Immediate disclosure action required by all participants
On November 1, 2016, the Internal Revenue Service (“IRS”) issued Notice 2016-66 (the “Notice”), designating a new "transaction of interest" (“TOI”) relating to certain captive insurance companies that make elections under Section 831(b) (labelled as “micro-captives” per the IRS).
IRS Micro-Captive Concerns
It is important to note that within the first section of the Notice, the IRS acknowledges that not all micro-captives involve abusive tax avoidance; however, the IRS believes certain Micro-Captives have a potential for abusive tax avoidance or evasion. Section 1 of the Notice goes on to detail factors which demonstrate the perceived abuse. An overall concern in the Notice is that the manner in which certain insurance contracts are interpreted, administered, and applied is inconsistent with arm’s length transactions and sound business practices. Specific factors causing concerns for the IRS are:
- the insurance payments are determined without an underwriting or actuarial analysis that conforms to insurance industry standards;
- the insurance payments are not made consistently with the schedule in the insurance contract;
- the insurance payments are agreed to by the insured and Micro-Captive without comparing the amounts of the payments to payments that would be made under alternative insurance arrangements providing the same or similar coverage;
- the insurance payments significantly exceed the premium prevailing for coverage offered by unrelated, commercial insurance companies for risks with similar loss profiles;
- if insured includes multiple entities, the allocation of amounts paid to Micro-Captive among the insured entities does not reflect the actuarial or economic measure of the risk of each entity;
- Insurance or reinsurance is procured from an entity related to a Promoter of the transaction;
- Allocation of risk among the layers of risks in a reinsurance arrangement with Micro-Captive does not reflect the actuarial or economic measures of the risks associated with the particular layers;
- Any claims filed for reinsurance fall within the layer or layers that only cover risks of insured;
- Micro-Captive fails to comply with some or all of the laws or regulations applicable to insurance companies in the jurisdiction in which Micro-Captive is chartered, the jurisdiction(s) in which Micro-Captive is subject to regulation because of the nature of its business, or both;
- Micro-Captive does not issue policies or binders in a timely manner consistent with industry standards;
- Micro-Captive does not have defined claims administration procedures that are consistent with insurance industry standards;
- Insured does not file claims for each loss event covered by the insurance contract;
- Micro-Captive does not have capital adequate to assume the risks that the insurance contract transfers from insured;
- Micro-Captive invests its capital in illiquid or speculative assets usually not held by insurance companies; or,
- Micro-Captive loans or otherwise transfers its capital to insured, entities affiliated with insured or the owners or persons related to the owners of the insured.
Transactions of Interest
Section 2 of the Notice specifies the Micro-Captive TOI and expressly states that a transaction described in Section 2 is identified as a TOI "regardless of whether the transaction has the characteristics described in section 1." Hence, the unfortunate rub here is that the IRS seeks to capture information on both abusive and nonabusive Micro-Captives for use in further analysis and developing a final position in this area.
A Micro-Captive TOI is any transaction that is the same as, or substantially similar to the following criteria, is a TOI:
1. A person (A) directly or indirectly owns an interest in one or more entities (“Insured”) conducting a trade or business,
2. An entity (“Captive”), directly or indirectly owned by A, the Insured or by persons related to A or to the Insured, issues one or more insurance contracts to the Insured, or reinsures insurance contracts the Insured purchased from an intermediary insurance company (commonly referred to as the "fronting" company),
3. Captive elects under Code section 831(b) to be taxed only on taxable investment income (if organized offshore, Captive has also elected under Code Section 953(d) to be taxed as a US taxpayer).
4. A, the Insured, or one or more persons related (within the meaning of Section 267(b) or Section 707(b)) to A or to the Insured directly or indirectly owns at least 20% of the voting power or value of the outstanding stock of the Captive.
5. One or both of the following apply:
a. The liabilities for losses and claims administrative expenses of the Captive during the "Computation Period" are less than 70% of premiums earned by the Captive during the Computation Period, reduced by policyholder dividends paid by the Captive during the Computation period.
b. During the Computation Period, the Captive has, directly or indirectly, made (or has agreed to make) any portion of the payments under the insurance contract(s) available to A or to the Insured or to any party related (within the meaning of Section 267(b) or Section 707(b)) to A or to the Insured (a Recipient), either as financing or in some other transaction that did not result in taxable income or gain to Recipient, such as through a guarantee, a loan or other transfer of the Captive's capital.
The Computation Period is the most recent five tax years of the Captive or the period of the Captive's existence if it has been in existence for less than five tax years. If the Captive has been in existence for less than five tax years and is a successor to one or more Captives created or availed of in connection with a transaction described in the Notice, tax years of the predecessor entities are treated as tax years of the Captive. For purposes of defining the Computation Period, a short tax year is treated as a tax year.
Substantially similar transactions to the Notice
The Notice applies to any transaction that is the same as, or substantially similar to, the described transaction. The term "substantially similar" is defined in Treas. Reg. Section 1.6011-4(c)(4) to include "any transaction that is expected to obtain the same or similar types of tax consequences and that is either factually similar or based on the same or similar tax strategy." The regulation states that the term "must be broadly construed in favor of disclosure."
