Sean King

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San Juan, Puerto Rico, United States

Saturday, October 8, 2011

My Humble Tribute to Steve Jobs, with a big assist by Don McLean:

(To the tune of American Pie)

A short, short time ago...
After the end of September
Died a man who used to make us smile.
He knew if he had his chance
That he could make the people dance
And, maybe, they’d be happy for a while.

His recent frailty made me shiver
But I never doubted he’d deliver.
Then bad news came by way of text;
I could not conceive of what was next.

It’s been a long time since I’ve cried
But, when I read about his widowed bride,
Something touched me deep inside
The day the Music died.

So bye-bye, to the American guy.
All our hearts are heavy,
Miss that glint in your eyes.
Even enemies, they grieve your demise.
Saying, "I just can’t believe that he’s died."
“I just can’t believe that he’s died.”

Did you write the book of love?
You had no faith in God above
Cause you never trusted ‘bout what is so.
But you did believe in rock ’n roll,
That Music soothes the mortal soul.
And you taught us all things we couldn’t know.

Well, I know that you’wr in love with tech
`cause it set you off on your treck.
You and Wos rolled up your sleeves
Determined to make us all believe.

As lonely teenage broncin’ bucks
With your imaginations and a little luck,
You and Woz, you made your bucks
Before your Music died.

People then were singin’,
“Hi hi, new American guy.
All our hopes are lifted,
By that dream in your eye.
Hey, hey Steve, show us another surprise.”
You’d say, "You won’t believe your two eyes."
“You just won’t believe your two eyes.”

For many years you ran things on your own.
Knowin’ moss grows fat even on rollin’ stones,
You’wr never hampered by what used to be.
Then a jester challenged you, the Founder,
Thinkin’ his crazy ideas were sounder,
And predictably Apple began to flounder.

And while you, Steve, were looking down,
The jester stole your thorny crown.
The boardroom was adjourned;
A dire verdict was returned.
So while that imposter made low the Mac,
Bill Gates played the copycat,
And you were laid out on the mat.
You thought your Music died.

You were crying,
"bye-bye, Apple of my eye.”
“So hard to see the dream,”
“I gave my life to die.”
“Them good old boys, they won’t know how to survive.”
"This’ll be the day that it dies.”
“This’ll be the day that it dies."

Thirty years old and you’d lost your swagger.
Maybe they were right: You’wr just a braggart,
Eight miles high and falling fast.
But you’d land foul on the grass.
And you’d give business another pass,
Showing the world from the sidelines what was NeXT.

Now the half-time air was sweet perfume.
It led you from NeXT to remake cartoons.
T’was much celebration,
O’er your feats of animation:
As the hoppers tried to take the field;
The ants, they all refused to yield.
Do you recall what was revealed
After your dream had died?

We were singing,
"My, my, that American guy.
“All our hearts are lifted,
By that new dream in your eye.”
“Hey, hey Steve, show us another surprise.”
You'd say, "You won’t believe your two eyes."
“You just won’t believe your two eyes.”

Oh, and there we were all in one place,
A generation lost in cyberspace
With no time left to start again.
So come on: Jack be nimble, Jack be quick!
Jack Sculley sat on a candlestick
Cause fire is the devil’s only friend.

Oh, and as you watched him on your stage
Your hands must’ve clenched in fists of rage.
No angel born in hell
Could break that satan’s spell.
As Apple’s flames climbed high into the night
To light the sacrificial rite,
You were finally reinstated with delight.
The Music nearly died.

You were singing,
"Hi-Hi, miss Apple pie.”
“I remember when”
“You’wr just a gleam in my eye.”
“Them good old boys, they nearly let you die.”
“But today is not the day that you’ll die.”
"Today is not the day that you’ll die."

And so your girl, she was singing the blues.
And you asked her for some happy news,
But she just smiled and turned away.
Then you went down to the sacred store
Where you’d heard the Music years before,
And you remade the store in a whole new way.

And in the streets: the children screamed,
The lovers cried, and the poets dreamed.
And in boardrooms words were spoken;
As the old ways all were broken.
Like the three men you admired most:
You made things that were grandiose,
And the establishment caught trains for the coast.
But they, they could not hide.

And yet now they’re singing,
"Bye-bye, Mr. American guy
“We drove our chevys to the levee,”
“But the levee was dry.”
“Till you we good-ole boys were drinkin’ kool-aid and lies”
“Singin’, ‘this’ll won’t be the day that we die.’”
"’This won’t be the day that we die.’"

And now they’re singing,
“Bye-bye, to the American guy.”
“All our hearts are heavy,”
"Miss that fire in your eyes.”
“Even enemies, we grieve your demise.”
“Even we can’t believe the Music died."

Hope and Change:

Tuesday, October 4, 2011

Hale Stewart Weighs in on Life Insurance and Captives

Hale Stewart has weighed in on the issue of captives and life insurance, posting the following some time ago on his blog and more recently on Jay Adkisson's LinkedIn captive group:

I addressed this issue (life insurance in captives) in a recent post on my tax law blog. Here is the post in its entirety.

The topic of life insurance and captive insurance companies is fairly controversial. Some practitioners have no problem recommending that a captive invest in life insurance as part of their investment portfolio, while others recommend against it. I fall into the latter camp for the following reasons:

1.) The vast majority of time when a captive invests its investment assets into life insurance products, it does so because that has been the strategy since the beginning of the sales process. That is, a salesperson went to a prospect and said, "I've got a great idea; we can form a captive insurance company and have the company invest in life insurance as part of their investment portfolio." The problem with this approach is it runs against the basic legal function of a captive insurance company -- to underwrite risk. If the sales process completely avoids this central tenant -- or, if underwriting risk is not the primary reason for forming the captive -- the transaction runs counter to the primary legally defensible reason for forming a captive.

The entire history of anti-avoidance law is filled with cases where the sales literature, methodology, and presentations used demonstrated an intent counter to a standard business transaction. For further reading on the topic, I would recommend the entire series of equipment leasing cases from the 1980s, the COLI cases from the 2000s or the new codification of the economic substance doctrine by the IRS.

2.) The 831(b) captive is already a tax-advantaged vehicle; it is taxed on its investment portfolio rather than its gross earnings. Why would a company that has a tax advantage invest in a tax advantaged product? It's a situation directly similar to a person with $30,000 in annual income investing in a municipal bond; it's a complete mismatch between the investor's investment profile and the investment.

3.) Before I was a lawyer, I was a bond broker. Insurance companies made up about half of my clients. In all the time I dealt with the investment side of insurance companies I never once saw them invest in life insurance. Why? Because the actuarial department of insurance companies spend a fair amount of time aligning the duration of the expected liabilities and the duration of the investment portfolio (for more on this idea -- at least from the fixed income side -- read Frank Fabozzi's Fixed Income Mathematics). Life insurance just doesn't serve in this capacity. But another way, the duration of the average life insurance policy is far longer than the average expected P and C claim.

Why is this important? Because the third prong of the three prong Harper test states the court will recognize a captive so long as the transaction "was for “insurance” in its commonly accepted sense." I call this test the "duck test;" the captive must walk and talk like an insurance company. Because other insurance companies don't invest in life insurance, captives shouldn't either.

All that being said, there are two places where life insurance can play a part in the captive process.

1.) Buy-sell agreements: these are especially appropriate when the captive is inter-twined with an estate plan. The parents and the children create and sign a buy-sell agreement funded with life insurance at some point in the captive's life cycle. This strategy can also be employed when the captive has multiple owners. Buy-sell agreements are standard business plans that will not draw any unwarranted scrutiny.

2.) A highly liquid loan to an ILIT: once a captive has been in existence for a number of years it will have the ability to make loans thanks to excess cash. One of these loans could be a callable loan to an irrevocable life insurance trust that is part of an overall estate plan. The loan must conform to transfer pricing rules and regulations.

As I ran out of room, let me add that reasonable minds can differ on this topic. But given what I see as a situation that will draw increased scrutiny from the IRS (which I believe applies to captives in general), why risk it?

Let me begin by commending Hale for recognizing that this is an issue upon which reasonable minds can and do differ. Unlike Jay (who is not a tax attorney), Hale avoids overly-broad, useless and inflammatory labels like " tax scam", "shills", "shelter", etc., and he doesn't imply that those who disagree with him are going to jail. So, Hale is someone with whom one can have a reasoned and productive debate. I'm grateful for that.

With that in mind, I do want to challenge a few of his comments and conclusions above. First is his contention that incorporating life insurance into the discussion early in the sales process is somehow inconsistent with the captive's objective of underwriting risk. It should be noted that people with insurance licenses, be they life insurance brokers, P&C brokers, health insurance brokers, or all three, are in the risk-management business. Helping people mitigate risk is the very definition of what they do. Some focus on the risk of dying, others on the risk becoming sick or disabled, others on commercial risks, and yet others on the risk of losing money due to markets, lawsuits, taxes, etc. Various types of insurance are useful in responsibly managing each of these risks, no?

So, there's nothing improper or unseemly about a risk manager or insurance broker being involved with a risk-management entity like a captive. A captive is simply another means of mitigating risk, which is what insurance brokers do.

Additionally, fixed life insurance products in general, and Equity Indexed Universal Life Insurance contracts in particular, are uniquely-suited to managing what, next to a catastrophic claim, is perhaps the greatest risk to a captive--namely, a diminution or erosion of its assets due to market losses (whether in real estate, stocks, commodities, etc.), lawsuits, taxes, or the like. Modern high cash value life insurance contracts are highly liquid, uniquely stable (coming as they do with numerous built-in guarantees), and tax-efficient. Although it is beyond the scope of this post to elaborate, I'm confident that I could demonstrate to Hale why, ignoring any and all benefits of life insurance to the business owner or his family, life insurance is an ideal investment vehicle for the captive itself--that is, that captives investing into life insurance are more prepared and able to pay expected claims rather than less. There are certainly exceptions where life insurance is not a fit, but those exceptions simply prove the general rule.

