Section 831(b) “Micro-Captive” Transactions Now a Transaction of Interest
The Treasury and IRS have materially turned up the pressure and sharpened their focus on transactions involving small captive insurance companies – the so-called “micro-captive transaction” as they refer to the transaction in recently issued Notice 2016-66 (the “Notice”). We have previously issued an alert on small captive insurance companies and advised on recent changes in their taxation . That the Treasury and IRS are taking such action should come as little surprise, given that the IRS has placed micro captives on its “Dirty Dozen” list of tax scams for the last two years.
As described in the Notice, in this type of transaction, a taxpayer typically attempts to reduce taxable income of the taxpayer, related parties, or both, using contracts that the parties treat as insurance contracts as well as a related company that the parties treat as a captive insurance company. Reinsurance or pooling arrangements may be involved. Each entity that the parties treat as an insured entity under the contracts claims deductions for premiums for insurance coverage. The micro-captive transaction is structured so that the captive has no more than $1,200,000 in net premiums written (or if greater, direct premiums written) for each taxable year ($2,200,000 for taxable years beginning after December 31, 2016) in which the transaction is in effect. The related company that the parties treat as a captive insurance company elects under IRC Sec. 831(b) (“Alternative Tax for Certain Small Companies”) to be taxed only on investment income and therefore excludes the payments directly or indirectly received under the contracts from its taxable income.
However, Treasury and the IRS take the view that the manner in which the contracts are interpreted, administered and applied is inconsistent with arm’s-length transactions and sound business practices, e.g., the coverage involves an implausible risk; the coverage does not match a business need or risk of the insured; the description of the scope of the coverage in the contract is vague, ambiguous or illusory; and/or the coverage duplicates coverage provided to the insured by an unrelated commercial insurance company and the policy with the commercial insurer has a far smaller premium. Amounts paid to the captive, claims procedures and management of the captive, the captive’s capital, the use of an intermediary, and the claimed tax treatment and benefits are also viewed by the IRS as suspect.
Accordingly, transactions that are the same as, or substantially similar to, the transaction described in the Notice are now identified as a “transaction of interest,” effective November 1, 2016. Persons entering into these transactions on or after November 2, 2006 must disclose the transactions as described below. Material advisors also have disclosure and list maintenance obligations under this Notice.
A transaction of interest is a transaction that is the same or substantially similar to one of the types of transactions that the IRS has identified by notice (such as this Notice), regulation or other form of published guidance as a transaction of interest. It is a transaction that the IRS and Treasury believe has a potential for tax avoidance or evasion, but for which there is not enough information to determine if the transaction should be identified as a “listed transaction.” And indeed, the Notice indicates that Treasury and the IRS lack sufficient information to identify which IRC Sec. 831(b) arrangements should be identified specifically as a tax avoidance transaction (i.e., listed transaction) and may lack sufficient information to define the characteristics that distinguish the tax avoidance transactions from other IRC Sec. 831(b) related-party transactions.
While not a listed transaction, a taxpayer’s micro-captive transaction may be challenged under other provisions of the Code or judicial doctrines such as sham transaction, substance over form, or economic substance.
The Transaction of Interest
Specifically, the Notice describes the transaction of interest as follows:
- A, a person, directly or indirectly owns an interest in an entity (or entities) (“Insured”) conducting a trade or business;
- An entity (or entities) directly or indirectly owned by A, Insured, or persons related to A or Insured (“Captive”) enters into a contract (or contracts) (the “Contracts”) with Insured that Captive and Insured treat as insurance, or reinsures risks that Insured has initially insured with an intermediary (“Intermediary”);
- Captive makes an election under IRC Sec. 831(b) to be taxed only on taxable investment income;
- A, Insured, or one or more persons related (under prescribed related taxpayer rules) to A or Insured directly or indirectly own 20% of the voting power or value of the outstanding stock of Captive; and
- One or more of the following apply—
- The amount of the liabilities incurred by Captive for insured losses and claim administration expenses during the Computation Period (defined below) is less than 70% of (A) premiums earned by Captive during the Computation Period, less (B) policyholder dividends paid by Captive during the Computation period; or
- Captive has at any time during the Computation Period directly or indirectly made available as financing or otherwise conveyed or agreed to make available or convey to A, Insured, or a person related to A or Insured (collectively the “Recipient”) in a transaction that did not result in taxable income or gain to Recipient, any portion of the payments under the Contract, such as through a guarantee, a loan, or other transfer of Captive’s capital.
