DISCLOSURE DEADLINE MOVED TO MAY 1, 2017 FOR 831(B) MICRO-CAPTIVES (TRANSACTIONS OF INTEREST)11 / 02 / 2016
IRS NOTICE 2016-66 (November 1, 2016)
The Department of the Treasury and the IRS have issued this notice, letting the general public know that they are aware of a certain "831(b) micro-captive transaction" and that they believe this transaction is one that has the POTENTIAL for tax avoidance or evasion. They refer also to IR-2016-25 (discussing characteristics of an abusive micro-captive insurance structure). The reason the IRS has now designated this transaction to be a "transaction of interest" is because they claim to lack sufficient information to identify WHICH Section 831(b) arrangements should be identified specifically as a "tax avoidance transaction" and MAY lack sufficent information to define the characteristics that distinguish tax avoidance transactions from other Section 831(b) related party transactions. The notice describes one particular transaction and alerts those who are involved in such transactions to their reporting and maintenance requirements.
The transaction is a "micro-captive" transaction in which A, a person, directly or indirectly owns an interest in any entity (entities)(the "Insured") conducting a trade or business. A, persons related to A, or both, also directly or indirectly own another entity (or entities) whcih are set up as captive insurance companies. In some cases, this captive enters into a contract with the insured, and the captive then enters into reinsurance or a pooling agreement. In other cases, the captive indirectly enters into the contract by reinsuring risks that insured has initially insured through an intermediary.
In cases in which the captive enters into a contract with the insured, the parties treat the contract as an insurance contract for Federal income tax purposes. The captive insurance company provides coverage for the insured. Those offered coverage are either the persons related to or affiliated with the insured or other entities represented by a person who is promoting the transaction. Under this transaction, the insured makes the payments to the captive and treats these insurance premiums as deductible ordinary and necessary business expenses under Section 162 of the IRC. Even if the captive is not a domestic corporation, it makes an election under Section 953(d) to be treated as a domestic corporation. The transaction is structured so that the captive has no more than $1.2 million in net premiums written (or if greater, direct premiums written) for each taxable year ($2.2 million for transactions in effect after 12/31/2016). Captive makes an election under Section 831(b) to be taxed only on taxable investment income and excludes the premiums from taxable income.
The notice discusses the role of the promoter and the continuing services it usually provides to the captive. The notice discusses the coverage provided by the captive, its characteristics, as well as the characteristics of the payments made by insured to the captive, including how the payments are determined without an underwriting or actuarial analysis conforming to industry standards, not made consistently with the schedule under the contract, with no price shopping evident, and with the payments significantly exceeding prevailing premiums offered by unrelated commerical insurances companies for risks with similar loss profiles. The captive's claims procedures and policies are not issued in a timely manner, and it fails to comply with some or all of the laws or regulations applicable to insurance companies in the jurisdiction where the captive is chartered, where the insured does not file claims for each loss event covered by the contract, and where the captive does not have defined claims administration procedures that are consistent with insurance industry standards. The captive does not have adequate capital and invests in illiquid or speculative assests not usually held by insurance companies. Captive loans or otherwise transfers its capital to insured or those affiliated or related to insured.
The notice also describes how in certain cases, the captive indirectly enteres into a contract by reinsuring risks that the insured has initially insured through an intermediary, where the intermediary enters into a contract with the insured and a reinsurance contract with the captive. The intermediary is unrelated to A or insured, but related to the promoter.
The notice makes clear that the IRS recognize that related parties may use captive insurance companies that make elections under Section 831(b) for risk management purposes that do NOT involve "tax avoidance" but believe that there are cases in which the use of such arrangements to claim the tax benefits of treating the contract as an insurance contract is improper. Therefore, they have identified transactions and transactions substantially similar to that which is described in the notice as a "transaction of interest" for purposes of 1.6011-4(b)(6), as well as IRC Sections 6111 and 6112.
As the notice makes clear, the notice is effective November 1, 2016, and persons entering into those transactions on or after November 2, 2006 MUST disclose the transaction as described in Regs. Section 1.6011-4. Material advisors who make a "tax statement" on or after November 2, 2006 , with respect to transactions entered into on or after November 2, 2006, have disclosure and list maintenance obligations under IRC Section 6111 and 6112. See 1.6011-4(h) and Regs. Section 301.6111-3(i) and Section 301.6112-1(g). The Department of the Treasury and IRS has gathered enough information about these potentially abusive 831(b) arrangements, they may decide to remove the transaction from the "transaction of interest" category, designate it as a "listed transaction" or provide a new category of "reportable transaction," and warn that in the interim, they may still challenge these transactions under other provisions of the Code or judicial doctrines such as sham transaction, substance over form or economic substance. The notice makes clear that the IRS will consider for purposes of 1.6011-4(c)(3)(i)(E) that the insured, the captive and the intermediary (if applicable) are "participants" in each year in which their respective tax returns reflect tax consequences or a tax strategy of a "transaction of interest" as described in the notice.
The timeliness of disclosures for those entering into transactions is generally January 30, 2017, with the threshhold amounts for material advisors being the same as that required for listed transactions as set forth in Regs. 301.6111-3(b)(3)(i)(B). The notice goes on to describe what information is required to be set forth in IRS Form 8886, and reminds the public of the applicability of penalties for those required to disclose.
At the end of the notice, the IRS request comments, to be submitted in writing on or before January 30, 2017.