Assuming what I have said above is true, then why does it suddenly become improper or suspect for a risk management specialist who just happens to have a life insurance license to suggest layering one risk-management technique (life insurance) on top of another (captive insurance). Captive insurance protects the business, and investing into life insurance protects the captive from market losses and other risks and helps insure that it is best able to pay claims. So...what's the issue?

The answer is that there shouldn't be one. There is nothing inherently inconsistent between a captive investing into life insurance and it fulfilling its "basic legal function of a captive insurance company--to underwrite risk." Quite the contrary--in most cases, the former supports the latter. However, there is admittedly a danger that the IRS or courts could perceive an inconsistency here. For instance, if a captive were formed with no regard for underwriting risk but merely as a shell through which its owner can purchase tax-deductible life insurance, then clearly there's cause for concern. But, if that's indeed the motive, isn't this motive equally improper regardless of the captive's investment vehicle? For instance, a sham captive formed mainly for the purpose of purchasing tax-deductible real estate as an investment is just a wrong as one formed for mainly the purpose of purchasing tax-deductible life insurance, no?

That being the case, the question resolves itself down to this: Does creating an investment policy statement and integrated investment plan for the captive from the outset, even prior to it's formation, jeopardize its legitimacy? I don't know anyone who suggests that it does, unless life insurance, which is demonstrably a superior investment for most captives, is involved. Why is that? Why does the presence of a particular type of risk management and investment specialist, a life insurance broker, at the outset of a deal (as opposed to, say, an non-insurance licensed investment advisor or a real estate agent or a bank or a captive manager or an attorney) make it significantly more likely in anyone's mind that the captive was formed for improper purposes?

Honestly, I don't see the connection. We don't question a client's motive in forming a captive when a captive manager or attorney brings the deal to the table, do we? And, like the life insurance broker, don't captive managers and attorneys make more money only if the prospective client actually implements the captive and, in some cases, invests the money with them? Isn't convincing clients to form captives and then managing them or their assets how these guys make a living? Assuming so, don't they have just as great a motive to convince a client to do a captive as the life insurance broker does? As a result, aren't' they just as (un)likely to overemphasize the tax planning benefits of a captive, as opposed to its risk management benefits? Why do we expect that the client's motives will be more pure when they deal initially with a captive manager or attorney, neither of whom are typically licensed risk management specialists and both of whom have ulterior motives, rather than a true risk management specialist like a life insurance agent?

Jay isn't out there publishing Forbes articles warning the public to, "run if a captive manager approaches you about a captive, especially if he emphasized the tax advantages. After all, he only makes money if you do the deal and he'll say anything to get you to do it." Why is that? I agree wholeheartedly that "if underwriting risk is not the primary reason for forming the captive -- the transaction runs counter to the primary legally defensible reason for forming a captive", but once again, why does the presence of a life insurance agent, as opposed to any number of other professionals, make an improper motive any more likely? Are life insurance agents any more likely than other professionals to use improper sales material or emphasize the tax angle? Not in my experience. I hate to say it, Hale, but it seems to me to be a simple matter of captive managers and attorneys wanting to protect their traditional turf from another class of risk management specialists--the licensed brokers, including life insurance brokers, who have until recently largely overlooked captive planning.

Regarding Hale's contention number 2, that it makes no sense to invest into a tax-advantaged product inside of a tax-advantaged vehicle, I could put forth innumerable retorts. Let me just offer up a few in the interest of time.

First, as to its earnings, captives are not in any way "tax advantaged". Earnings are taxed at ordinary C-corp rates, and are taxed again if and when they are distributed as dividends. Perhaps start-up captives might be in a fifteen percent tax bracket, but long-established ones certainly won't be. Regardless, trying to shelter those earnings from at least some of these taxes is an imminently reasonable thing for any company to do, and captives are no exception.

Hale's analogy to municipal bonds is misplaced. Folks making $30,000 per year shouldn't invest in municipals because equally-rated corporates offer a higher expected after-tax yield. This is not the case with life insurance at all. Rather, just the opposite. At least as compared to fixed life insurance products and equity indexed universal life, equally (un)risky investments most definitely do not offer captives a higher expected after-tax yield in today's world. Quite the contrary. This isn't just some opinion but rather is easily demonstrated numerically.

Second, Hale's whole argument on this point rests upon the assumption that the reason captives invest into life insurance is simply to avoid tax. In my considerable experience, this is not the case at all. In my experience, captives invest in life insurance because it provides a unique bundle of features that simply cannot be obtained anywhere else. Included among these is the ability to earn market-based returns while enjoying stability of principal, high liquidity (versus real estate, limited partnerships, or other common captive investments), the ability to borrow against the policy on a non-recourse basis at a very favorable rate upon a moments notice without having to apply or be approved for the loan and regardless of one's credit rating, the ability to defer payments on such loan indefinitely so long as the life insurance policy stays in force, asset protection (in some states), and, yes, tax efficiency. Can you name for me any other vehicle that provides a corporation with this unique bundle of benefits? Isn't it obvious how this unique bundle of benefits could benefit most captives, enhancing their ability to pay claims?

Hale's argument 3 above is founded on the premise that a captive investing into life insurance results in a mismatch of assets and liabilities. Specifically he says: "The duration of the average life insurance policy is far longer than the average expected P and C claim." That sounds somewhat intuitive, it true? No!

Hale seems to think that we need to wait for the death benefit of the policy to mature before we have sufficient liquidity to pay claims. This completely ignores the fact that the cash surrender value of the policy is compounding all along at rates that similarly (un)risky options simply can't touch. It's the cash surrender value that the captive will access to pay claims, not the death benefit. And, this cash surrender value is highly liquid. It can be accessed on a moment's notice either by cashing the policy in or, more likely, by simply borrowing against it. In the latter case, no gain/loss upon sale is realized, so there's no adverse tax consequence to paying the claim. Compare this to any other investment where the captive would have to sell assets to pay claims, triggering a potential tax liability or else locking in losses at a potentially unfavorable time.

If you think about it for a minute, a captive is highly analogous to a non-qualified deferred compensation plan ("NQDC") like those offered by many large companies. In fact,, from an asset/liability matching perspective, it's much more analogous to a NQDC comp plan than it is a traditional insurance company. NQDC plans receive "contributions" each year, the total amount "invested" in the plan typically grows over time (since contributions generally exceed withdrawals), and a few times a year the company will need to access the money in these plans to pay out a termination or retirement benefit. Likewise, the typical captive will receive premiums each year, the total amount invested in the captive (i.e., its assets) typically grows each year (since premium income generally exceed its expenses), and a few times a year (for most captives) it will need to use a portion of its assets to pay claims.

However, like a NQDC plan, and unlike a "real" insurance company, captive expenses are unpredictable in timing and amount (e.g., in the case of the NQDC plan, a key executive could retire unexpectedly and cash out a large portion of the plan, and in the case of a captive a massive claim could be file ). Unlike traditional insurance companies, the law of large numbers does not lend predictability to the captive insurance company's expected claims rate, and claims flow can be highly variable and unpredictable. In most years a captive may have a very small amount of claims (in dollar terms), but in some years it could have massive claims--claims so big that they nearly bankrupt the company. Consequently, like with NQDC plans, the stability, predictability and liquidity of its investment portfolio is paramount. In other words, if one is not sure when he's going to have to cough up a large amount of money on a moment's notice, he better keep is safe and liquid in the meantime, right?

Thus, while a traditional insurance company can invest in a large, diversified portfolio of riskier and hopefully higher yielding assets, and can count on the tenants of diversification and the law of large numbers to help protect it against massive losses (either market losses or claims or both), captives can't be, or at least shouldn't be, so bold.

This is why the Hale's argument that you-never-see-real-insurance-companies-invest-most-of-their-assets-into-life-insurance--so-captive's-shouldn't-either is misplaced. You also never see "real" insurance companies invest most of their assets into money market funds or bank accounts, which captives often do. But nobody complains about that, and they shouldn't. The simple fact is that a typical, professionally-managed captive's investment portfolio shouldn't look anything like that of a "real" insurance company regardless of whether or not it invests in life insurance. Why? Because of the very asset/liability mismatch that Hale notes above. The risk and investment considerations that govern a "real" insurance company's portfolio decisions are simply inapplicable to most captives. Thus, it would be highly irresponsible for most captives to mirror an investment portfolio based on how "real" insurance companies invest.

Hale just gets it exactly wrong is by suggesting that using life insurance aggravates the asset/liability mis-match. It doesn't. It actually resolves it! And this is exactly why using life insurance makes so much freaking sense for most captives. It's the same reason why nearly seventy percent of Fortune 1000 companies invest all their NQDC plan money, which has an asset/liability profiles highly analogous to captives, into life insurance. Fixed or indexed life insurance arrangements allow these companies to get market-based returns with stable asset values, high liquidity, tax-advantaged growth, and tax-advantaged access to their funds when needed. All of these things are of little importance to a "real" insurance company, which can count on principles of diversification and the laws of large numbers to protect it against large losses, but it's of critical importance to a captive or a NQDC plan that can't.

To conclude, using life insurance within most captives is in no way inconsistent with its primary purpose of underwriting risk. In fact, life insurance often supports this objective like no other option can. Fixed and indexed life insurance represents an imminently reasonable compromise between earning no yield in a money market or bank account, and exposing the captive's assets to significant potential market losses or liquidity risks by chasing higher returns elsewhere. If the IRS doesn't understand this for some reason, then it should be made to. It's current failure to grasp the concept (if Jay is to be believed) is no reason for honest taxpayers motivated by genuine risk management concerns to forfeit all the benefits that life insurance arrangements can offer them. The benefits of life insurance to the captive, not to mention its owners, are enormous and shouldn't be passed on lightly.

