Shifting the Risk
How does tax insurance work? Suppose that John Taxpayer owns a company valued at $200 million. Following professional advice, he causes the company to establish an employee stock ownership plan, and he sells half of his stock to the ESOP for $100 million. He then invests the proceeds in a special-purpose security, and borrows $90 million against that asset, which he invests in a diversified portfolio of liquid investments. His advisors say this transaction will allow him to avoid $25 million of federal and state taxes on the gain he realizes on the sale of stock. In this kind of case, he can buy a cost-effective tax insurance policy that would provide $35 million of protection, locking in his anticipated tax savings and providing coverage for any possible penalties or fines. This protects his tax benefit, but perhaps even more importantly, it provides certainty—and the peace of mind that goes along with it.

In some cases the window of opportunity to insure tax liabilities is limited by new legislation. For this reason, individuals should consider obtaining insurance at the same time a strategy is evaluated. In doing so, the taxpayer has indirectly commissioned a risk assessment of the transaction before entering into it. If it can be insured cost effectively, it makes sense to move ahead. If it cannot, the entire transaction should be reevaluated. Past transactions can be insured retroactively, but must be evaluated, using the same criteria as new transactions, on a case-by-case basis.

In an environment in which tax authorities are increasingly skeptical about the validity of opinion letters, wealthy individuals and their advisors can consider tax insurance as a useful risk-mitigation tool.