IRS targets ‘micro-captive transactions’ as transactions of interest

Editor: Kevin D. Anderson, CPA, J.D.

On Nov. 1, 2016, the IRS issued Notice 2016-66, in which it identified a particular transaction involving captive insurance companies (“micro-captive transaction”) that it believes has a potential for tax avoidance or evasion. In issuing this notice, Treasury and the IRS continue their scrutiny of captive insurance transactions that they deem to be abusive. They expressed concern regarding the use of the micro-captive transaction as an attempt to create deductions for a policyholder that would not be treated as income to the captive insurance company due to the ability to elect under Sec. 831(b) to tax certain small captive insurance companies on their investment income only (i.e., the premium income would not be subject to federal income tax). Many taxpayers have attempted to use such Sec. 831(b) captives as estate planning techniques.

As described in the notice, in these micro-captive transactions:

a taxpayer attempts to reduce the aggregate taxable income of the taxpayer, related persons, or both, using contracts that the parties treat as insurance contracts and a related company that the parties treat as a captive insurance company. Each entity that the parties treat as an insured entity under the contracts claims deductions for premiums for insurance coverage. The related company that the parties treat as a captive insurance company elects pursuant to [Sec.] 831(b) to be taxed only on investment income and therefore excludes the payments directly or indirectly received under the contracts from its taxable income.

According to the notice, “the manner in which the contracts are interpreted, administered, and applied is inconsistent with arm’s-length transactions and sound business practices.”

Designation of certain micro-captive transactions as ‘transactions of interest’

With Notice 2016-66, Treasury and the IRS acknowledge that related parties may use captive insurance companies that make elections under Sec. 831(b) “for risk management purposes that do not involve tax avoidance.” However, they also believe that there are cases in which taxpayers are using such arrangements to improperly claim the tax benefits. Therefore, Treasury and the IRS decided to identify certain transactions described in the notice (and transactions substantially similar to these transactions) as transactions of interest for purposes of Regs. Sec. 1.6011-4(b)(6) and Secs. 6111 and 6112.

Section 2.01 of Notice 2016-66 identifies the following as transactions of interest:

(a) A, a person, directly or indirectly owns an interest in an entity (or entities) (“Insured”) conducting a trade or business;

(b) 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, CompanyC;

(c) Captive makes an election under [Sec.] 831(b) to be taxed only on taxable investment income;

(d) A, Insured, or one or more persons related (within the meaning of [Sec.] 267(b) or 707(b)) to A or Insured directly or indirectly own at least 20 percent of the voting power or value of the outstanding stock of Captive; and

(e) One or both of the following apply:

(1) the amount of the liabilities incurred by Captive for insured losses and claim administration expenses during the Computation Period … is less than 70 percent of the following:

(A) premiums earned by Captive during the Computation Period, less

(B) policyholder dividends paid by Captive during the Computation Period; or

(2) 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 (within the meaning of [Sec.] 267(b) or 707(b)) 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 notice defines the computation period as the captive insurance company’s five most recent tax years, or if it has been in existence for less than five tax years, the entire period of its existence. If the captive insurance company has existed for less than five tax years but is a successor to one or more captive insurance companies “created or availed of in connection with a transaction described in the notice,” these entities’ tax years are treated as tax years of the captive insurance company. For these purposes, a short tax year is treated as a tax year.

Implications for insurers

Transactions that are the same as, or substantially similar to, the transaction described in Section 2.01 of Notice 2016-66 are identified as “transactions of interest” for purposes of Regs. Sec. 1.6011-4(b)(6) and Secs. 6111 and 6112, effective Nov. 1, 2016. Persons entering into these transactions on or after Nov. 2, 2006, must disclose the transaction as described in Regs. Sec. 1.6011-4. Material advisers who make a tax statement on or after Nov. 2, 2006, with respect to transactions entered into on or after Nov. 2, 2006, have disclosure and list maintenance obligations of their own under Secs. 6111 and 6112.

In addition to being classified as transactions of interest, transactions that are the same as, or substantially similar to, the transaction described in Section 2.01 of Notice 2016-66 may also be subject to the requirements of Sec. 6011, 6111, or 6112, or the regulations thereunder. In the notice, the IRS says that when it and Treasury have “gathered enough information regarding potentially abusive” Sec. 831(b) arrangements, they may take further action, which could include “removing the transaction from the transactions of interest category in published guidance, designating the transaction as a listed transaction, or providing a new category of reportable transaction.” In the meantime, the IRS says it may challenge a position taken as part of a transaction that is the same as, or substantially similar to, the transaction described in Section 2.01 of Notice 2016-66 under other provisions of the Code or judicial doctrines such as sham transaction, substance over form, or economic substance.

For insurers, the first step will be determining if this designation will affect their businesses. Because of the issuance of Notice 2016-66, taxpayers (and material advisers) affected by the designation of the micro-captive transaction as a transaction of interest will need to meet the significant disclosure requirements by May 1, 2017, to avoid penalties. The original deadline for the disclosures was set for Jan. 30, 2017, but was extended to May 1, 2017, by Notice 2017-8.

In addition, Notice 2017-8 extended the 90-day period provided in Regs. Sec. 1.6011-4(e)(2)(i) to 180 days. That regulation requires taxpayers that have participated in a transaction that becomes a listed transaction or transaction of interest after their tax return is filed but before the end of the assessment limitation period for any year the taxpayer participated in the transaction to file a disclosure within 90 days after the date the transaction became a listed transaction or transaction of interest. The disclosures, which are made on Form 8886, Reportable Transaction Disclosure Statement, must identify and describe the transaction in sufficient detail for the IRS to be able to understand the tax structure of the transaction and identify all parties involved in it.

EditorNotes

Kevin Anderson is a partner, National Tax Office, with BDO USA LLP in Washington.

For additional information about these items, contact Mr. Anderson at 202-644-5413 or kdanderson@bdo.com.

Unless otherwise noted, contributors are members of or associated with BDO USA LLP.