DISCLOSURE: IRS regulations require me to inform you that this post is not intended or written by me to be used (and cannot be used by you) for the purpose of avoiding penalties that may be imposed with regard to the tax consequences arising from any matters discussed in this message or for the purpose of promoting, marketing or recommending to another party any transaction or matter addressed in this message.

Monday, October 3, 2011

Jay Adkisson: Was He Lying Then or is He Lying Now?

Anyone who knows anything about Jay Adkisson (who is self-admittedly not a tax attorney, by the way) knows that he loves disparaging the work of tax professionals in order to drive business to his firm. His most recent example is a posting on Forbes' blog that I extensively critiqued here and here.

Importantly, at least for purposes of this post, Jay (who is not a tax attorney) warns the public in the Forbes posting to avoid at all costs group captive arrangements that are organized with an eye towards tax planning, and any captive arrangement involving life insurance, especially when captive comes to your attention via a life insurance agent. Such arrangements are "scams", "tax shelters" and "red flags", Jay self-righteously insists.

Well, I have already demonstrated how these public comments fly in the face of what Jay (who is not a tax attorney) actually says privately to life insurance agents behind the public's back, and now I will show that it also contradicts what he sometimes does in practice.

Consider, for instance, this marketing piece. It is unquestionably a solicitation for participation in a group captive arrangement between unrelated parties. The first page says "the opportunity enables you and a business for which you are a related party to purchase different types of insurance in a tax-advantaged manner." Page two says, "as a result of these transactions, you will own shares of preferred stock in the [captive], your business will obtain one or more types of insurance [note that the types and amounts haven't even been determined yet]; and you will manage the LLC through which you will acquire cash value life insurance on your life and other approved investment products." Page three says, "the business opportunity provided by the [captive] offers you a unique method of obtaining various types of insurance for your business that otherwise would be difficult to obtain. Simultaneously, the [captive] may provide you with an immediate tax deduction for premiums paid that constitute ordinary and necessary business expense (sic), and the ability to defer taxes on any gains...".

The described deal works as follows: For every $100,000 in premiums a participating business pays to the group captive (yes, the deal is being offered in $100,000 premium units that, according to Jay Adkisson's usual logic, must have everything to do with the level of desired tax deduction and nothing to do with the actual insurance needs of the business), approximately $5,500 is paid to a captive management firm and $5,000 is retained by the captive. The remaining $89,500 is invested by the captive into a subsidiary LLC managed exclusively by the participating business owner. From there it ultimately gets invested'll never insurance on the business owner's life or such other investments the business owner, as manager of the LLC, may choose. Thus, ninety percent of the assets of the captive are more or less under the direct control of the business owner participant where, if the promoter has his way, it will end up invested into life insurance.

And, who is going to sell this life insurance and other investments to the LLC? The captive's promoter, as noted on page 10 of the memo. It reads: "[Promoter] is in the process of obtaining licenses for securities, life insurance and mutual fund sales, as it is contemplated that he will receive fees and commissions from the formation of the [captive]..the management of the insurance company..asset management of the companies..and the placement of life insurance products."

Okay, so far this is starting to look like a deal that Jay Adkisson (who is not a tax attorney) would ordinarily lambaste publicly, right? Let's count they ways that Jay (who is not a tax attorney) might puke all over such an arrangement: First, we have a group captive being created by a "promoter" who will solicit participation from unrelated persons for the purpose of obtaining "tax-advantaged" insurance. Second, the promoter will apparently receive a portion of the fees charged by the captive manager that will form and manage the captive--so it seems the promoter and captive manager are in cahoots and are not totally independent of each other in this transaction. Fourth, most all of the premiums paid to the group captive will be immediately placed under the business owner's direct control via a subsidiary LLC arrangement. And finally, the promoter intends from the get-go to convince (or even require?) each LLC to place its assets under his management where the money will likely (or maybe definitely?) be invested into life insurance.

You'd think Jay Adkisson (who is not a tax attorney) would be rolling over in his...desk chair, right?

Well, it gets worse. The guy who wrote the solicitation memo (i.e., the "promoter" in Adkisson terms) admits over and over that neither he nor the captive itself have any experience managing an insurance business in general or captive insurance companies in particular. But never fear, dear business owner, for he tells you explicitly that the captive "will rely extensively on the advice of its management company in all aspects of the insurance business" including but not limited to, we are assured, formation of the company, development of the captive's business plan (which I assume would include the plan to invest into subsidiary LLCs), managing the underwriting and pricing of policies, determining the types of polices to be issued and their terms, etc. Ignore for a moment the fact that the captive manager is apparently compensating the promoter for hiring him since the promoter will "receive fees and commissions from the formation of the [captive and]..the management of the insurance company."

So, one doesn't even have to read between the lines to conclude that this whole deal is actually being organized, facilitated and managed by the management company, right? Or, at the very least, it's a joint effort between the management company and the promoter? After all, if the memo is to be believed, the promoter is ignorant about the formation and operation of captives and the management company will thus do all the actual work. Well, if it's true that the promoter is ignorant as to the formation and operation of captives, there's little chance that the promoter could have dreamed up this whole business structure in the first place, nor could he have written the solicitation memo by himself. So...who is helping him? Who will help him? Well, the trusty management company, he insists time and again in the memo. And who is behind the trusty management company--the only party to this deal that seems to actually know how captives work and should be operated? Well, that's where it starts to get really, really interesting:

You see, page 8 tells us that the management company is "Trafford". Okay, but how can you, dear business owner, know that Trafford is competent and legit as you read this memo? I mean, why should you be comfortable paying hundreds of thousands of dollars in premiums to a captive controlled by a stranger, with other strangers as partners, which is managed by yet another party, where you've not yet been told what types of insurance it will provide or in what amounts, where it will supposedly invest ninety percent of its premiums into an LLC that you control (which will subsequently invest most of it into life insurance)? Well, because, as noted on page 9, Trafford is "owned and managed" by three very trustworthy and reliable people--people with lots of credentials and who certainly would know a scam if they saw one. You know the type of scam I'm talking about here, right? One's where, as Jay (who is not a tax attorney) notes in the Forbes article, unrelated people are brought together by an unrelated promoter, especially a life insurance salesperson, to share the costs of operating a group captive with an eye towards reducing taxes and with little regard to the types and amount of captive insurance to be provided, where the money is placed under the business owner's control in short order, and especially where the money ends up in life insurance?!

So, the reader will be astounded to learn, as I was, that the first-listed among these esteemed three "owners and managers" of Trafford noted on page 9 of the memo, the firm that is responsible for "all aspects" of the captive's insurance business, is none other than (yes...squint your eyes and look for yourself) that group-captive-denoucing, life-insurance-hating, purveyor of promoter paranoia, the man we've all come to know and (dis)respect--the "melanoma from Oklahoma" himself--Jay Akdisson (who, I might add, is not a tax attorney).

I rest my case (for now).

DISCLOSURE: IRS regulations require me to inform you that this post is not intended or written by me to be used (and cannot be used by you) for the purpose of avoiding penalties that may be imposed with regard to the tax consequences arising from any matters discussed in this message or for the purpose of promoting, marketing or recommending to another party any transaction or matter addressed in this message.

Sunday, October 2, 2011

Jay Adkisson's AALU Presentation on Captives: Res Ipsa Loquitur

Last weekend I offered an extensive critique of Jay Adkisson's marketing tactics, including a detailed refutation of many of the assertions made in his recent post that was picked up by Forbes.

This weekend I want to further expand my critique by documenting just how disingenuous and hypocritical many of Jay's criticisms of other captive professionals really are. Consider, for instance, the following criticisms that Jay lobs at certain captive insurance companies and their "promoters" in the Forbes article:

Like most tax shelters, there are actually real and bona fide group captives and cell captives, etc., that are legitimately used by businesses as property-casualty risk management tools, but we’re not talking about those. Instead, we are talking about the proliferation of those types of entities to be misused as something other than a real risk management tool, and instead primarily as a tax shelter. With the bad deals we are discussing, the main reason that people get interested in them and use them is to save taxes, not for insurance. That’s the first bright red flag too.

Very importantly, the scam deals involve situations where a bunch of people who have absolutely no relation to one another, except for the desire to save taxes, are thrown together into the same deal. The promoter needs to do this to try to save administrative fees and keep the costs of the shelter down. Thus, this is one way to distinguish the scam deals from the completely legitimate deals; the legitimate arrangements are known as “pure captives” and occur where businesses form their own captive insurance companies that they alone own and control and which underwrites only the insurance risks of their own businesses (and which follow the established IRS guidelines for such companies).

By whatever name the promoter calls the deal, whether “group captive” or “cell captive” or “ICC”, etc., the base shelter concept is the same:

Your business will pay a large insurance premium (which, amazingly, will be the same amount as the deduction that you desire) for some sort of insurance against a risk that is probably never to occur, such as terrorism insurance for a business in Tennessee. Would you normally buy that insurance or pay premiums at the amount they want you to pay? Of course not — that’s why it is a shelter and not a real insurance deal.

Your business will then take a deduction in 2011, but the idea will be that in some later year either your business or you will get your money back either by what is known as a “premium refund” (or maybe a “dividend” if the particular arrangement you have chosen is a cell captive arrangement).

And he says:

Note to file: If somebody ever uses the terms “captive” and “life insurance” in the same sentence, run! Unless you have a burning desire for the IRS to act as your proctologist, that is.

