In two separate posts over the past couple of years, we told you about the demise of Notice 2016-66 and the reporting requirements for so-called “micro-captive transactions”.
To briefly recap, in November, 2016, the IRS issued Notice 2016-66, which designated certain 831(b) captive insurance companies, called “micro-captive transactions” by the IRS, as transactions of interest. This designation imposed a reporting requirement on the captive, the insured and the owners of the captive and the insured; a reporting requirement that is satisfied by attaching Form 8886 to the tax returns of participants in the “micro-captive transaction”.
Shortly after Notice 2016-66 was issued, CIC Services filed a lawsuit challenging the Notice. Among the contentions in the lawsuit was the failure of the IRS to comply with the notice and comment requirements of the Administrative Procedure Act (APA). After a tortured litigation process, and in reliance on the Sixth Circuit’s decision in Mann Construction, Inc. et al v United States of America, the United States District Court for the Eastern District of Tennessee in CIC Services, LLC v Internal Revenue Service, Department of Treasury and the United States of America invalidated Notice 2016-66. Thus ended the reporting requirements for so-called “micro-captive transactions”.
Or, so we thought.
In response to its loss in the courts, the IRS published a Notice of Proposed Rulemaking and Notice of Public Hearing in the Federal Register on April 11, 2023. The Notice contains proposed regulations that designate certain “micro-captive transactions” as listed transactions and certain other “micro-captive transactions” as transactions of interest.
The Notice also states that comments are due sixty days after publication in the Federal Register and that a public hearing on the proposed regulations is scheduled for July 19, 2023, at 10:00 AM ET. In other words, even though the IRS contends that the courts were wrong in ruling that it had violated the APA, it has decided to comply with the notice and comment requirements of the APA in its efforts to reimpose a reporting obligation.
The IRS has proposed adding two, new subsections to Treas. Reg. section 1.6011 – section 1.6011-10 and section 1.6011-11; the first of which designates certain “micro-captive transactions” as listed transactions, and the second of which designates certain other “micro-captive transactions” as transactions of interest.
In the proposed regulations, the IRS designates certain “micro-captive transactions” as listed transactions. Treas. Reg. Section 1.6011-10(a) provides that:
(a) Identification as listed transaction. Transactions that are the same as, or substantially similar to, transactions described in paragraph (c) of this section are identified as listed transactions for purposes of section 1.6011-4(b)(2) . . .
Treas. Reg. 1.6011(c) provides that a transaction is described in this paragraph (c), and, therefore, is a listed transaction, if it is described in either paragraph (c)(1), (c)(2) or both. So, what do paragraphs (c)(1) and (c)(2) say?
A transaction is described in paragraph (c)(1) if it:
. . . involves a Captive that, at any time during the Financing Computation Period, directly or indirectly made available as financing or otherwise conveyed or agreed to make available or convey to a Recipient, in a transaction that did not result in taxable income or gain to the Recipient, any portion of the payments under the Contract, such as through a guarantee, a loan or other transfer of Captive’s capital . . .
A transaction is described in paragraph (c)(2) if it:
Involves a Captive for which the amount of liabilities incurred for insured losses and claim administration expenses during the Loss Ratio Computation Period is less than 65 percent of the amount equal to premiums earned by Captive during the Loss Ratio Computation Period less policyholder dividends paid by Captive during the Loss Ratio Computation Period.
In order to understand the foregoing, we need to understand the terms contained in the descriptions. The definitions of those terms are contained in Treas. Reg. 1.6011-10(b).
Captive means any entity that:
(i) Elects under section 831(b) of the Internal Revenue Code to exclude premiums from taxable income;
(ii) Issues a Contract to an Insured, reinsures a Contract of an Insured issued by an Intermediary, or both; and
(iii) Has at least 20 percent of its assets or the voting power or value of its outstanding stock or equity interests directly or indirectly owned, individually or collectively, by an Insured, an Owner, or persons Related to an Insured or an Owner.
Contract means any contract that is treated by a party to the contract as an insurance contract or reinsurance contract for Federal income tax purposes.
Insured means any person that conducts a trade or business, enters into a Contract with a Captive or enters into a Contract with an Intermediary that is directly or indirectly reinsured by a Captive and treats the amount paid under the Contract as insurance premiums for Federal income tax purposes.
Intermediary means any entity that issues a Contract to an Insured or reinsures a Contract that is issued to an Insured, and such Contract is reinsured, directly or indirectly by a Captive.
Owner means any person who, directly or indirectly, holds an ownership interest in an Insured or its assets.
Recipient means any Owner, Insured or person Related to an Owner or an Insured engaged in a transaction described in paragraph (c)(1) of this section.
Related means having a relationship described in one or more of sections 267(b), 707(b)(2)(C) and 2704(c)(2) of the Code.
Loss Ratio Computation Period means the most recent ten years of the Captive. A Captive that has not been in existence for ten years does not have a Loss Ratio Computation Period and is not described in paragraph (c)(2). (But, as discussed below, it can be a transaction of interest.)
Financing Computation Period is the most recent five taxable years of the Captive or all taxable years of the Captive if the Captive has been existence for less than five years.
This means that most 831(b) captive insurance companies that have been around for ten years or more will be a listed transaction under the regulations and required to file a Form 8886, notwithstanding the invalidation of Notice 2016-66. However, most does not mean all. So, how can a Captive avoid being a listed transaction and the reporting obligation?
