Insurance Loophole Helps Rich
By David Cay Johnston

April 1, 2003

Fifty years ago Congress, trying to help farmers and others having a hard time getting insurance, allowed the creation of tiny, tax-exempt insurance companies. Now, some of those taking advantage of the program do not make their living off the soil.

One is Peter R. Kellogg, a billionaire Wall Street investor who has used the insurance exemption to escape more than $100 million in taxes on investments in four years. Eighty-five hospitals in New York State have avoided $27.5 million in taxes over five years. Alfa Mutual Fire Insurance in Montgomery, Ala., saved $58 million on federal corporate income taxes over three years.

They are doing it with the blessing of, and sometimes even at the suggestion of, accounting firms, which are paid for advice on how to use the exemption and then collect fees for preparing reports to the Internal Revenue Service. Some tax shelter promoters are also showing companies and wealthy individuals how they can make taxes vanish through a tax-exempt insurance company.

The technique is legal, taking advantage of a loophole: Congress exempted insurance companies from taxes if they collected less than $350,000 in premiums. But Congress did not limit how much in assets these insurance companies could own and invest free of taxes. So the companies simply collect a small amount in premiums for a small amount of insurance. But they set aside as reserves far more money than would ever be needed to pay claims, and invest that money tax-free.

Two experts on insurance and taxes who have studied this exemption say many of these insurance companies, especially the larger ones, amount to nothing more than a tax dodge that should be shut down.

"These are perfectly legal under the letter of the law," said J. J. MacNab, an insurance industry analyst who tracks tax dodges. She said the I.R.S. could deny the tax benefits because these companies are not principally in the business of insurance. "But the I.R.S. is not willing to fight it," she said. "Legislation is needed to stop this."

For years the I.R.S. never even audited these companies, and even today it is examining only a handful just to learn how they can be abused, said Rosie Johnson, the agency's director of audits for tax-exempt organizations.

Indeed, promoters of these tax techniques, knowing that no one even reads the annual reports that such companies must file with the I.R.S. to retain their tax-exempt status, have been selling them as a way to escape taxes with almost no risk of detection.

The law, enacted in 1954 and revised in 1986, says that insurance companies that collect less than $350,000 a year in premiums can operate exempt from taxes so long as their primary business is property and casualty insurance or any other line except life insurance.

The original law refers to "mutual" insurers companies owned by policyholders. But in 1986 Congress changed the rules to allow a single owner, like Mr. Kellogg, to earn profits tax-free provided that the principal business is insurance.

For years the I.R.S. approved only a few of these insurers, but in the last few years it has approved as many as a dozen in a single week. And the sums shielded from taxes have soared.

As of 1999, the most recent year for which the I.R.S. made numbers available, at least nine of these tax-exempt insurance companies had more than $50 million of revenues and more than $50 million of assets that they could invest tax-free. Several dozen more had that much in either revenue or assets.

Yet many of these companies technically qualify for the tax exemption because they collect less than $350,000 in insurance premiums. Indeed, some do not collect enough in premiums to pay the salary of one clerk, much less a staff of insurance professionals.

One of Mr. Kellogg's tax-exempt companies, IAT Reinsurance, collected $33,173 in premiums from 1996 through 1999 while making investment profits of $315.1 million. Being tax exempt saved the firm $110.3 million on corporate income taxes.

SLK Reinsurance, Mr. Kellogg's other tax-exempt insurer, collected $1,332 of premiums in 1999 while holding $37.8 million in assets, and saved $1.2 million in taxes.

The I.R.S. supplied dozens of reports by tax-exempt insurers at the request of The New York Times but could not find others in its own files.

Federal law requires companies to make their I.R.S. filings available on request to anyone and, in the event of "exceptional circumstances," allows a one-day delay. Each company contacted by The Times provided the documents except for Mr. Kellogg's companies. He provided only one return for one year for SLK Reinsurance.

Mr. Kellogg did not respond to telephone and written requests for an interview.

Jay Adkisson, a Laguna Niguel, Calif., lawyer who tracks tax frauds and who has helped clients create what he says are legitimate tax-exempt insurers, said many promoters flouted the law.

"This law was meant to let small insurance companies start up and grow up to become tax-paying companies," he said. "That sounds well and good except for the people at the large accounting firms and the tax shelter promoters who are abusing this."

