businesses from even engaging in conservative planning strategies.

Carlyn McCaffrey, an attorney in New York who represents a broker of tax insurance policies, says there are many instances in which it takes months for the courts to determine whether a tax shelter is legal or not. And sometimes the courts rule they are illegal after teams of attorneys had advised clients that they were legal.

In such cases, she says, the client and the insurance company were not intentionally violating the law. “It doesn’t seem fair to me to put a penalty on someone who does something before it has been determined to be abusive,” she said.

Chicago tax attorney Jared Kaplan said there has been lots of talk among tax attorneys about whether the type of insurance Frommer wants banned “actually exists in the real world, or is just urban legend.”

“It doesn’t sound to me like anything the insurance companies would be willing to insure,” he said. “But if it does exist, it is probably a bad product.”

Kaplan and other attorneys are eagerly awaiting the results of California’s Franchise Tax Board investigation. Officials involved say that investigation will shed light on how the insurance policies work.

“We’re trying to get a sense of what sort of communication was going back and forth,” said state Controller Steve Westly. “Selling insurance policies to people who may be cheating on their taxes is just wrong.”

The move to crackdown on the insurance companies comes as the state ratchets up its penalties for using illegal tax shelters. A new law makes the use of the shelters significantly more risky for taxpayers.

Hundreds of taxpayers who used abusive shelters in the past recently took advantage of an amnesty program that offered them a chance to settle up without penalties before the new, stricter fines took effect earlier in the spring.

State officials anticipated the government would net about $90 million from the program.

Instead, $1.3 billion came in, suggesting to lawmakers like Frommer and Sen. Gil Cedillo (D-Los Angeles) a co-sponsor of the insurance legislation, that use of the abusive shelters is far more widespread than they had anticipated.

“In California we just enacted the toughest penalties in the country,” said Frommer. “These insurance policies seem to be an attempt to go around the new law and continue with business as usual.”