The CIC Services1 decision recently handed down by a federal district court in Tennessee has drawn the attention of those involved in microcaptive insurance transactions, other taxpayers engaged in reportable transactions, and administrative law watchers. The business that brought the lawsuit, CIC Services, an adviser and manager of microcaptive insurance transactions, had previously secured a U.S. Supreme Court victory in which the Court held that the company’s suit was not precluded by the Anti-Injunction Act. On remand to district court, CIC Services now has another win — this time with the court invalidating Notice 2016-66, which classifies certain microcaptive arrangements as reportable transactions. This article examines the possibly far-reaching implications of the federal district court’s March 2022 holding. Before delving into the decision and its broader repercussions, however, it may be helpful to review what microcaptive insurance arrangements are, the IRS’s efforts to crack down on their abuse, and the prior developments in the CIC Services litigation.
Microcaptive insurance companies
To protect against certain risks, businesses can create “captive” insurance companies that are typically owned by the business’s owners or family members. There are tax advantages to this arrangement because the insured party can deduct the premium payments as a business expense. In addition, under a provision in the Code that benefits small insurers, the insurance company can exclude from taxable income up to $2.45 million of premium payments per year by electing under Sec. 831(b) to be taxed only on its investment income. As a result, the insured party can take a deduction and there is no corresponding tax on the captive insurer. These small insurance companies are referred to as “micro” captives.
If these arrangements are used for real insurance purposes, the Code permits them. However, the arrangements set up by business owners (often on the advice of unscrupulous promoters or advisers), frequently lack the true attributes of insurance, for example, by insuring implausible risks, failing to address genuine business needs, duplicating the business’s commercial insurance coverage, or charging excessively high “premiums.”
To help curb microcaptive insurance abuses, the IRS issued Notice 2016-66. As background, the Service has authority under the American Jobs Creation Act of 20042 to collect information about potential tax shelters and impose civil and criminal penalties upon taxpayers failing to disclose reportable transactions. Although Congress instructed the IRS to define reportable transactions “under regulations,” the IRS began to issue subregulatory guidance via IRS notices. In Notice 2016-66, the Service announced that Sec. 831(b) microcaptive insurance transactions substantially similar to the transaction described in the notice would be classified as transactions of interest that are reportable transactions requiring disclosure under Regs. Sec. 1.6011-4 and Secs. 6011 and 6012.
CIC Services case
CIC Services, a Tennessee-based captive insurance manager and material adviser to taxpayers that participate in microcaptive transactions, challenged Notice 2016-66 in district court. It argued the IRS violated the Administrative Procedure Act (APA) in promulgating the notice and requested that the court hold that the notice is invalid. Specifically, CIC Services argued the notice violated the APA in two ways: (1) It was arbitrary and capricious, and (2) the IRS failed to engage in standard notice-and-comment rulemaking as required by the APA.
Rather than address the APA claims, the IRS initially fought the case by arguing that the suit was blocked by the Anti-Injunction Act (Sec. 7421) — a law originally enacted in 1867 that prevents taxpayers from stopping the IRS from assessing and collecting taxes. The district court for the Eastern District of Tennessee agreed with the IRS that CIC Service’s claims were barred by the Anti-Injunction Act and dismissed the case for lack of jurisdiction.3 A divided Sixth Circuit affirmed the district court’s decision.4
Supreme Court holding
CIC Services appealed the case to the U.S. Supreme Court.5 In May 2021, the Court unanimously reversed the Sixth Circuit decision. It held that the Anti- Injunction Act did not prevent CIC Services from filing suit to invalidate Notice 2016-66. The Court offered several reasons for its holding, including that CIC Services should not have to intentionally violate the law — risking criminal liability and ruinous civil penalties — in order to secure its day in Court. The Supreme Court decision, which was discussed in the August 2021 issue of The Tax Adviser,6 meant that CIC Services could move forward with its lawsuit.
District court decision
Now able to reach the merits of the case, the district court for the Eastern District of Tennessee issued a March 2022 opinion in favor of CIC Services. The court vacated Notice 2016-66 because the IRS had not followed the APA’s notice-and-comment procedures in promulgating the notice and the notice was arbitrary and capricious under the APA. This outcome is a major blow to the IRS and its ability to require reporting on Form 8886, Reportable Transaction Disclosure Statement, for Sec. 831(b) microcaptives.
Notice-and-comment procedures; Mann Construction
The IRS argued that it was exempted from complying with the APA’s notice-and-comment procedures or, in the alternative, that the notice was not a legislative rule that required notice and comment. The district court took into consideration a recent Sixth Circuit opinion not involving microcaptives, Mann Construction, Inc.,7 handed down just 2½ weeks earlier. In Mann, the Sixth Circuit held that the lack of a notice-and-comment period as required in the APA invalidated a similar notice in which the IRS designated certain cash value life insurance trusts as reportable transactions.