Both Ms. MacNab and Mr. Adkisson said they had turned in promoters to the I.R.S., but the agency had not acted against them. Indeed, the I.R.S. has never listed an insurer in its periodic reports of organizations that lose their tax exemption. And a search of court records revealed no enforcement action against this kind of company.

David Harris, a lawyer in the I.R.S.'s Office of Tax Shelter Analysis, said the agency had recently begun a study of these taxexempt companies.

But both Ms. MacNab and Mr. Adkisson say the I.R.S. is focusing on the smallest abusers, primarily car dealers and other retailers, while missing much larger abuses that are obvious simply by examining the annual reports filed by the tax-exempt insurers.

In some cases, existing insurance companies take advantage of the loophole by collecting little in premiums for a period of years to qualify for the exemption.

Take the Alfa Mutual Fire Insurance Company, which slashed its sales of insurance to qualify. In 1999 alone Alfa earned $45 million in tax-free profits while collecting $301,870 in premiums, down sharply from the millions in premiums collected in earlier years. In 2000, having built up $530 million of assets, Alfa dropped its tax-exempt status when its premiums exceeded the $350,000 maximum. Paul C. Till, Alfa's spokesman, said the company had complied fully with the law.

How does a company make millions of dollars in profits when the insurance premiums it collects each year are minuscule?

The first trick is to create huge reserves, far beyond any possible claims by the insured, and to invest the money, which collects dividends, interest, capital gains and other income ? free of tax.

Mr. Kellogg, for example, held $330 million in assets at his IAT Reinsurance firm in 1999, when it collected premiums of $3,330.

And the losses it paid that year on insurance claims? Zero.

That's the second trick: paying little or nothing in losses.

In the four years from 1996 through 1999 IAT Reinsurance did not lose one dollar because of insurance claims.

But the firm did report some expenses, including $680,984 listed as a consulting fee in 1999, a $129,770 management fee that year and an $8,315 write-off on a company car. Some years it reported spending more than a thousand dollars a month on telephone calls. Because each of these expenses amounts to more than the insurance premiums raises questions about whether the company is principally in the insurance business or is mainly a mechanism for avoiding taxes.

The New York State hospitals' insurance company, created by members of the Hospital Association of New York State (Hanys), says it is not a tax dodge but a relic of a failed 1985 state law intended to deal with a crisis in malpractice insurance. The Hanys Member Hospital Self Insurance Trust does not take in insurance premiums but it does have more than $100 million in investment assets and has paid no claims in some years.

Mark Morris, the Albany lawyer who runs the insurance operation, said other laws made each participating hospital vulnerable to unlimited liability claims. "When we applied to the I.R.S. we relied on the advice of our accountants" that becoming a tax-exempt insurance company would solve these liability problems.

Mr. Adkisson said there were easy ways for the I.R.S. to identify sham insurance companies that were just tax dodges. "To qualify for this you are supposed to be a real insurance company with actuarial studies and a reasonable relationship between income and reserves to pay claims," he said. But even having such studies is not enough, he said.

"Having $1,000 of premiums and $100 million of reserves is so out of proportion that no actuary on earth would say that is reasonable," he said.

It is the lack of limits on the size of reserves that is key to the attractiveness of these companies.

Here is one sales pitch, explained by an individual who works in the business, that Mr. Harris said the I.R.S. had also heard about:

A business owner creates an insurance company, often in Bermuda or another tax haven where there are few regulations, but under rules subjecting it to American tax law. The owner then applies to the I.R.S. to have the company taxed under Section 501(c)(15) of the tax code, which makes it exempt from taxes so long as it takes in less than $350,000 of premiums.

The owner then insures his own businesses and, sometimes, solicits some business from others, in many cases collecting only a few thousand dollars in total premiums.

It is the second and third steps that make the deal attractive, especially to someone with an asset that has soared in value.

Say the owner has stock worth $100 million that, if sold, would cause a $20 million capital gains tax, leaving him with $80 million. By contributing the stock to his insurance company, as a reserve against claims, and having his company sell the stock he avoids the capital gains tax because the insurance company is tax exempt.

The $100 million is then used to buy a diversified portfolio of stocks and bonds, eliminating the risk from being highly concentrated in one stock. The dividends, interest and any future capital gains on this money are tax-free so long as the money stays with the insurance company.

If this $100 million grows to $150 million and the owner then decides to close the insurance company, he could take the money back and owe taxes only on the $50 million gain.

Ms. MacNab laughed at the thought that anyone doing this would even pay those taxes, however. "The I.R.S. would never notice" if the taxes were not paid, she said.

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