In what situations should a business owner purchase tax insurance?
Tax insurance is usually used in two types of scenarios. The first is during transactions, when buying and selling companies. A wide range of tax risks may be faced by such parties, including, for example, tax-free transactions, partnership issues, golden parachute excise tax issues, capital versus ordinary treatment, tax credits (low income, historic, solar and wind) and so on. Generally, if a tax expert can form a view on the tax treatment of a situation, a tax insurer should be able to consider it.
If it meets the insurer’s underwriting standards, which generally seek to determine whether there is a sound business purpose and the tax analysis is based on sound reasoning, a policy then would be offered. However, it is important to note that tax shelters and reportable or listed transactions cannot be insured.
The other situation deals with FIN 48 accounting rules. These income tax rules came into effect over the last couple of years, first for public companies and now for private companies, as well reporting under U.S. GAAP standards. These rules set stricter and more transparent methodologies for companies to report income tax obligations in their financial statements.
There’s a great deal of difficulty and uncertainty in applying these rules, as the tax rules are subjective and require a great deal of judgment by the experts. Companies are required to test every material tax position to determine how strong it is, both under the tax law and how it’s measured.
The company has to put up a reserve and make specific disclosures if there is not greater than a 50 percent confidence level. There’s a role for FIN 48 insurance to help mitigate some of the downside if those determinations are ultimately challenged and proven wrong.
How can business owners determine if their situation requires tax insurance?
There are two sides to determining if tax insurance is right for the situation. The first is in the context of a transaction or financing where a third party is looking for comfort. That should be an indicator that insurance can be used to ease the financial pain of providing that comfort through traditional escrows and indemnities. Tax insurance also can be an effective tool for a buyer to make a better offer to a seller for an asset because by using insurance, the seller can be relieved of having to provide an indemnity.
FIN 48 insurance also can be helpful if you’re a business with a sizeable tax situation that has been recognized (not reported) for FIN 48 purposes. These policies can help manage that risk such that if they should go wrong, it will not be a catastrophic situation to you or your financial statements.
What risks do business owners face if they choose not to purchase tax insurance?
Insurance provides a financial backstop for an unexpected tax liability. Business owners certainly can and should seek advice from their tax advisers. However, professional opinions typically have caveats and exceptions and are not intended to provide indemnity if the intended treatment is not ultimately upheld.
The insurance operates in a similar fashion to how a private letter ruling would work. The taxpayer provides the factual predicate to the insurer through reps, warranties or documents. The insurer then provides comfort through the insurance policy that the intended treatment will be respected, and that it will pay the tax, interest and penalties if it is not.
Gary P. Blitz is managing director with Aon Financial Solutions. Reach him at (212) 441-1106, (202) 429-8503 or [email protected].