Because Tennessee is part of the Sixth Circuit, the district court found that it was bound by the Sixth Circuit’s analysis in Mann, which applied equally to the arguments advanced regarding Notice 2016-66. As the Sixth Circuit had held with respect to the notice in Mann, the court held that the IRS was not exempt from the APA notice-and-comment procedures and Notice 2016-66 was a legislative rule subject to those procedures.
Arbitrary and capricious action
Besides holding that notice-and comment procedures must be followed, the court also found that Notice 2016-66 was arbitrary and capricious under the APA. In Department of Commerce v. New York, 139 S. Ct. 2551 (2019), the Supreme Court held that in determining whether an agency action is arbitrary and capricious under the APA, a court looks at whether an agency examined the relevant data in making its decision and articulated a satisfactory explanation for it, including a rational connection between the facts the agency found and the choice it made.
In the case of Notice 2016-66, the district court found that the IRS’s administrative record showed no evidence that the IRS had examined relevant data or articulated a satisfactory explanation for listing microcaptives as reportable transactions. The IRS’s only rationale for issuing the notice, according to its own administrative record, was that the Service “believed” there was the potential for tax avoidance or evasion in microcaptive transactions, and consequently these were transactions of interest that were reportable transactions. The court found this explanation lacking because the IRS had provided no underlying data or facts to support the IRS position that microcaptives have the potential for tax avoidance or evasion. As a result, the court concluded that besides not being promulgated according to APA noticeand- comment procedures, the notice was also an arbitrary and capricious action of the IRS.
Having determined that the IRS had not followed the required APA notice-and-comment procedures and that the issuance of Notice 2016-66 was arbitrary and capricious, the court considered the appropriate relief it should grant CIC Services. In its amended complaint, CIC Services asked the court to set aside Notice 2016-66, to enjoin all agencies from enforcing the notice and offering documents produced by any individual or entity in response to the notice in judicial or administrative proceedings, and to require the IRS to destroy or return materials produced in response to the notice. The IRS argued that the court should not set aside the notice and, instead, should leave it in place, pending the IRS’s promulgation of a new or amended rule. The IRS alternatively argued that the court should limit its vacating of the notice to CIC and should not grant any of CIC’s requested injunctive relief.
The court granted some but not all of CIC Services’ requested relief. The court granted the company’s request that Notice 2016-66 be set aside in its entirety. While the court noted that the IRS might be able to rectify the problems with Notice 2016-66 in promulgating a new rule, it concluded that nothing about the IRS’s actions supported leaving the notice in place while the Service took the actions necessary to comply with the APA or vacating the notice as to CIC only. In support of this conclusion, it pointed to the Sixth Circuit’s prior observations that the IRS did not have a great history of complying with APA procedures8 and that it does not follow the “basic rules of administrative law.”9
The court initially also held that the IRS must return all documents and information collected under the notice, including those collected from nonparty taxpayers and material advisers. However, the court later narrowed its order to exclude materials submitted by nonparty taxpayers and material advisers. The court explained that because CIC Services was the only plaintiff in the case and had not filed a class action, “the Court should not have ordered affirmative injunctive relief that extends to nonparty taxpayers and material advisors.”10
The court, however, refused CIC Services’ request to issue an injunction to bar agencies from offering in judicial or administrative proceedings any documents that had been produced in response to the notice. The court, observing that Notice 2016-66 was only one possible source for the documents for the IRS, found that granting this relief might prevent the IRS from using for the public’s benefit documents that it had lawfully acquired in the future and would in effect create future litigation over how and when the IRS received documents in its possession. The court appeared to be balancing the IRS’s need for information that would benefit the Service in its investigative work on behalf of the public against the fact that the IRS had not followed proper administrative procedures.
Broader implications of CIC Services
The district court’s decision in CIC Services appears to remove the Form 8886 filing requirement for microcaptive arrangements for taxpayers within its jurisdiction, but the IRS can continue to contest the issue in other jurisdictions. Will the IRS try to relitigate the case elsewhere, in other federal circuits? And what about taxpayers who are subject to reporting obligations because of reportable transaction designations made by different IRS notices that may be similarly defective under the APA? Taxpayers in these circumstances may wonder whether it is truly necessary to file Form 8886. But given the large penalties for failing to comply with Form 8886 filing requirements, taxpayers must carefully weigh the risks of not reporting against the very burdensome disclosure requirements.
Before highlighting the hefty penalties that can be imposed for noncompliance, it is worth discussing the preparation time necessary to complete Form 8886.