And he continues:

There are myriad problems with these arrangements and easy reasons why they will blow up in your face:

* The purpose of the arrangement was not truly insurance, but instead tax savings, and thus there is no true economic purpose.
* The premiums paid bear no relationship to the true cost of the insurance (even if some actuary signs off on it — one can find an actuary to sign off on pretty much anything, including tidal-wave insurance for a Nebraska business in one actual deal).
* The arrangement is pre-designed so that the premiums are returned somehow to the participant, meaning that the entire arrangement was a sham from the get-go.
* The arrangement violates all sorts of IRS rules relating to risk-shifting and risk-distribution, even if the promoters swear on a stack of IRS Code Books that the deal is compliant.
* Some arrangements for getting the money back on a tax-favored basis pass the line beyond a mere shelter and are just criminal tax fraud.

So, in fairness to Jay, and taking the above quotes in context, let's compile a quick list of those things that he implies are red flags--i.e., things that are indicia of tax scams or fraud:

1) Multi-owner captives where those owners are unrelated (i.e., "legitimate" deals are apparently "pure captives" with a single owner or related owners);

2) Captives where tax planning is a primary objective (this, he says, is a "bright red flag");

3) Arrangements where the amount of insurance purchased is driven by tax planning or investment considerations rather than the true amount of insurance one "needs";

4) Arrangements where the captive insures low-risk things like "terrorism insurance in Tennessee";

5) Arrangements where you would never agree to pay a third party a similar amount for the same coverage (i.e., captives that are used to simply insure risks that one already self-insures rather than replacing third-party insurance);

6) Deals that are prearranged in such a way that the captive's profits ultimately inure to the benefit of the business, the business owner, or his/her family on a tax-favored basis (e.g., via premium refunds, dividends, loan backs, etc.);

7) Arrangements that mention life insurance and captives in the same sentence;

All of that's fair enough, I suppose. I mean, every man is entitled to his opinion as to what constitutes a red flag, right? But what if that man speaketh out of self-interest and with a forked tongue? Should his opinion on the topic then be trusted?

Keep that question and the seven red flags above (according to Jay) in mind as you peruse the presentation on captives that Jay Adkisson and Tom Vorhees gave a couple of years ago to the Association for Advanced Life Underwriting (a life insurance industry group comprised of America's top life insurance agents). As we shall see, this presentation raises every single supposed red flag, and many more than once. (In reading the analysis of Jay's presentation below, the numbers appearing in parentheticals after certain sentences correspond to the numbered red flags above.)

Let's begin with Slide 12 of the presentation, which you can see for yourself by following the above link. It lists the "Primary Benefits of Captives". Note that it specifically emphasizes income tax planning opportunities (especially the ability to reserve for claims on a pre-tax basis and the tax "arbitrage" available by trading ordinary income taxes for long term capital gains)! The same slide also emphasizes opportunities for estate and gift tax planning via a captive. Again, these are not noted as simply ancillary benefits of owning captive but as "Primary Benefits of a Captive", as the slide's title suggests. Does this not clearly raise supposed red flag number 2 above? it only a red flag if someone other than Jay raises it?

Slides 18, 19, and 21 continue with describing the income and estate tax planning opportunities of a captive (2), with slide 21 specifically describing how a captive can loan its assets back (6) to its owner (in this case an irrevocable trust for the benefit of the business owner's children).

Slide 24 discusses the ability to do "group captives" (1). You remember those, right? Jay says in his quote above that group captives formed with an eye towards tax savings (which he just emphasized in previous slides) are indicative of a "tax shelter".

Slides 25 goes on to discuss life insurance in particular, noting specifically that it is a "permissible investment" (7). In fairness, would a reader of Jay's Forbes article conclude that investments into life insurance by a captive are permissible? Hardly! The IRS will "act as your proctologist", he warns.

Slide 25 continues by emphasizing the tax advantages of life insurance (2 and 7) as opposed to its many economic advantages (e.g., the guaranteed right to borrow against cash surrender values on a non-recourse basis, etc.). It notes specifically that captives can be structured from the beginning so that they, and therefore the death benefit of the life insurance policies they own, are outside of the business owner's taxable estate, resulting in a "dramatic" planning impact (2, 3, 6 and 7). It further notes that the life insurance owned by the captive (7) can be used to provide key-man coverage and facilitate buy-sell and split-dollar arrangements, all of which directly benefit either the business, the business owner personally, or the business owner's family (6), but not necessarily the captive itself. This slide does caution against arrangements that are designed "just" to sell "pre-tax life insurance", but how is the reader to know when that's the case? Jay's implied answer: It's not the case if Jay Adkisson does your captive work (ha!), but with anyone else it's buyer beware.

Unbelievably, Slide 27 lists again the potential benefits of owning a captive, and notes first and foremost the ability to "create business tax deductions for the insured company" resulting in the ability to have a "tax-advantaged investment portfolio" (2, 3). It also lists as benefits "create family wealth transfer opportunities" and "purchas[ing] life insurance on the owner" (2, 3, 6 and 7).

Slide 30 begins a section titled "Illustrating a Group Captive" (1). Oh no, there's that bad word again--"group captive". Slide 31 compares the benefits of a business participating in a group captive arrangement to doing nothing (i.e., maintaining the status quo). In the "Benefits Comparison" section of the slide, it notes first and foremost that the group captive results in significant "annual deductions from business income", then it calculates the "ten year estimated income tax savings" from the arrangement (nearly $3 million!), and finally it highlights specifically the estate tax planning opportunity afforded by the arrangement (1, 2, 3, 6 and 7).

Slide 32 begins an entire section on "Integrating a Single Parent Captive into a Blueprint for Improving After-Tax Capital for Retirement Income and Wealth Transfer" purposes (2, 3 and 6). Slide 33 notes that "every premium dollar paid [to a properly structured captive] is a tax-free transfer outside the estate" (2, 3 and 6). How could that be unless the business owner had planned in advance to have the captive owned by an irrevocable trust or other appropriate entity or perhaps his children? And, how could he have decided to do that without considering the tax planning opportunities of the structure ab initio? And, why in the world would he have bothered to do that unless tax planning was a significant consideration in the overall structure?

Slides 34 through 36 offer up a specific case study highlighting exactly how captives can be prearranged to create estate and income tax savings opportunities (2, 3 and 6), the benefits of which are summarized on slide 37. It notes specifically that the captive results in "increased income tax deductions" of some $8 million dollars over the period in question, and results in nearly $7 million of federal estate tax savings (2, 3 and 6)!

Slide 39 begins a discussion of the types of risk that might suitably be insured through a captive. The opening sentence on this slide says "a key to a profitable captive is identify and insure risks that are legitimate but have a low probability of happening" (4). Why? So the captive can be more profitable? So it can better pay claims? No! Because "insuring risks that have a high probability of occurring would inhibit the ability of the captive to help achieve the owners (sic) other financial goals" (2, 3, 4, 5, 6 and 7). It notes further that a qualified underwriter should have little trouble identifying suitable risks. And finally, it provides a listing of potential low-risk coverages that one might legitimately insure through a captive. Included in this list'll never believe it..."loss due to terrorist attack" (4) (notably with no exclusion mentioned for residents of fly over states like Tennessee).

The remaining twenty-two pages of the presentation is a series of slides that, in light of Jay's comments quoted above, should leave the reader positively gobsmacked. In the interest of time, I can only highlight a few:

Slides 40 and 41 discuss structures through which the captive can make indirect loans to family members or invest into life insurance on the business owner (6 and 7). Slide 41 is specifically titled "Ways to Invest Capital Fund in [Life] Insurance" (6 and 7). Slide 47 discusses, once again, how the captive's assets can be invested so as to "Improve After Tax Capital for Retirement Income and Wealth Transfers" (6 and 7). Slide 52 highlights the economic and tax benefits of the captive investing into life insurance (6 and 7), which are considerable. Slide 53 notes that life insurance is, first and foremost, "demonstrably more tax efficient" than other investments the captive might choose (6 and 7). It then goes on to provide a number of suggestions for captives that wish to pursue this alternative.

Slide 54 and 55 demonstrate in graphical and numeric form the positive economic impact of using life insurance inside of a captive (6 and 7). Slide 56 qualifies these discussions by noting that they assume that the captive was previously formed for "the purpose of providing insurance", but goes on to note that "it is not unreasonable for the investment decisions made by the CIC to be influenced by long-term exit strategies, so long as investment decisions do no compromise the CIC's ability to provide insurance" (2, 3, 6 and 7). Thus, as noted on slide 58, captives can be "owned at inception by [an] estate planning vehicle, such as a trust" (2, 3, 6 and 7).

And, presumably it's not improper to plan in advance for the ultimate tax-favored disposition of the captives assets. For instance, slide 59 notes two ways of doing so--via operating or liquidating dividend (either of which, it is noted, is currently taxed at capital gains rates) (2, 3, 6, and 7).

Taking all of these slides in context, it is clear that Jay has no issue with intentionally contemplating and maximizing the tax benefits of the captive structure, or investing its assets into life insurance, or arranging in advance for the ultimate tax-favored disposition of the captive's assets to the business owner or his family at some point in the future, just so long as the captive was originally formed "for the purpose of providing insurance". Now, in fairness, would any reader of the Forbes article quoted above come to this same conclusion as to Jay's views on these points? No. So query why in the world Jay strives so hard to create a false impression in the mind of Joe Public?

To conclude, it is impossible to read Jay's public writings and view his private presentations (or even his actual legal work) without concluding conclusively that he's an unethical hypocrite. In this single presentation to the Association for Advanced Life Underwriting (and there are yet other examples), Jay Adkisson advocates doing exactly what he warns the public to avoid lest they be thrown into prison for tax fraud. He not only raises every single one of his own supposed red flags, but he waives each viciously.