There are two exceptions to the listed transaction designation contained in the proposed regulations; neither of which is relevant to this discussion. However, a Captive can avoid designation as a listed transaction, without reference to the exceptions, by failing to meet the descriptions in paragraphs (c)(1) and (c)(2) discussed above.
It should be easy for a Captive to avoid paragraph (c)(1). A Captive can avoid paragraph (c)(1) by not allowing an Owner, whether of the Captive or the Insured, access to its assets, other than through the payment of taxable dividends to the Captive’s Owners. The IRS takes the position that, if the Insured makes tax-deductible premium payments to the Captive, and the Captive, in turn, makes tax-free distributions of those premium payments to the Owner of the Captive or the Insured, whether by loans, investments or other transfers, then the arrangement is not insurance but tax avoidance. In other words, the Owner of the Captive or the Insured cannot treat the Captive’s assets as a personal bank account. The assets of the Captive must be treated as insurance company reserves, set aside to pay claims.
It will be more difficult for a Captive to avoid paragraph (c)(2). That paragraph requires a Captive to have a loss ratio of at least 65% over a ten-year period. However, many Captives do not approach that loss ratio. Paragraph (c)(2) differs from Notice 2016-66 in two significant ways. First, it increases the computation period from five years to ten years. Second, it reduces the loss ratio from 70% to 65%. The IRS explains these changes by saying that it recognizes that Captives tend to insure against risks that are low frequency, but high severity. As a result, a Captive’s loss ratio in any given year may be lower than the standard in the commercial insurance industry. However, the IRS believes that, over a period of time, 65% is a reasonable loss ratio. Otherwise, the premiums paid by the Insured may not reflect the risk assumed by the Captive.
A Captive can increase its loss ratio, even without significant claims, by paying dividends to its Owner. The denominator of the loss ratio is premiums earned by the Captive during the Loss Ratio Computation Period less dividends paid by the Captive during that period. The IRS believes that, if a Captive has greater assets than it needs to pay expected claims, it should pay dividends to its Owners. Of course, it believes that because dividends are taxable to the Owner.
The definition of transaction of interest is contained in Treas. Reg. section 1.6011-11. Paragraph (a) of Treas. Reg. section 1.6011-11 says:
(a) Identification as transaction of interest. Transactions that are the same as, or substantially similar to, transactions described in paragraph (c) of this section are identified as transactions of interest for purposes of section 1.6011-4(b)(6) . . .
Treas. Reg. section 1.6011-11(c) provides that:
(c) Transaction description. A transaction is described in this paragraph (c) if the transaction involves a Captive for which the amount of liabilities incurred for insured losses and claim administration expenses during the Transaction of Interest Computation Period is less than 65% of the amount equal to premiums earned by Captive during the Transaction of Interest Computation Period less policyholder dividends paid by Captive during the Transaction of Interest Computation Period.
Further, Treas. Reg. section 1.6011-11(b)(2) defines Transaction of Interest Computation Period as:
. . . the most recent nine taxable years of a Captive (or all taxable years of Captive, if Captive has been in existence of less than nine years).
So, the definition of transaction of interest differs from the definition of listed transaction in that a transaction of interest does not have the financial component of listed transactions and the loss ratio period is nine years or less, as opposed to ten years.
The reporting requirements under the proposed regulations are similar to the reporting requirements under Notice 2016-66 with two significant differences. First, the amount of information requested is less under the proposed regulations than under Notice 2016-66. All participants in the transaction are required to describe when, how and from whom the participant became aware of the transaction and how the participant participated in the transaction – for example, whether as an Insured, a Captive or other. In addition, a Captive is required to provide the following information:
1. All the types of policies issued or reinsured by the Captive.
2. The amounts treated as premiums by the Captive as premiums.
3. The name and contact information of each actuary or underwriter who assisted in the determination of the amounts treated as premiums.
4. The total amount of claims paid by the Captive.
5. The name and percentage of interest held by each person in the Captive.
An Insured is simply required to provide the amounts treated by the Insured as premiums paid to the Captive and the names of all Owners to whom the Insured provided the notice discussed in the paragraph below.
The second way in which the reporting requirements under the proposed regulations differ from the reporting requirements under Notice 2016-66 is that the owners of the Insured are no longer required to file a Form 8886 as long as the owner receives an acknowledgment from the Insured that the Insured has complied with its reporting obligations under Treas. Reg. 1.6011-4. That acknowledgment can come in the form of the copy of Form 8886 filed by the Insured. If the Insured does not provide the required notice, then the owner of the Insured will have separate reporting obligations.
Proposed regulations are not binding on anybody. They do not become effective until they are issued as final regulations and published in the Federal Register. This will not happen until after the IRS has received all comments, held the public hearing and has responded to the comments that it received.
At this time, no action is required of any Captive, Insured or Owner of the Captive or Insured. Unless and until the proposed regulations are issued in final form, the Court’s decision in the CIC Services case is the governing law. After publication of the regulations in final form, there will be reporting obligations, and the failure to file the required form can result in the imposition of penalties; some of them severe.
However, it is important to remember that the fact that a transaction may have been identified as a listed transaction by the IRS says nothing about the tax treatment of the transaction. Treas. Reg. section 1.6011-4(a) says that:
The fact that a transaction is a reportable transaction shall not affect the legal determination of whether the taxpayer’s treatment of the transaction is proper.
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