You can master many areas of law, but taxation is another story. Congress never tires of changing the rules, and governments and courts everywhere do their best to complicate matters.
Tax advisers often speak in tongues, explaining to clients that a “more likely than not” or “should” reporting position prevails. But these judgment calls offer little comfort to a taxpayer who wants a direct answer when declaring hundreds of millions of dollars in taxes.
I have answered thousands of questions with answers like these as an associate of two law firms, but neither I nor my law firm could guarantee an outcome. Nonetheless, clients rely on these words as a dim light in a fog of uncertainty to buy or sell businesses, take a position on performance, or avoid financial statement disclosure.
Enter Tax Insurance
Some A-rated insurance companies aspire to absorb the risk that an outcome in court will differ from an adviser’s best judgment. This market is a small but growing subset of a larger insurance market that underwrites representations and warranties in mergers and acquisitions transactions. The result is an effective guarantee of expected tax results and a powerful tool that every practitioner should wield.
Insurers underwrite these risks by reviewing the analysis of applicable tax laws by outside advisors and engaging their own advisors to underwrite them. These underwriters engage in a proven process of reviewing an expert’s opinion (like a civil engineer’s report) and competing on price to ensure the financial downside of unlikely outcomes (like the collapse of a bridge).
Brokers like me act as gateways to insurance markets by connecting ratepayers with carriers and getting quotes in a week or less, with a policy underwritten and committed often in a week longer. The taxpayers’ outside attorneys and accountants have already undergone the tax analysis or due diligence required to determine the correct tax position in the first place.
Prices vary, but for most issues, initial premiums currently cost as little as 3 or 5 cents on the dollar of coverage. Taxpayers who want to guarantee the results of solar and wind tax credits benefit from lower premiums because coverage in this space is prolific and almost commoditized, with more carriers and carrier experience.
Carriers will absorb tax risks even after they are discovered by the IRS or a state, local or foreign tax authority. Premiums tend to be three to four times higher in such cases, as fewer carriers have the appetite for such uncovered issues. The pricing effect is more of an imbalance of supply and demand than an actuarial determination of an “audit lottery”; there is no data on the likelihood of an audit for a particular risk.
Risk appetite varies from carrier to carrier and will even vary over time within the same carrier as staff change roles or carriers. This is not surprising, given that comfort levels differ between partners in the same law or accounting firm. The uncertainty of the law requires a variation in expectations.
Premiums are well below what counterparties to a transaction would assume the cost of tax risk is due to insurers competing with each other; have a low cost of capital, often accessing reinsurance markets to syndicate higher dollar risk; and can decentralize these risks among many people around the world. Never adjust a purchase price for tax risk without pricing insurance, as the parties are bound to overstate the cost and destroy the value.
The stronger the underlying tax conclusion, the lower the premium. And the higher the coverage amount, the lower the weighted average premium. Carriers and brokers syndicate larger tax risks into a layer cake through a process the industry calls “building a tower.” Higher stacked exposure, lower premium and highest premium go to dollar one coverage supported by major carriers.
Hedging towers of $1 billion or more are not out of the question, and towers worth hundreds of millions of dollars are regularly built. The industry expects this cap to increase as new carriers enter the market and existing carriers commit more capacity. The floor size of coverage starts around $5 million simply because a lower premium amount is simply not worth the hassle of due diligence.
Taxpayer risk tolerance rules
Tax insurance is a godsend between policyholders with low risk tolerance and those with higher risk appetite. When risk appetite falls below the cost of insurance, there is a deal.
But risk tolerance is a moving target. M&A buyers have a very low appetite for a tax position reported by the sellers of their target. Risk appetite also drops to a very low level in exits, whether exiting a company, fund or state or country; when special tax considerations increase risk (for example, some REIT sales generate 100% tax); or when entering a new business or taxing jurisdiction. High net worth individuals who engage in estate tax planning and family limited gifts, as well as trust and estate trustees seeking to make distributions where no potential tax liabilities may remain, are also tolerant candidates. low risk.
Lawyers and accountants advise their clients well, but rarely understand a client’s risk tolerance. Advisors would be better off suggesting insurance companies guarantee an outcome, rather than leaving open the possibility of receiving a call in which a client complains that they could have avoided a $100 million tax liability for 3 to $5 million if the advisor had only mentioned the option.
Uncertainty is a problem that money can solve
Whenever money (insurance markets) can solve a problem that people (law firms and accountants) have solved, money will always be more innovative and accurate. Tax advisory services will always be needed, but practitioners and clients now have a powerful tool in tax assurance to gain certainty amid risk and chaos.
This article does not necessarily reflect the views of Bloomberg Industry Group, Inc., publisher of Bloomberg Law and Bloomberg Tax, or its owners.
James Chenoweth is Managing Director of Alliant Insurance Services Inc. and was a tax partner at the law firms of Gibson, Dunn & Crutcher and Baker Botts.
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