Which raises a key question: Was he lying then (when he delivered his presentation to the AALU), or is he lying now? Are these really as big of red flags as Jay would have the public now believe? For instance, should the public really "run" anytime anyone mentions life insurance in conjunction with a captive or emphasizes it's tax benefits? If so then, they now know to include Jay Adkisson, the world's best-known captive promoter, among those from whom they should flee.

My issue with Jay is simply this: This man, who works in a tiny firm, whose father answered the phone for him last time I called his office, and who doesn't even have published Martindale peer review ranking, would have the public believe that only he is sufficiently knowledgable and skilled to guide it through what he insists is very dangerous territory. Hire any other as your guide, Joe Public, and you very well might be "eating with a spork [in prison] on Christmas morning"! In Jay's world, other captive professionals, no matter what their credentials or experience, and no matter how superior their Martindale rating, are embezzling con men or tax frauds at worst and naive incompetents at best. What a crock! It's time for other professionals to speak out on against this crap.

As for the public at large, let me ask the reader a simple question: Would you buy a used car from a man who was constantly implying to you that, if you purchase a vehicle from anyone else, it very well may be a lemon (at best) or a death trap (at worst)?

Of course not. Remember that the next time you read an article by Jay Adkisson.

UPDATE:> Jay might try to dodge the criticisms noted above by pointing to Slide 5. Slide 5 says that everything that comes after it assumes that the client has a non-tax reason for the insurance to be offered by the captive and that the presentation is only meant to explain "ancillary benefits" of a captive. Review the presentation and decide for yourself whether this is true. In light of what the other slides actually say, color me skeptical.

But, even if it is true, it does not help Jay dodge his own bullets. For instance, he says explicitly to run from anyone who mentions life insurance in the same sentence as a captive or who emphasizes the tax-planning opportunities they provide. He does not qualify this statement in the Forbes article by saying "well...unless life insurance and tax planning is just an ancillary benefit." And yet the presentation he gave to a group of the life insurance industry's top salespersons spends an inordinate amount of time describing in excruciating detail the tax planning benefits of a captive and how life insurance can improve those planning opportunities.

And, he says that businesses shouldn't purchase low risk policies (like terrorism insurance in Tennessee) from their captive, and then he participates in giving a presentation that says the exact opposite. He doesn't say in his Forbes article that low risk policies are okay so long as they are merely an "ancillary benefit", does he? No! Instead he insists that says that low-risk policies are indicia of "tax shelters." Who is he trying to fool? You? Me? Joe Public? The IRS?

And lastly, doesn't Jay think that every other captive "promoter" (be it a CPA, attorney, captive manager, or life insurance salesperson) in the country has a page in his/her presentation that says exactly the same thing (more or less) as his Slide 5? Of course they do. And they do so because, contrary to his constant implication, they have no more interest in helping people set up inappropriate captives than Jay does. light of Jay's presentation, maybe I should rephrase that.

Anyway, the point is that Slide 5 is utterly useless to the public in helping it distinguish between the good guys and the bad guys about which Jay is so fond of warning them. If it's acceptable for Jay Adkisson to talk extensively about the "ancillary benefits" of owning a captive with only a disclaimer page here or there, as he does in the AALU presentation, then it's just as acceptable for other professionals, even life insurance professionals or captive managers, to do that same. And doing so doesn't make them promoters, tax cheats, shills, embezzlers, greedy bastards, or any of the other tawdry labels that Jay is so fond of throwing around. Jay should be absolutely embarrassed and ashamed for suggesting otherwise.

UPDATE 2:> Jay had this to say today in response to one of the comments on his LinkedIn captive blog discussing his Forbes article [the bracketed comments below are my own]:

Barry: "Is it not true the iRS has deemed 50% appropriate use of reserves for life insurance?"

Not that I am aware of -- what are you basing this on?

[The IRS has not issued any guidance on what constitutes an appropriate or inappropriate level of life insurance in the context of a captive.]

Not all life insurance inside a captive is per se bad -- in some limited circumstances it may make economic sense to have life insurance inside a captive. It is simply a "red flag".

[I wonder if readers of his Forbes post would conclude that life insurance is not per se bad, or that in some cases it makes economic sense?]

The concern is where a captive is primarily sold for some purpose other than as a risk management tool for the business, i.e., it is sold as a tax shelter or as a way for the business owner to purchase life insurance with pre-tax dollars, etc.

[I'm not sure why how a captive is "sold" is particularly relevant. What's relevant is why the client in question implemented the captive. Even if a captive was "sold as a tax shelter", which I doubt happens nearly as often as Jay wants the public to believe, does that mean the client implemented the captive for this reason? The last car I bought was "sold" to me as one of the safest cars in the world. I could've cared less. All I wanted was a great ride.]

This is what some of the audits in Atlanta are all about -- the IRS obtained some literature from promoters where captives were marketed as tax shelters and had life insurance illustrations built into the proposals. [Like you did in your AALU presentation, Jay?] The IRS then started audits of some of those who had set up captives through these promoters and found that the premiums paid for the property-casualty insurance underwritten by the captive was significantly overpriced and bore no actuarial relationship to reality, i.e., the premiums were not based on actuarial tables, industry loss history, etc., but rather on "how much of a deduction do you need this year?" [And how exactly, Jay, would you know whether this was true or not? Just because the IRS told you so? If so, what are you doing talking to the IRS about active audits? Did you actually review the pricing of the policies in question yourself? Do you know whether independent actuaries or insurance consultants were involved? Have you never known the IRS to assert a position that was contrary to fact? Could the IRS be wrong in its conclusion? It seems you assume too much. We have a saying here in fly over country about those who assume.]

In my conversations with IRS agents who deal with captives, they have indicated that life insurance is a "red flag" to them, not because life insurance is inherently bad but because it tends to indicate to them that the captive was created for some other purpose (tax savings or wealth transfer) than to underwrite non-life risks. [Again, do you think that's what readers of your Forbes post understood you to say, Jay? And regardless, isn't that exactly what you taught life insurance agents to do in your AALU presentation--that is, to emphasize the "ancillary benefits" of owning a captive like tax savings, retirement income and wealth transfer?]

I don't think that life insurance inside a captive will ipso facto invalidate the captive, but it is something that can draw unnecessary attention to the captive, as well as concerns about the liquidity of the captive and ability to pay claims. It is "another factor" towards the IRS taking the position that the captive is something other than a risk management tool, which a captive is supposed to be, as opposed to a tax management tool, i.e., a tax shelter, which it is absolutely not. So why do it?

[Oh...I don't know. Maybe for all the reasons that you so emphasized in your presentation to the AALU? As was said in the presentation, the economic benefit of including life insurance is..."dramatic" and life insurance is "demonstrably more tax efficient" than other alternatives (your words)].

My advice is to get a second opinion. I'm not saying "go to me" because I don't practice tax law, but go to Chaz Lavelle in Louisville or Tom Jones in Chicago or Bruce Wright in New York or David Slenn in Naples, etc., and get one of those captive tax advisors to give you a second opinion.

[Wow! Now I'm blown away! Jay Adkisson doesn't practice tax law?! I wonder if readers of Jay's posts know that? Perhaps you might mention that at the beginning of each of your rants from now on, Jay. You regularly offer up to the public tax opinions on what constitutes a "tax shelter", or a "tax scam", or a "bogus risk distribution pool", etc., and yet you self-admitedly aren't even a tax attorney?! To make matters worse, Jay, you constantly warn the public not to trust the opinions of others know...actually are tax attorneys--"shills", I think you call them--many of whom who are no doubt far more experienced than you in tax matters and in dealing with the IRS, many of whom no doubt have Master's degrees in Law with concentrations in taxation from prestigious schools like New York University or others, many of whom have practiced in established firms of note, and many of whom have five-star Martindale peer review ratings. How convenient for you!

And, here's a question for Forbes: What the H-E-Double-Toothpicks are you doing publishing the tax opinions of someone who admittedly doesn't even practice tax law? If you're going to have someone scare the public about tax scams, at least find someone know...actually practices in the subject area].

And run -- fast! -- from anybody who advises you not to get a second opinion. [ last we agree, Jay. Well, just so long as that second opinion isn't from you. After all, you "don't practice tax law." Please be sure to mention that anytime you offer up tax opinions from now on.]

DISCLOSURE: IRS regulations require me to inform you that this post is not intended or written by me to be used (and cannot be used by you) for the purpose of avoiding penalties that may be imposed with regard to the tax consequences arising from any matters discussed in this message or for the purpose of promoting, marketing or recommending to another party any transaction or matter addressed in this message.

Sunday, September 25, 2011

Jay Adkisson...There You Go Again

Not too long ago I called out attorney Jay Adkisson for unprofessionally marketing his services by slandering the work of others. Well, he's at it again, this time on Forbes' blog. Forbes should be ashamed for publishing such drivel.

Like last time, Jay's comments are full of self-serving and misleading statements, exaggeration and scare tactics. And, once again, I shall count the ways that his comments fall short of the truth:

First, Jay suggests that "terrorism insurance in Tennessee" is an illegitimate risk to insure through a captive insurance company (or perhaps he means through any insurance company?). Sounds about right for a "city slicker" who considers everything between LA and New York to be fly-over country. As a stereotypical city slicker, Jay can't be expected to know that virtually all the uranium for the United States' first atomic bombs was enriched in Oak Ridge, Tennessee as part of the Manhattan Project, or that a significant portion of the nation's bomb-grade uranium is stored there today, or that Oak Ridge National Laboratory, a top secret facility, still conducts much of the country's nuclear and scientific research? All of these things, and more, make Oak Ridge both a perfect strategic and symbolic target for terrorists (much more so than say...oh...the Murrah Federal Building in Oklahoma City), but Jay can't be expected to know that.