Form 8886 disclosure requirements
For many material advisers, Forms 8886 are filed for numerous — sometimes hundreds — of clients. The instructions to Form 8886 suggest a total estimated preparation time of over 21 hours per submission due to the lengthy requests for disclosure.
For example, for Sec. 831(b) captive transactions such as those at issue in CIC Services, Notice 2016-66 indicates all named persons, including the business owner, the insured, and the captive, must meet the disclosure obligations for all years in which their respective tax returns reflect tax consequences or a tax strategy.11 This results in an annual filing requirement of multiple Forms 8886 for most microcaptives.
The voluminous disclosure requirements create a substantial time and reporting requirement for taxpayers. The table “Form 8886 Disclosures” (at the end of this article) outlines the basic Form 8886 disclosures and the disclosures specific to Sec. 831(b) microcaptive arrangements.
Large penalties for noncompliance
Many taxpayers file Form 8886 because they want to avoid the significant penalties for noncompliance. Failure to properly disclose reportable microcaptive transactions under Regs. Sec. 1.6011-4 can lead to a penalty under Sec. 6707A. The penalty is generally 75% of the reduction in tax as a result of participation in the transaction but not less than $5,000 for an individual and $10,000 for any other case. The maximum annual penalty under Sec. 6707A is $10,000 for an individual and $50,000 in any other case.
In its recent hiring initiatives, the Service has signaled its continuing commitment to pursue microcaptives.
The IRS may also impose accuracyrelated penalties under Sec. 6662 or 6662A for reportable transaction understatements. The accuracy-related penalty under Sec. 6662A is 20% (or 30% in certain circumstances) of the reportable transaction understatement.
IRS’s possible next steps on microcaptives
Only time will tell how the district court’s decision in CIC Services will affect microcaptive litigation in other circuits. There are many microcaptives with litigation currently pending with the IRS. There are indications from recent microcaptive cases that the IRS may be reevaluating its litigation efforts based on CIC Services.
For example, in October 2021, following the Supreme Court decision in CIC Services, the IRS conceded its $2.7 million Sec. 831(b) microcaptive case against Puglisi Egg Farms.12 Puglisi Egg Farms, a privately held Delaware egg farm, sought to cover risks for which commercial insurance is not available, such as avian influenza, and formed a captive insurance company managed by Oxford Risk Management Group. Prior to going to trial, the IRS conceded, for undisclosed reasons, almost all taxes and penalties assessed under Sec. 6662.
Following the Mann and CIC Services rulings, the question remains whether the IRS will continue to litigate similar cases in other courts, or if more cases will be resolved similarly to the Puglisi case. The Service might also decide to issue a new notice or promulgate regulations, as discussed next.
IRS could issue a new notice
One alternative for the IRS is to issue a new notice for microcaptives that would allow for a notice-and-comment period, given that the CIC Services and Mann decisions limit the Service’s ability to make transactions reportable without following APA procedures. There are several potential concerns with this option from the IRS’s perspective.
Arbitrary and capricious standard remains a concern: One potential worry for the IRS is that microcaptive owners and advisers might challenge a new notice as being arbitrary and capricious. The CIC Services court emphasized that there must be evidence in the administrative record that the IRS “examined the relevant data” and provided a satisfactory explanation for reaching the decision to make microcaptives reportable transactions based on the potential for tax avoidance or evasion. The IRS would need to demonstrate, with sufficient data and research, that microcaptive transactions run the risk of tax avoidance or evasion in order for a new notice to be valid.
Notice and comment could result in a lengthy delay: Another potential concern for the Service with issuing a new notice involves potential delay. If the IRS believes the information collected on the Forms 8886 is valuable and difficult to ascertain through other auditing techniques, it may be beneficial to invest the time and effort to draft a new notice. However, the drafting process and notice-and-comment period may result in a lengthy time delay. During this review period, microcaptive activity may go unreported or there may be significant confusion about current reporting requirements.
IRS regulations could clarify valid microcaptives
Another option for the IRS is to issue proper regulations for microcaptives. Properly issued guidance (i.e., what the courts ruled was not done in Mann or CIC Services) is designed to produce sensible, meaningful, and clear rules with at least some public input. In this instance, regulations could provide clarity to taxpayers to determine what is and what is not a valid microcaptive insurance arrangement. Currently, in the absence of clear regulatory guidance, case law has been the primary means of establishing key definitional aspects.
The Tax Court’s 2017 decision in Avrahami13 addressed when a microcaptive arrangement may qualify as insurance for federal tax purposes. The four requirements for valid insurance set out in Avrahami14 are whether the arrangement involves (1) risk shifting, (2) risk distribution, and (3) insurance risk, and (4) looks like commonly accepted notions of insurance. Regulations could expand taxpayers’ understanding of these criteria and provide more certainty about the proper structuring of microcaptives. Regulations could also help the IRS police abusive microcaptive transactions by clarifying when premiums paid to a microcaptive may not be properly labeled as deductible.
