By Dustin Covello

Not every tax position is obviously right or wrong. Often, there can be many shades of gray. When a gray position is challenged by the IRS or another taxing authority, taxpayers and CPAs incur risk for increased tax, penalty, and interest, as well as professional fees and the stress of undergoing an audit. In many situations, these risks have hindered taxpayers from developing or maintaining gray (but defensible) tax positions, which in turn negatively impacts their financial and business objectives. In the past several years, though, a valuable new tool has emerged to help taxpayers mitigate these risks: tax insurance. This blog discusses how tax insurance works and where it could be useful.

Top Uses

Like insurance generally, tax insurance can help reduce risk in certain circumstances. The three most common times when tax insurance is used are as follows:

• To support a tax position on a client’s initial tax return. A client, faced with a favorable but potentially risky tax position, can obtain insurance to mitigate downside risk.
• To smooth over a complex tax issue when closing a valuable transaction. Tax insurance, for instance, has been used in the purchase and sale of transferable tax credits under the Inflation Reduction Act because those transferable tax credits, while incredibly valuable for a buyer to reduce their income tax liability, are subject to legal and recapture risks.
• To preempt potential tax objections when in the mergers and acquisition market. By laying a target’s tax risk on an insurer, buyers and sellers eliminate a potentially thorny issue.

What Is Insurable?

The number of tax issues that can be insured is broad, and virtually any “known” issue can be insured against. So, whether it’s an S corporation that inadvertently terminated its S corporation election, the tax classification of an arrangement as a sale or license, or if compensation is excessive or complies with Section 409A, all of these common issues – and more – can and are insured.

Process, Terms, and Pricing

Tax insurance is customizable to a taxpayer’s needs, but most policies and the process to obtain coverage share some basic similarities.

The Process – Taxpayers typically enter the tax insurance market through a tax attorney and an insurance broker. To underwrite a policy, most insurers require a detailed memo or tax opinion drafted by a tax attorney that analyzes the facts and relevant tax law. That opinion is typically provided by the broker to several large insurers in a sort of auction process. The broker will gather quotes from the insurers and then discuss the pros and cons with the taxpayer before pursuing insurance. After choosing an insurer, the position is subject to diligence by the insurer and their legal counsel, and then a custom insurance policy is drafted. In my experience, the entire process can be relatively fast, with a policy bound within a few weeks.

The Terms – Policies typically have a seven-year term beyond the extended six-year statute of limitations applicable in certain circumstances, such as if the taxpayer omits more than 25% of gross income under IRC 6501(e)(1)(A).

The losses covered usually include tax, penalties, interest, reasonable professional fees to defend a tax audit, and a gross-up to account for the fact that an insurance recovery itself is often taxable income to a taxpayer. There is typically an upper limit on the amount of insurable losses and a small retention or deductible to be retained by the taxpayer. These provisions are negotiable and obviously impact pricing: the more laid off risk increases the premium, and the more retained risk decreases the premium. These levels can be negotiated and designed to meet the taxpayers’ needs.

The Price – Tax insurance can be expensive. Therefore, it may only be practical when a material tax position is at stake. To illustrate, most insurers charge minimum “diligence” fees to underwrite and analyze a potentially insurable tax position. In the transactions that we have been involved with, the diligence fees have typically been about $50,000. A premium will cost in the ballpark of 3% to 5% of loss exposure, depending on factors such as the loss limits, the potential insured’s retention, and the insurer’s perception of the risk of the tax position failing in an audit. Most insurers also require a minimum premium in the low six figures as well.

A Recent Case Study

Recently, an individual client struggled with the treatment of a termination payment on a valuable contract as ordinary income or capital gain. Precedent in this area can be complex and inconsistent. Although we were able to point to case law and make a cogent analysis supporting capital gains treatment, we were not able to reach a high comfort level or assure the client that he would prevail in an audit and/or avoid penalties. To help mitigate the client’s worry, we introduced him to the concept of tax insurance. After several weeks of diligence and negotiating terms, the client purchased a policy. He decided that the premium was well worth the peace of mind to lock in his tax benefit.

Dustin Covello is a partner and chair of the tax practice at the Philadelphia office of the law firm Royer Cooper Cohen Braunfeld LLC. He can be reached at dcovello@rccblaw.com.

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^{Statements of fact and opinion are the authors’ responsibility alone and do not imply an opinion on the part of the PICPA's officers or members. The information contained herein does not constitute accounting, legal, or professional advice. For actionable advice, you must engage or consult with a qualified professional.}