And, he can't be expected to know that two of the nation's nuclear power plants operate in Tennessee, or that the Tennessee Valley gets a large percentage of its power from dams. Both nuclear power plants and dams make ideal strategic targets for terrorist attack, no? How many businesses in Tennessee could operate without power?

Maybe Jay's problem isn't with Tennessee in particular, but with terrorism insurance in general. Maybe he doesn't consider terrorist attack to be a "real" risk to most small businesses? Well, if that's the case, he should know that his government disagrees with him. The Department of Homeland Security has a website that emphasizes the risk of terrorist attack to small businesses and implores them to prepare. This website includes a link to the Emergency Preparedness and Business Continuity Standard that, among other things, emphasizes the importance of insurance in mitigating risk, including terrorism risk. For instance, it says specifically that "the mitigation strategy should include...acceptance/retention/transfer of risks (insurance programs)." FEMA likewise has a page that emphasizes the risk of terrorist attack and recommends preparedness planning. Interestingly, neither of these government pages say that the recommended precautions don't apply to Tennesseans.

Additionally, when it passed the Terrorism Risk Insurance Act (TRIA), which specifically mentions captive insurance companies, Congress itself recognized that terrorism is a real threat to the American economy, and that an inability to obtain reasonably-priced terrorism insurance jeopardized America's economic security. TRIA says:
The Congress finds that—
(1) the ability of businesses and individuals to obtain pro-
perty and casualty insurance at reasonable and predictable prices, in order to spread the risk of both routine and cata- strophic loss, is critical to economic growth, urban development, and the construction and maintenance of public and private housing, as well as to the promotion of United States exports and foreign trade in an increasingly interconnected world;
(3) the ability of the insurance industry to cover the unprecedented financial risks presented by potential acts of terrorism in the United States can be a major factor in the recovery from terrorist attacks, while maintaining the stability of the economy;
(4) widespread financial market uncertainties have arisen following the terrorist attacks of September 11, 2001, including the absence of information from which financial institutions can make statistically valid estimates of the probability and cost of future terrorist events, and therefore the size, funding, and allocation of the risk of loss caused by such acts of ter- rorism;
(5) a decision by property and casualty insurers to deal with such uncertainties, either by terminating property and casualty coverage for losses arising from terrorist events, or by radically escalating premium coverage to compensate for risks of loss that are not readily predictable, could seriously hamper ongoing and planned construction, property acquisition, and other business projects, generate a dramatic increase in rents, and otherwise suppress economic activity....

In light of the government's own proclamations on the risk of terrorism in general and the importance of terrorism insurance to small business and the American economy as a whole, Jay's contention that such coverage is irrelevant to most small businesses (especially those in Tennessee, I guess), or that most small business owners must be acting under pretext when considering the effect of a terrorist attack on their business, is either ignorant or disingenuous. At this point, I suspect the latter.

Or, maybe it's not that Jay has issues with terrorism insurance in general, but with how such policies are priced in the captive market. For instance, he says: "Would you normally buy [terrorism] insurance or pay premiums at the amount they want you to pay? Of course not — that’s why it is a shelter and not a real insurance deal."

Really? Surely Jay does not mean to suggest that the only risks one can legitimately insure via a captive are those that the business previously insured through a third party. After all, the very reason captives were "invented" to begin with was to insure against risks for which coverage could not be obtained at a reasonable price in the third party insurance market. If coverage for an undeniably real risk were available from third parties at a price the business owner considered reasonable, then wouldn't every business owner just purchase the insurance from a third party rather than bother setting up a captive? The only reason to form a captive is if the business owner considers the premium charged by third party insurers to be unreasonable in light of his assessment of a given risk. By setting up a captive, every business hopes to retain the likely (but not certain) underwriting profits for itself, profits that would otherwise inure to the benefit of a third party insurer.

And, Jay must surely know that terrorism insurance policies offered by third party insurers often exclude the most important risks--i.e., losses from chemical, biological, nuclear, and/or radiological attack. Likewise, he must know that third-party policies typically only provide coverage for damages to property and not loss of business income (unless, in some cases, the loss of income is directly attributable to property damage). And yet, for most small businesses, the latter is much more important than the former. Direct damage from a terrorist attack may be unlikely for any single small business, but indirect damage to a small business resulting from loss of income is an all-too-real, and potentially devastating, possibility.

And yet protection against the above-described risks is often not available from third party insurers at any reasonable price. Were it not for the federal government subsidizing the cost of terrorism insurance via TRIA, it might not be available at all. Consider whether this is because the risk of loss to the insurance industry by providing such coverage is too small (i.e., because the risk is bogus, as Jay implies) or whether it is because it is too great! Clearly, it's the latter. Thus, these risks are very, very real, even in fly-over states like Tennessee. If they weren't, every insurance company in the world would be offering protection against nuclear, chemical and biological attack to Tennesseans for almost nothing, and TRIA would be unnecessary. And yet they don't, and it isn't. Quite the contrary. This itself is sufficient to refute Jay's silly assertion that premiums charged by captives for terrorism insurance are generally bogus and inflated.

Terrorism insurance is commonly purchased through captives not because it is a bogus tax-dodge, as Jay suggests, but because it is an economically feasible way to managing a very real risk and because policies offered by captive insurance companies typically insure one or more of the excluded risks noted above (e.g., many cover chemical and biological attack) at a cost that's reasonable to a business owner once he considers that he retains a share of the captive's profits. Also, unlike many third party policies, captive policies often cover not just direct losses that may result from a terrorist attack, but indirect losses as well. Given that equivalent policies are not available from third party insurers for any reasonable premium, most any premium charged by a captive for such coverage can't be de facto unreasonable. If anything the amount that most captives charge for such terrorism insurance can be criticized for being too low!

But, to prove another point, let's engage in a thought experiment: Let's assume for a minute that a business owner could buy purely third party insurance that would cover terrorism risk to the same extent as captive policies at some reasonable, albeit very high, cost. Does the fact that a given business owner may choose not to suffer a certain very high loss (by way of third party insurance premiums) in order to protect against an uncertain extraordinarily high loss (i.e., terrorist attack) mean that it is de facto unreasonable or disingenuous for the business owner to try to mitigate the impact of terrorism risk through captive insurance where he/she retains any underwriting profits? In other words, should such a business owner be barred from a captive arrangement simply because he would never purchase identical insurance from a third party at the same extraordinarily high price? Of course not. Yet, this is what Jay would apparently have his readers believe.

Next Jay goes on his traditional diatribe against life insurance. First he suggests that a captive investing in life insurance is somehow improper (i.e., the IRS will "act as your proctologist"). In response I will ask one simple question: Can Jay cite even a single federal statute, regulation, revenue ruling, court case or private letter ruling that holds that it is in any way improper for a C-corporation in general, or a captive insurance company in particular, to invest into life insurance? I'll save you the wait and state unequivocally that he can't because no such authority exists. Are we to fear IRS examination so much that we pass on doing perfectly legal things in hopes of avoiding an audit? Only people who have something else to hide should be inclined to take this approach.

The fact is that C-corporations invest into life insurance all the time. To provide just one (among innumerable) examples, a study by the American Society of Actuaries done some years ago indicates that nearly seventy percent of Fortune 1000 companies invest their non-qualified deferred compensation plan money, the money that is expected to fund retirement for the company's most senior executives, guessed insurance. There are many reasons why almost seventy percent of the country's most sophisticated CFOs made that decision, and at least some of those reasons apply in the context of a captive insurance company. There is absolutely no reason whatsoever that an honest taxpayer who chooses to have his captive invest in life insurance for legitimate economic reasons should fear the IRS, at least not any more than an honest CFO who funds his retirement plan with life insurance should. Jay should be ashamed for implying otherwise.

Jay next slanders life insurance arrangements as paying "obscene" commissions to those pesky "promoters", presumably making them a raw deal for the consumer. Really Jay? Those Fortune 1000 executives who invest their own retirement dollars in life insurance must be pretty stupid people, getting "hoodwinked" by those slick life insurance salespeople all the time. Apparently, Jay, you're not just an expert on captives, but you know more about life insurance than most Fortune 1000 CFOs as well! Your expertise knows no bounds.

Jay's criticism of life insurance combined with captives is all the more mystifying since he gave a talk a few years ago to the Association for Advanced Life Underwriting (a group made up of the industry's top life insurance salespersons) describing in detail (in addition to all the various tax planning opportunities captives provide) how captives can be combined with life insurance to achieve important planning objectives. Talk about a shill! If Jay's admonition to run from anyone who even mentions life insurance in conjunction with captives is to be taken literally, then include Jay Adkisson among those from whom the reader should run. The fact is that Jay himself has on more than one occasion formed captives where life insurance was involved.

Lastly, Jay continues with his all-too-familiar scare tactics designed to drive business away from others and toward his firm. He implies over and over throughout the "article" that anyone who does business with a captive professional (other than himself, it is implied) is taking their lives into their own hands. For instance:

Reading the article at the above link, you might be forgiven for thinking that everybody who mentions a captive, other than Jay, is a "promoter." How silly: There's simply no captive attorney in the country who has been more involved in self-promotion in general and promotion of captives in particular than Jay Adkisson. Adkisson is a captive promoter extraordinaire! A simple Google search will prove the point. Anyone who fears high profile "promoters" should fear Jay first and foremost.