Implications for Participants
The practical reality of the Notice is that all taxpayers "participating" in a Micro-Captive TOI on or after November 2, 2006, must disclose the transaction as described in Treas. Reg. section 1.6011-4. Hence, each of the taxpayer parties described in Section 2 of the Notice - A, Insured, Captive or the intermediary fronting insurance company – “participates” in the Micro-Captive TOI likely has a reporting obligation.
Penalties for Non-Compliance
A taxpayer who fails to properly disclose the transaction under Treas. Reg. section 1.6011-4 may be subject to the Section 6707A penalty of 75% of the reported tax benefits, with a maximum of $50,000 for entities/$10,000 for individuals and a minimum of $10,000 for entities/$5,000 for individuals. In addition, the IRS may impose other penalties on participants in these transactions, including the accuracy-related penalties.
The Notice requires each participant to disclose information as to when and how the taxpayer became aware of the transaction. Micro-Captive must provide additional information in its disclosure, including the authority under which Micro-Captive is chartered, types of coverage provided, how premiums were determined (including the name and contact number of any actuary or underwriter who assisted in the determinations of such premiums), a description of claims and a description of assets.
Past-year(s) participation: A taxpayer who has participated in a micro-captive TOI on or after November 2, 2006, and during a year for which the tax return has already been filed but for which the statute of limitation for assessment remains open as of November 1, 2016, must disclose that participation by submitting a properly completed Form 8886, Reportable Transaction Disclosure Statement, to the IRS Office of Tax Shelter Analysis (“OTSA”) (address in Form 8886 instructions) by January 30, 2017.
Current-year participation: A taxpayer who is currently participating in this TOI must disclose the transaction by attaching a properly completed Form 8886, Reportable Transaction Disclosure Statement, to its federal income tax returns for the current tax year and each future tax year in which the taxpayer participates. A copy of the Form 8886 must be sent to OTSA at the same time that the transaction is disclosed for the first time.
Material advisors: Generally, material advisors will need disclosure information on any person who was provided material aid, assistance or advice with respect to organizing, managing, promoting, selling, implementing, insuring or carrying out any reportable transaction and keep lists detailing certain information about participants in Micro-Captive TOIs. Material advisors have to file as well, and are subject to penalties for nonfiling.
The Notice provides some additional welcome clarification from the IRS of policies and viewpoints for Micro-Captives. First, section 1 confirms that the IRS recognizes that Micro-Captive may be legitimate and non-abusive. The IRS has repeatedly recognized legitimate Micro-Captives in its administrative guidance and legitimate Micro-Captives have been repeatedly recognized by the courts. In particular, Captives have a long line of favorable judicial decisions supporting legitimate Captive transactions, included several significant decisions within the last year alone. Second, section 1 provides a list of bad facts to assist us in determining which Micro-Captives may be potentially abusive and hence subject to contest by the IRS. Micro-Captives displaying multiple bad facts are likely to be examined and the subject of controversy. Third, the information gleaned and examinations which flow from the disclosures are likely to root out bad actors in the Micro-Captive insurance market, which hopefully deters Congress from taking further broad-based action in this area, like removing the recently increased $2,200,000 tax exemption for net premiums written (or, if greater, direct premiums written) for each taxable year that is currently available to section 831(b) electing insurance companies.
Unfortunately, the Notice does require disclosure of many legitimate insurance arrangements that are implicitly acknowledged by the IRS as within the intent of the law. This does create additional expense for such captives. The penalties for non- disclosure are significant and material and may be disproportional to the claimed offense by the IRS. Accordingly, great care needs to be taken to completely disclose transactions within the Notice in a timely manner.
In our experience only disclosures acceptable by the IRS will be able to avoid penalties. Penalties imposed under Code section 6707A are not subject to judicial review and generally are only rescinded by the IRS itself under stringent criteria. Hence, this penalty is similar to a strict liability penalty. Moreover, failure to disclose by the January 30, 2017, deadline cannot be cured by filing an amended return after the deadline.
Of immediate concern, past transactions generally need to be disclosed by January 30, 2017, a date which can easily be missed as it is not a normal income tax filing deadline. This date is the same for participants as well as material advisors. Hence, the IRS will have two sources of information concerning participants in the Micro-Captive TOI, one directly from the participant and one directly from material advisors to the transactions (often a single transaction will have multiple material advisors).
In short, the compliance obligation created by this Notice is very real, and you should make certain that you meet it. Consideration should also be given to the practical viability and exposure of the Captive moving forward.
DUGGAN BERTSCH, LLC has broad experience working with and counseling clients on their captive insurance operations, structure, and corresponding compliance obligations, and has successfully represented clients with Micro-Captives in tax controversies with the IRS as well as proper preparation of the required disclosures. We would be happy to independently review your situation and provide our experienced insight on your particular situation and available options.