Tax Insurance May Serve as a Salve to Fears of IRS Enforcement

As the IRS prepares to receive a significant boost in funding and staff, tax insurance may be a solution to help high-income taxpayers and major corporations gain some certainty around their tax positions.

Tax insurance is exactly what it sounds like—a solution to tax complexity that transfers the risk of successful tax authority challenges to an insurer. Introduced in the 1980s, its usage has grown in recent years, particularly in mergers and acquisitions as a precautionary measure against possible legal headaches, clawbacks of anticipated tax benefits, and future cash outlays. It protects policyholders enmeshed with complex tax planning who, although adopting seemingly reasonable positions, nonetheless may be unexpectedly tripped up by the intricacies of navigating the US tax code. For many, an IRS dispute over a tax return position could mean assessments of millions to hundreds of millions of dollars. Fortunately, the right tax insurance policy can preempt such a possibility.

Tax insurance also addresses a spectrum of theoretical tax exposures. It can protect buyers from unanticipated pre-closing tax liabilities on positions inherited from sellers in an M&A transaction and has proven popular among renewable energy investments involving tax credits. As a financial planning tool, it can provide a backstop should an investment or tax position fail to qualify under different IRS interpretations by covering assessed amounts (tax, interest, etc.) and defense costs to make the policyholder economically whole.

For these reasons, tax insurance has become a preferred financial planning tool for an increasing number of prominent companies, high-net-worth individuals, and small business owners fearful of prolonged and costly litigation with tax authorities. With many anticipating that the IRS’ newly acquired $80 billion will prompt a rise of legal challenges, tax insurance could offer some additional assurance for tax positions.

IRS Funding Boost

The IRS plans to use the $80 billion from the Inflation Reduction Act to finance additional hires, extensive training, and augmented tax law enforcement, setting aside a subset for litigation. This influx is an overdue correction for the agency, which has endured steep budget cuts over the last decade. As detailed in Bloomberg, a report by the Government Accountability Office found that audit rates have dropped across all income levels over the past 10 years, with the sharpest fall occurring in the income bracket of $200,000 or more.

In a letter to the Senate, IRS Commissioner Charles Rettig emphasized that the IRS’s allocation of enforcement resources “will not rise relative to recent years for households making under $400,000.” Although his remarks may comfort most taxpayers, they’re bound to raise eyebrows for many that have grown accustomed to a historically lax litigation landscape. The number of civil tax lawsuits brought to federal court in July 2021 was half the number that had been filed in 2011, and many of the country’s largest corporate entities were simply not audited at all in recent years.

The forthcoming boost in funds likely will mitigate this downward trend. The IRS signaled its intentions of ramping up enforcement efforts even before the law was formally enacted, with the number of audits on wealthy taxpayers increasing as of late. The percentage of audits doubled on taxpayers with incomes between $500,000 and $10 million for 2019 filings between September 2021 and May 2022.

The effects of the IRS’ additional resources won’t be felt immediately, as it will take time to train fresh hires as well as implement new and improved tools. However, over the next five to seven years, the agency will be better positioned to litigate and closely scrutinize high earners and prominent corporate entities, including any party undertaking more complex tax planning. This enhanced scrutiny could result in rising numbers of small businesses challenged in court by the IRS, the majority of which will opt to settle rather than prolong the litigation and accumulate legal fees.

Risk Mitigation

Volatility and uncertainty are pervasive elements in the market, making complex tax planning a daunting prospect with severe consequences if done incorrectly. As the IRS becomes better situated to dig into the details, even the most sophisticated tax opinions from prestigious law and accounting firms may not provide risk-averse taxpayers with the same scale of comfort as they once did.

While private letter rulings obtained pre-filing are a well-established route for avoiding IRS assessments, tax insurance’s streamlined nature makes it a quicker and more practical alternative. Though the IRS has tried to address the lengthy process of attaining a private letter ruling through “fast-track” programs, rulings continue to be available for only specific and narrow issues. Because underwriting a policy can take as little as two to three weeks, obtaining tax insurance could be a more efficient and cost-effective substitute for pursuing a private letter ruling.

Although tax insurance may be a novel solution for most, the flexibility and protection it offers could make it commonplace for substantive business and tax planning endeavors. Policies can be used in a wide array of circumstances and scenarios—safeguarding value in mergers and acquisitions, streamlining potential family disputes in estate settlements, or protecting the tax-free nature of a business separation—allowing policyholders to ringfence hypothetical challenges from deal negotiations and normal business operations. Potentially insurable tax positions range from corporate restructurings (taxable or tax-free) to more complex areas like international taxes, basis studies, net operating losses, and transfer pricing. From an optics perspective, possessing tax insurance also serves to secure confidence from lenders, creditors, and investors.

Projecting competence and caution could prove crucial in the coming environment. Should the IRS become more litigious, this could dampen high-net-worth taxpayers’, corporations’, and family offices’ appetite for risk as they navigate tax planning. Down the line, this could carry serious repercussions for companies’ projections and stifle growth potential. The cost-benefit analysis of engaging in litigation versus purchasing tax insurance is straightforward—the insured stands to pay only pennies on the dollar depending on the level of exposure, transferring risks to insurance companies and being empowered to conduct business without fear of litigation, disruptions to one’s balance sheet, or challenges to liquidity.

While private letter rulings and input from trusted lawyers and accountants traditionally have been viewed as the best avenues for navigating the tax code, tax insurance policies afford the high degree of protection and reliability. For more and more individuals, corporations, and business owners with complex tax positions, it’s worth considering that tax positions ought to be treated like any other valuable and potentially vulnerable aspect of one’s business—insured and well-protected.

This article does not necessarily reflect the opinion of The Bureau of National Affairs, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.

Author Information

Jessica Harger is managing director of Aon’s M&A and Transaction Solutions. She focuses on tax insurance for private equity and corporate clients, while providing risk management solutions for tax risks arising from acquisitions, historic tax positions, and future tax planning.

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