Jay also suggests that if tax savings is a consideration in establishing a captive, then there's "no true economic purpose" for the entity. Really Jay? Can you find me a single court case that says that tax planning can't play any role in a contemplated transaction lest its economic substance be jeopardized? I wonder if Jay contributes to a 401(k) or an IRA and, if he does, whether he takes a deduction? Why would anyone would ever contribute to a 401(k) (that had no match) if he didn't get a tax deduction by doing so! Why would anyone voluntarily tie up his or her own money in a plan controlled by his/her employer--where he/she can't get to the money unless he/she first dies, becomes disabled, or terminates service; where he/she has a limited number of investment options chosen by someone else; where there are penalties if he/she takes the money out and spends it prior to 59.5, and additional penalties if he/she leaves it in past 70.5--if they didn't get a tax deduction in return? They wouldn't. The simple fact is that the only reason most people fund their 401(k)'s and IRAs is because they get a deduction. Does this mean that IRAs and 401(k)'s have "no economic substance" and are just "tax shelters"? Again, of course not. Admittedly tax planning probably should not be the primary motivation in forming a captive, but to imply that tax considerations must be ignored or down-played is just dishonest. Jay knows better.

He also suggests that there's something improper about the fact that the amount of captive premiums (in many cases) just so happens to equal the amount of the business owner's desired tax deduction for the year, as if that's improper. First, I'm not so sure that this is true since, in my experience, people desire much greater tax deductions than they typically obtain via captive premiums. Thus, captive premiums are typically less than the desired deduction, not equal to it. However, Jay is correct that, in the captive world, the amount of budgeted premium typically drives the amount of coverage purchased (rather than the desired amount of coverage driving the amount of premium), but that's every bit as much a function of general business budgeting considerations as tax planning. But, even if the amount of premium is driven in part by tax planning considerations, does that make the arrangement somehow de facto improper or a sham? Of course not. After all, isn't the amount of every single 401(k) or IRA contribution usually driven by a combination of budget considerations and the desired amount of a tax deduction (or the government's contribution limits)? Of course. Very, very few of us have actually taken the time to do the math that is necessary to make sure that we don't contribute any more or less to our 401(k) or IRA in a given year than is necessary to actually fund our retirement. Does this mean that our retirement plan contributions are shams? Of course not. Likewise, so long as a business isn't purchasing from its captive more insurance than it reasonably needs, the fact that budgeted premiums drive the amount of insurance purchased rather than the amount of insurance driving the premium is in no way improper.

Jay then warns about arrangements where premiums paid have no bearing to the "true cost", or where there is insufficient risk shifting and risk distribution, and he (as usual) cautions against relying on actuaries, attorneys or other professionals to determine what a reasonable premium should be or whether risk distribution/shifting is sufficient. Respectfully, Jay, how is Joe Public to know whether premiums and risk distribution/shifting are reasonable without reliance upon professionals? Oh yah, I almost forgot: Your problem isn't with all professionals, just any professional other than you. Everyone else is incompetent, a crook, or a shill in your world. Only you can be counted on to give clients the unvarnished truth and protect them from those mean old folks at the IRS. If I remember that, then at least your writings make a modicum sense.

Next, Jay warns against working with anyone who doesn't have a private letter ruling from the IRS, implying that lack of such a ruling makes an arrangement "bogus". How dishonest! Jay certainly knows that the IRS issues letter rulings only in limited circumstances, and that it regularly declines to do so in areas that are too "fact and circumstances" specific or where it doesn't want to concede any ground or where it simply hasn't arrived at a formal position yet. He likewise knows that there are thousands of perfectly legitimate transactions done every single day that aren't backed by letter rulings. To suggest that absence of a ruling means a transaction is "bogus" or even inherently suspect is just...lying. For what it's worth, it's a virtual certainty that Jay has not himself obtained a PLR for every captive with which he has been involved. Given the time and cost it takes to get one, I'm guessing that he obtained a ruling in only a small fraction of the captives he has formed.

I guess Private Letter Rulings are for the little guys. Great Men like Jay Adkisson can only rarely be bothered, but all of us advisors out here in fly-over country...well...we should be expected to produce one for every client/transaction.

Come on, Jay. Get real.

Remember when you were a kid and you'd let out a "silent but deadly" fart with your friends? What did you do next? If you were like most, you'd immediately shout out "Gross, who farted?!", in a rather shameless attempt to divert attention away from yourself and toward others. However, did you really fool your friends very often? Probably not. They likely outed you after a while. So, here in the fly-over country, we've developed a saying that's relevant to this topic: Whenever someone shout's "Who farted?", especially if they do it loudly and obnoxiously, we are apt to respond "the smeller's the feller!", meaning he who complains about the fart first and most loudly probably did it.

And when it comes to captive insurance companies, no one's out there screaming "Who farted?!" more loudly and obnoxiously than Jay Adkisson. As Shakespeare said, "the [man] doth protest too much." Remember that the next time you read an article by Jay.

UPDATE:> Shockingly, the Tennessee Highway Patrol doesn't know that terrorism isn't a threat in Tennessee. If only they'd listened to Jay, they wouldn't have wasted their money.

DISCLOSURE: IRS regulations require me to inform you that this post is not intended or written by me to be used (and cannot be used by you) for the purpose of avoiding penalties that may be imposed with regard to the tax consequences arising from any matters discussed in this message or for the purpose of promoting, marketing or recommending to another party any transaction or matter addressed in this message.

Tuesday, June 14, 2011

Understanding Bitcoin: A Guide for Newbies

Bitcoin has been all the buzz in recent weeks, not only among geek types but in mainstream sources like the Washington Post, The Atlantic, NPR, and even The Economist. Even so, it's apparent by searching for #Bitcoin on Twitter that many still don't understand what it is and why both its liberating and subversive potentials are so enormous.

I think this confusion is due to the fact that most people who have explained Bitcoin so far get bogged down in the technicalities of what makes it new and revloutionary rather than analogizing it to what we all already understand--our tried and true banking system. In this post I'll attempt to explain Bitcoin in terms everyone can understand.

The Current System

In our current financial system we can transfer money to others in two general ways: (1) directly by giving them cash, or (2) indirectly by working through a financial intermediary (such as a bank or credit card company). For very practical reasons, most financial transactions today are conducted indirectly through an intermediary. Among the reasons for this are the facts that transporting large quantities of cash from one person/place to another is both dangerous and comparatively expensive.

Thus, we presently store our cash at banks which, if they do their job properly, are supposed to keep it safe for us, and we transfer that cash to third parties not by actually delivering cash to them but by ordering the intermediary to pay the money to their account or to their order. We do this by, for instance, writing checks, through the ACH system, or by wiring the funds. Banks charge fees for these custody and transfer services.

While this system has worked for centuries, it has several major drawbacks. I'll mention just a couple here. First, it's inefficient: All those transaction fees and monthly charges add up over time. Banks make BIG money for providing custodial and transfer services. These banking fees essentially represent an additional tax on commerce--one paid to bankers rather than governments. To the extent these fees can be avoided, our system of commerce would be far, far more efficient.

Second, contrary to the expectations of the naive, banks don't actually keep the money we deposit with them in a safe. Instead, they loan it out to other people--not people that we select or approve, but people of the bank's choosing. And, all too often they loan it to people who ultimately can't or won't repay. If they do that too many times and for too long, the bank eventually goes bankrupt and, unless the government bails it out, our "deposited" money disappears along with the bank.

Also, even if these borrowers do repay, it's the banker that keeps the interest they pay, passing only a very small portion of it (if any) on to us. Thus, in addition to the fees banks charge us for custodying our money, they also use it for their own purposes and profit.

Hypothetical Solutions

Well, what if you didn't need a bank to keep your money safe and transfer it? What if sending actual cash from one person to another was as easy as sending an email or a text message? For instance, imagine a world where you (and everyone else) could "scan" your cash into your computer and then email it to others whenever you want to "spend" it. We do this with things of great value every single day (e.g., legal documents, priceless pictures, etc.), so...why not currency?

Such a system has obvious advantages. First, your money never leaves your custody. There are no intermediaries and thus no transaction fees. And, maybe best of all, no checkbook to reconcile! In such a system your money would reside safely on your computer or smartphone (where it can easily be protected via encryption and automatic backups) until you "spend" it by sending it to others. Pretty neat, huh?

But, there are obvious practical problems with the scanning of money, right? I mean, once you scan your money, you now have two copies of it--the paper or metallic original and the electronic copy on your hard drive. If both are equally "spendable", then money will eventually become worthless since anyone and everyone can essentially counterfeit money by scanning it. And, once it's scanned, they could make multiple additional electronic copies at will, inflating the money supply even more. That sounds kinda fun for a while, but eventually everyone becomes money makers, the supply of money increases drastically, and runaway inflation sets in as prices are bid up by people with money to burn.

Clearly, that won't work.

So, how can we resolve these problems? Well, what if the scanner were designed in such a way that it destroyed the paper or metal currency the very second that it stored the electronic copy on your hard drive? That's clearly a better system since now you can't spend both the paper currency and the electronic currency. It's a first step, but it's not enough.

So, what if it were also possible to scan the money in such a way that the electronic copy on your computer couldn't be replicated. Or, more precisely, so that everyone could immediately tell (or rather their computers or smart phones could immediately tell them) if a given electronic copy of the currency was a duplicate or the original. So long as the replicated (i.e., counterfeited) copy could easily and immediately be distinguished from "original", then no one would accept the counterfeited one and only real ones would circulate, right?.

Electronic money of this type would make everyone happy (well, accept the banker, that is) and make our financial system much more efficient.

Enter Bitcoin

Until Bitcoin, such a system of electronic cash was just a pipe dream since no one had figured out how to prevent people from easily making multiple copies (i.e., counterfeiting) electronic money. Bitcoin resolved this problem in some ingenious ways.

First, the inventor of Bitcoin eliminated the need for us to scan our existing bills and coins into electronic money, thereby inflating the money supply. Instead of scanning paper money and coins into electronic currency and destroying the originals as contemplated in the hypothetical above (which would be illegal in any event), the founder of Bitcoin created a computer algorithm that "produces" a whole new type of electronic money, called "Bitcoins", at a predetermined rate and right on your hard drive. Thus, Bitcoins aren't simply copy of your existing money, they are newly "made" money.