A continuing IRS enforcement priority
Will the IRS treat the CIC Services decision as a one-off win for taxpayers, or will the decision lead the IRS to revise how it pursues microcaptive insurance arrangements as reportable transactions? In its recent hiring initiatives, the Service has signaled its continuing commitment to pursue microcaptives, which may suggest that it will decide to draft a new notice to correct the deficiencies in Notice 2016-66. Notably, the Office of Chief Counsel announced plans in January 2022, shortly before the decision in favor of CIC Services, to hire up to 200 additional attorneys to focus on tax schemes such as abusive microcaptive insurance arrangements.15 IRS Commissioner Charles Rettig was quoted in a news release as saying: “Combating abusive tax transactions that threaten to undermine our tax system remains a top priority for our enforcement efforts.” The IRS also warned that abusive microcaptive insurance arrangements continue to be a key area of focus for IRS enforcement.
As a result of Mann and CIC Services, tax advisers should be prepared to advise clients with microcaptives who have previously been involved in litigated cases or who have current disclosure requirements. Matters worth discussing may include whether to seek a penalty refund or what litigation strategy to adopt for current cases.
Form 8886 disclosures
The basic Form 8886 disclosures include:
1. Name of the reportable transaction including the initial year of participation and reportable transaction number (provided by material adviser).
2. Name, contact information, and fees paid to adviser/promoter related to the transaction.
3. The facts of the reportable transaction including types, amounts, and duration of tax benefits generated, investment/ basis in the transaction, and all individuals/entities involved in the transaction.
Specific to Sec. 831(b) microcaptives, Notice 2016-66 also requires the following disclosures:
1. Whether the captive is reporting because it is described in:
a. Section 2.01(e)(1) of Notice 2016-66 (i.e., fails the 70% test); or
b. Section 2.01(e)(2) of Notice 2016-66 (i.e., provides certain financial benefits to related parties including guarantees or loans);
2. Under what authority the captive is chartered;
3. A description of the type(s) of coverage provided by the captive during the year(s) of participation;
4. A description of how the amount of premiums was determined during the year or years of participation including the name and contact information of any actuary or underwriter who assisted with premium determinations;
5. A description of claims paid and reserves reported by the captive during the year(s) of participation and amount and reason for any reserves reported on the annual statement; and
6. A description of the assets held by the captive during the year(s) of participation including identification of related parties involved in any asset transactions.
1CIC Services, LLC, No. 3:17-cv-110 (E.D. Tenn. 3/21/22), modified on rehearing (6/2/22).
2American Jobs Creation Act of 2004, P.L. 108-357.
3CIC Services, LLC, No. 3:17-cv-110 (E.D. Tenn. 11/2/17).
4CIC Services, LLC, 925 F.3d 247 (6th Cir. 2019).
5CIC Services, LLC, 141 S. Ct. 1582 (2021).
6 Beavers, “Suit Challenging Information Reporting Requirements Can Go Forward,” 52 The Tax Adviser 534 (August 2021).
7Mann Construction, Inc., 27 F.4th 1138 (6th Cir. 2022).
8CIC Services, LLC, 925 F.3d 247, 258.
9CIC Services, LLC, 936 F.3d 501, 507 (6th Cir. 2019).
10CIC Services, LLC, No. 3:17-cv-110 (E.D. Tenn. 6/2/22).
11In relation to this, see Regs. Sec. 1.6011-4(c)(3)(i)(E).
12Puglisi, No. 4796-20 (Tax Ct. 10/29/21) (unpublished order).
13Avrahami, 149 T.C. 144 (2017). For more, see Yasmeh, “Beware of IRS Initiatives Against Microcaptive Insurance Arrangements,” 52 The Tax Adviser 677 (November 2021).
14Adopted from Le Gierse, 312 U.S. 531, 539 (1941).
15IRS News Release IR-2022-17.
Kaitlin Newkirk, CPA, MST, M.Acc., is an assistant professor in the Williams College of Business at Xavier University in Cincinnati. Sarah Webber, CPA, J.D., LL.M., is an associate professor in the School of Business Administration at the University of Dayton in Dayton, Ohio. For more information about this article, contact firstname.lastname@example.org.
Yasmeh, “Beware of IRS Initiatives Against Microcaptive Insurance Arrangements,” 52 The Tax Adviser 677 (November 2021)
“What You Need to Know About Captive Insurance Companies” (Dec. 11, 2020), with Bob Keebler, CPA/PFS, and David Slenn, J.D.
AICPA & CIMA National Tax & Sophisticated Tax Conference, Oct. 31–Nov. 1, 2022, Washington, D.C., and live online
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