The Computation Period is the most recent five taxable years of Captive, or if Captive has been in existence for less than five taxable years, the entire period of Captive’s existence. Also, if Captive has been in existence for less than five years and Captive is a successor to one or more Captives created or availed of in connection with a transaction described in the Notice, taxable years of the predecessor entities are treated as taxable years of Captive. A short taxable year is treated as a taxable year.
The Notice observes that there may be limited circumstances in which a captive insurance company arrangement that provides for employee compensation or benefits is identified as a transaction of interest under this Notice. If such arrangement is one for which the Employee Benefits Security Administration of the U.S. Department of Labor has issued a Prohibited Transaction Exemption, it is not treated as a transaction of interest under the Notice.
Under the Income Tax Regulations and the instructions to Form 8886 (“Reportable Transaction Disclosure Statement”), the form which must be filed, the required disclosure must identify and describe the transaction in sufficient detail for the IRS to be able to understand the tax structure of the transaction and the identity of all parties involved in the transaction. All “participants” (which includes any person owning directly or indirectly an interest in the Insured, the Insured, the Captive or an Intermediary (if any)) must describe on Form 8886 when and how the taxpayer became aware of the transaction.
Captive must describe (on Form 8886) at least the following:
- Whether Captive is reporting because (i) the amount of the liabilities incurred by Captive for insured losses and claim administration expenses during the Computation Period is less than 70% of the amount described in “5(a)” above; (ii) Captive has at any time during the Computation Period made available as financing or otherwise conveyed or agreed to make available or convey any portion of the payments under the Contract to A, Insured or a person related to A or Insured through a separate transaction, such as a guarantee, a loan or other transfer; or (iii) both (i) and (ii).
- Under what authority Captive is chartered.
- A description of all type(s) of coverage provided by Captive during the year or years of participation.
- A description of how the amounts treated as premiums for coverage provided by Captive during the year or years of participation were determined, including the name and contact information of any actuary or underwriter who assisted in these determinations.
- A description of any claims paid by Captive during the year or years of participation, and of the amount of, and reason for, any reserves by Captive on the annual statement.
- A description of the assets held by Captive during the year or years of participation, i.e., the use Captive has made of its premium and investment income, including but not limited to, securities (whether or not registered), loans, real estate, or partnerships or other joint ventures, and an identification of the related parties involved in any transactions with respect to those assets.
Form 8886 must be attached to the taxpayer’s tax return or information return, including amended returns, for each tax year in which the taxpayer participates in the transaction of interest. In the case of the initial year filing of Form 8886, an exact copy of the form is to be sent to the Office of Tax Shelter Analysis (“OTSA”) when the tax return is filed. However, for prior tax years for which the period of limitations for assessment of tax is still open, taxpayers have until January 30, 2017 to file the required disclosure with OTSA.
Persons required to disclose these transactions who fail to do so are subject to significant penalties. The penalty is 75% of the reduction in the tax reported on the income tax return as a result of participation in the transaction (or that would result if the transaction were respected for federal tax purposes), but not less than $5,000 in the case of an individual and $10,000 in any other case. The annual maximum penalty for failure to disclose a reportable transaction other than a listed transaction (e.g., a transaction of interest) cannot exceed $10,000 in the case of an individual and $50,000 in any other case. This penalty is assessed for each failure by an individual or entity required to file Form 8886 if the individual or entity fails to attach Form 8886 to the appropriate original or amended return, fails to file the form with OTSA, if required, or files a form that fails to include all the information required (or includes incorrect information). In addition, the IRS may impose other penalties on parties involved in these transactions, including an accuracy-related penalty.
The identification of certain transactions involving small captive insurance companies as a “transaction of interest,” and the resulting obligatory tax filings, is likely to significantly dampen the enthusiasm for using these vehicles. The endgame of Treasury and the IRS is surely the ultimate “upgrading” of certain more egregious transactions to “listed transaction” status, but by their own admission, they are still trying to obtain the necessary information to make that determination. The tax filings mandated by this Notice will help facilitate that education process. However, in the meantime, all micro-captive insurance arrangements will be adversely impacted (both transactions that are arguably problematic as well as those that have strong business purpose) due to the filing requirements discussed above. That is an unfortunate yet inevitable consequence of this process.