Because they are newly made and clearly different from exiting fiat currencies, they are not counterfeit and therefore do not inflate the money supply. For instance, making more Bitcoins does not impact the value of the US dollar anymore than the European Central Bank printing more Euros impacts the value of the dollar. More Euros reduces the value of each Euro, but it does not reduce the value of dollars. In a like manner, more Bitcoins reduces the value of each Bitcoin, but it doesn't impact the value or purchasing power of any other currency, at least not initially.

So, what gives each Bitcoin its value then? The same thing that gives any currency value--the willingness of others to accept it for goods or services or in payment of debt. And why would people be willing to accept Bitcoins? Because they are so freaking convenient, because they eliminate the middle man (banker), because they are easily divisible and transferable, and for at least a dozen other reasons.

To prevent people from counterfeiting Bitcoins, or altering the rate at which Bitcoins are created (and for other reasons), the Bitcoin software, which is available to anyone for free on the web, is hard-coded to award newly "minted" Bitcoins only when a given computer (any computer, even your computer) solves a very complex math problem. When that computer solves the problem, and can prove conclusively that it did so to other computers in the Bitcoin network, all computers in the network will recognize the "creation" of new Bitcoins by that computer, and those Bitcoins are deemed by the network to be owned by the computer that generated them, or rather the possessor of that computer. Because solving this very difficult math problem takes time (more than a year of processing for today's average desktop computer), and because only Bitcoins generated by a computer that can "prove" to others in the network in a verifiable and theoretically incorruptible way that it has solved the problem are recognized as authentic, counterfeiting Bitcoins is theoretically impossible. In fact, each electronic Bitcoin itself contains this "proof-of-work", proof of having solved the problem, within it.

Currently, over six million Bitcoins have been created in the manner described above and, at the time of this writing, each one is valued on the largest public Bitcoin exchange ( as being worth about $16 US dollars. After twenty-one million Bitcoins are so created, which will take many more years (till after 2030 by current projections), the process will end and mathematically no more Bitcoins will or even can be created. Or, if they are, they will not be recognized by the network as authentic. Thus, unlike fiat currencies which can be inflated or deflated in amount at the whim of some central bank or issuing government, the world's supply of Bitcoins will eventually become fixed.

While this requirement that each "created" Bitcoin contain proof of being the product of a computer having solved a very complex and time-consuming math problem largely solves the problem of counterfeiting, there remains the possibility of "double spending". In other words, once I've generated some Bitcoins via my computer, or obtained some in normal commerce, what keeps me from spending them more than once? After all, I could email some to you, but then forward that same email, with Bitcoins attached, to my friend, John.

In our present system, the "trusted" intermediary, the bank, prevents double spending. When I write you a check, the bank takes money from my account when it credits it your account. It's a zero sum game. Sure, I can overdraw my account by writing a subsequent bad check to you or someone else, but only those payees who present their checks to the bank first, while I still have money in my account to cover them, will actually get paid by the bank. The others get stiffed. By stiffing the others, the trusted intermediary insures that no new money is created as a result of my bogus checks. The integrity of the system is thus preserved, albeit at the expense of the stiffed party.

The Bitcoin Way

Since the whole purpose of Bitcoins is to do away with the trusted but expensive intermediary and make dealing in cash just as easy as dealing with checks and credit cards, the Bitcoin network resolves the double spending problem differently. When I send Bitcoins to someone (I don't actually do it by email but via a different software program--a "Bitcoin client"), the system automatically sends notification to every other computer in the network telling them exactly how much I sent, and to whom, and when. Thus, contrary to what has been implied in some media reports, every single Bitcoin transaction is public knowledge. With one important exception/protection that I will note below, anyone in the system can know at any given moment exactly how many Bitcoins I have, or anyone else has. And, they can also tell where I got them from. And where that person got them from, etc. Thus, because every transaction is instantaneously broadcast to the network in real time, double spending Bitcoins is all but impossible. In essence, everyone can see inside my/your/their wallet at any given moment!

Although broadcast of transaction information is instantaneous, not every computer in the Bitcoin network is always turned on. Thus, it may take some time, minutes or even hours or days, for knowledge of a given transaction to completely satiate the network. In the meantime, couldn't one of the computers without the complete transaction history be duped into excepting double-spent Bitcoins? If computer A didn't know that computer B had spent all its coins already, couldn't it be duped into accepting Bitcoins from B (analogous to B writing a bad check)?

Not really. Complete satiation of the network isn't really necessary to protect network participants. When a computer joins or rejoins the network, it simply queries all other computers in the network (called "nodes") to figure out which one has the longest, and therefore the most complete, Bitcoin transaction history. It, along with all others in the network, will then adopt the contents of the longest transaction history as its own. Only Bitcoins that are properly accounted for and recorded in the complete transaction history are recognized as valid by other computers in the network. Double spending, while theoretically possible, is extremely difficult in practice.

Furthermore, even if a computer were temporarily duped into accepting double spent Bitcoins, other computers in the network, the ones with the complete transaction history, wouldn't recognize the transaction as legitimate. Thus, the duped computer would be "stiffed" by the others in the network. The transfer of Bitcoins to the duped computer would be ignored. Such is the price for maintaining the integrity of the system. While this system is not perfect, it's far better than our current system where duping someone is as easy as writing a bad check (double-spending Bitcoins is far more difficult).

Privacy and Safety

But this ability to effectively see into everyone's wallet raises at least two other issues: Privacy and safety. After all, advertising one's wealth is a great way to make oneself a target! Would you feel comfortable publicly broadcasting to the world that you currently have $10,000, $100,000, $200,000 or even $1,000,0000 in CASH sitting at your home or office? Would you walk down the street broadcasting to the world that you had $10,000 in cash on your person at that very moment? Of course not. And, this is true even if you obtained every bit of that cash entirely legally. Thus, contrary to media report, the confidentiality built into Bitcoin (discussed below) is not JUST a privacy thing, and it's primary purpose is not to facilitate illegal actively. Rather, confidentiality is a SAFETY and SECURITY thing. Unlike banks, homes, offices and cell phones are not, by and large, protected fortresses.

Bitcoin resolves this confidentiality problem, and therefore the safety, security, and privacy problems, in very simple way: All Bitcoin transactions are reported to the network as taking place between two anonymous ID numbers, not two individual humans or businesses. Thus, when Bitcoin publicly broadcasts a transaction, it does NOT actually tell the world who the parties to that transaction were by name. Rather, it publicly broadcasts the ID number of the party that the money transferred from, the ID number of the party it transferred to, when it transferred, and how much was transferred. Thus, if I send ten Bitcoins from my ID number XYZ123 to your account ID number ABC456, Bitcoin would simply broadcast to the world that ID number XYZ123 just sent ten Bitcoins to ID number ABC456. That's it. Unless you or I tell others, nobody knows the persons or businesses behind each ID number.

But, if we engage in enough transactions with enough people, many will eventually come to know that ID number XYZ123 belongs to me, right? After all, people can't send me Bitcoins if they don't know my ID number, and vice versa. Since anyone who knows my ID number can then look it up in the network at anytime and see how many Bitcoins it contains, my privacy (and potentially my safety and security) is once again compromised.

To resolve this, the Bitcoin client lets you create as many ID numbers on your computer as you want (ID numbers, however, are actually called "Bitcoin addresses" rather than "ID numbers", but don't let the lingo throw you off). Importantly, neither the Bitcoin client nor the Bitcoin network keeps track of who "owns" each ID number.

So, I could, if I wanted, create a new ID number (Bitcoin address) for every single transaction in which I, or rather my computer, engages. Creating new ID numbers for each transaction could be automated so that I don't even have to think about it. So, for instance, I could have Peter send Bitcoins to one of my account numbers for legal work that I provided him today and another for legal work that I provide him tomorrow. Paul could send Bitcoins to yet another ID number to buy my golf clubs, and Mary to yet a third to reimburse me for the lunch I bought her. Same for James, Donald, Cindy, Carla, Marla, your employer, etc. Anytime I want someone to send me Bitcoins, my Bitcoion client can create a new, unique ID number for that transaction. No one in the Bitcoin network, save possibly the person sending me the Bitcoins, knows who is behind that ID. All my ID's are totaled by the Bitcoin client software on my computer so that I can tell at any moment how many Bitcoins I have in total.

Thus, each person with whom I conduct business only knows a few of my ID numbers, one for each transaction I have with them (if I'm smart). If Mary ever looks up the ID number that I gave her so she could reimburse me for lunch, she will be able to see only how many Bitcoins I have logged under that ID at that moment, if any. Neither she, nor anyone else, has any way to determine which other ID's on the Bitcoin network belong to me.

And, if I'm smart, I won't leave much money under the ID number that I gave to Mary or Peter or Paul or Paul. Rather, I will transfer the money out of that ID number to another that no one else knows I own. Again, this process could be automated. Thus, if Mary bothers to look, she could see the money she gave me leaving the ID that she knows about, and she can even tell where it went, but she won't know who is behind the receiving ID. Did I transfer the money to another of my ID's? To my wife's? Or to the electric company to pay my electric bill? Or to Walmart to buy shoes? Mary can't know.


In short, that's what Bitcoin is: Electronic cash that can be "emailed" from person to person with no intermediary, the supply of which is predetermined and can't be manipulated, and the value of which is determined solely by market forces. If successful, Bitcoin will undermine the foundations of our financial system in the same way that another peer-to-peer network, BitTorrent, undermined the foundations of the music and movie industries. Vested interests, big and powerful vested interests, will now doubt resist, but it remains to be seen whether they will be any more successful in restricting Bitcoin than they have been at limiting BitTorrent.