The Tool of Tax Insurance Can Absorb the Risks of Uncertainty

One can master many areas of law, but tax is another story. Congress never tires of changing rules, and governments and courts everywhere do their best to complicate matters.

Tax advisers often speak in tongues, explaining to clients that a reporting position “more likely than not” or “should” prevail. But these judgment calls offer little comfort to a taxpayer desiring a straight answer when reporting hundreds of millions of dollars in taxes.

I’ve answered thousands of questions with answers like these as a partner of two law firms, but neither I nor my law firm could guarantee a result. Nonetheless, clients rely on these words like a dim light in a fog of uncertainty to buy or sell businesses, take a position on a return, or avoid a financial statement disclosure.

Enter Tax Insurance

Certain A-rated insurance carriers hunger to absorb the risk an outcome at court differs from an adviser’s best judgment. This market is a small but growing subset of a larger insurance market underwriting representations and warranties in M&A transactions. The result is an effective guarantee of planned tax results and a powerful tool every practitioner should brandish.

Carriers underwrite such risks by reviewing outside advisers’ analysis of applicable tax law and hiring their own advisers to concur. These underwriters engage in a time-tested process of reviewing an expert’s opinion (such as a civil engineer’s report) and compete on price to insure the financial downside of unlikely outcomes (such as a bridge collapses).

Brokers like me act as gateways to insurance markets by connecting taxpayers with carriers and get pricing within a week or less, with underwriting and binding a policy often within just one more week. Taxpayers’ outside lawyers and accountants already have undergone the required tax analysis or diligence to determine the right tax position in the first place.

Pricing varies, but for most issues, upfront premiums currently cost as little as 3 or 5 cents on the dollar of coverage. Taxpayers wishing to guarantee solar and wind tax credit outcomes enjoy lower premiums because coverage in that space is prolific, and almost commoditized, with more carriers and carrier experience.

Carriers will absorb tax risks even after discovery by the IRS or a state, local, or foreign taxing authority. Premiums tend to be three to four times higher in such cases because fewer carriers having the appetite for such discovered issues. The pricing effect is more a supply-and-demand imbalance than an actuarial “audit lottery” determination; no data exists on the likelihood of audit for any particular risk.

Risk appetite varies by carrier and will even vary over time at the same carrier as personnel change roles or carriers. This is unsurprising, given that comfort levels differ between partners at the same law or accounting firm. Uncertainty in law demands variance in expectations.

Premiums are much lower than what counterparties in a deal would assume the cost of the tax risk is because insurance carriers compete; have a low cost of capital, often accessing re-insurance markets to syndicate higher dollar risks; and can decentralize these risks across many globally. Never adjust a purchase price for a tax risk without pricing insurance;, as the parties are bound to overvalue the cost and destroy value.

The stronger the underlying tax conclusion, the lower the premium. And the larger the amount of coverage, the lower weighted average premium. Carriers and brokers syndicate larger tax risks in a layer cake through a process the industry calls “building a tower.” Higher stacked exposure, lower premium, and highest premium goes to the dollar one coverage borne by primary carriers.

Towers of coverage of $1 billion or more aren’t out of the question, and towers in hundreds of millions of dollars are regularly built. The industry expects this ceiling to increase as new carriers enter the market and existing carriers devote greater capacity. Floor size of coverage begins around $5 million simply because a lower amount of premium just is not worth the diligence hassle.

A Taxpayer’s Risk Tolerance Rules

Tax insurance is a bargain between low-risk tolerant insureds and higher-risk appetite carriers. When risk appetite drops below the cost of insurance, there’s a deal.

But risk tolerance is a moving target. M&A buyers have a very low appetite for a tax position reported by their target’s sellers. Risk appetite also drops to a very low level in exits, whether exiting a business, a fund or a state or country; when special tax considerations raise the risk (for example, certain REIT sales generate 100% tax); or when entering a new business or taxing jurisdiction. High-net-worth individuals engaging in family limited partnership estate and gift tax planning, and trustees of trusts and estates looking to make distributions where no contingent tax liabilities can remain, are similarly low-risk tolerant candidates.

Lawyers and accountants advise clients well but rarely understand a client’s risk tolerance. Advisers are better off suggesting insurance carriers guarantee an outcome, rather than leave open the possibility of receiving a call down the road in which a client complains it could have avoided a $100 million tax liability for $3 million to $5 million if the adviser had only mentioned the option.

Uncertainty Is a Problem Money Can Solve

Whenever money (insurance markets) can solve a problem that people (law and accounting firms) have solved, money will always be more innovative and precise. Tax advisory services will always be necessary, but practitioners and clients now have a powerful tool in tax insurance to achieve certainty amid the risk and chaos.

This article does not necessarily reflect the opinion of Bloomberg Industry Group, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.

Author Information

James Chenoweth is a managing director for Alliant Insurance Services Inc. and has served as a tax partner for the law firms of Gibson, Dunn & Crutcher and Baker Botts.