Proposed Regulations Identify Micro-captive Transactions As Listed Transactions

(Parker Tax Publishing April 2023)

The IRS issued proposed regulations that identify transactions that are the same as, or substantially similar to, certain micro-captive transactions as listed transactions, a type of reportable transaction, and certain other micro-captive transactions as transactions of interest, another type of reportable transaction. The proposed regulations obsolete Notice 2016-66, which identified certain micro-captive transactions as transactions of interest, and which was held invalid on procedural grounds by a district court in CIC Services, LLC v. IRS, 2021 PTC 303 (E.D. Tenn. 2021). REG-109309-22.

Background

In Notice 2016-66, the IRS identified certain micro-captive transactions as transactions interest. Notice 2016-66 alerted taxpayers and their representatives that under Reg. Sec. 1.6011- 4(b)(6), the IRS identified as transactions of interest certain micro-captive transactions in which 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 an insurance company. Notice 2016-66 also alerted persons involved with the identified transactions that certain responsibilities may arise from their involvement.

Notice 2016-66 describes the following micro-captive transaction as a transaction of interest:

(1) a company that the parties treat as an insurance company (Captive) elects to exclude premiums from taxable income under Code Sec. 831(b);

(2) at least 20 percent of the voting power or value of the outstanding stock of Captive is directly or indirectly owned by the insured entity (Insured), owners of Insured, or persons related to Insured or its owners (20-percent relationship factor); and

(3) either or both of the following apply: (i) Captive has at any time during a defined Computation Period (referred to as the Notice Computation Period) directly or indirectly made available as financing, or otherwise conveyed or agreed to make available or convey, to certain related persons in a transaction that did not result in taxable income or gain to the recipient any portion of the payments treated as premiums, such as through a guarantee, a loan, or other transfer of Captive's capital (financing factor), or (ii) the amount of liabilities incurred by Captive for insured losses and claim administration expenses during the Notice Computation Period is less than 70 percent of the amount equal to premiums earned by Captive during that period less policyholder dividends paid by Captive during that period (70-percent loss ratio factor).

Notice 2016-66 requires disclosure of the information specified in Reg. Sec. 1.6011-4(d) and the Instructions to Form 8886, Reportable Transaction Disclosure Statement, which includes identifying and describing the transaction in sufficient detail for the IRS to be able to understand the tax structure of the reportable transaction and identity of all parties involved in the transaction.

In Mann Construction, Inc. v. U.S., 2022 PTC 63 (6th Cir. 2022), the Sixth Circuit held that Notice 2007-83, which identified certain trust arrangements claiming to be welfare benefit funds and involving cash value life insurance policies as listed transactions, violated the Administrative Procedure Act (APA) because the notice was issued without following the APA's notice-and comment procedures. In CIC Services, Inc. v. IRS, 2021 PTC 303 (E.D. Tenn. 2021), a district court viewed the analysis in Mann Construction as controlling and vacated Notice 2016-66 on the grounds that the IRS failed to comply with the APA's notice and comment procedures and acted arbitrarily and capriciously based on the administrative record.

Proposed Regulations

On April 11, the IRS issued proposed regulations which identify certain micro-captive transactions as listed transactions. The IRS determined that two categories of micro-captive transactions, described in Prop. Reg. Sec. 1.6011-10(c)(1) and Prop. Reg. Sec. 1.6011-10(c)(2), are tax avoidance transactions, and thus identify such transactions as listed transactions. The transactions in both categories involve related parties, including a Captive, at least 20 percent of the voting power or the value of the outstanding stock or equity interest of which is owned, directly or indirectly, by an Insured, an Owner, or persons Related to an Insured or an Owner.

In addition, the IRS determined that a third category of micro-captive transactions, described in Prop. Reg. Sec. 1.6011-11(c), has a potential for tax avoidance or evasion, and thus identified such transactions as transactions of interest. This category of micro-captive transactions also involves related parties and is identified by the presence of a loss ratio factor that falls below 65 percent over a shorter Transaction of Interest Computation Period, generally because Captives involved have been in operation for a shorter period of time. With respect to this third category of transactions, the IRS stated that it requires more information to determine if the transactions are being used for tax avoidance or evasion. The proposed regulations therefore identify transactions that are the same as, or substantially similar to, the Micro-captive Transaction of Interest described in Prop. Reg. Sec. 1.6011-11(a) as transactions of interest.

The IRS stated that, based on examinations of taxpayers and promoters and information received through disclosures in response to Notice 2016-66, certain changes to the micro-captive transaction identified in Notice 2016-66 are appropriate for the proposed regulations. Thus, the transactions described in Prop. Reg. 1.6011-10 and Prop. Reg. 1.6011-11 share common features with the micro-captive transactions described in Notice 2016-66, but with modifications to the scope of the 20-percent relationship factor and the factors used to distinguish between listed transactions, transactions of interest, and transactions that are not reportable transactions under the proposed regulations.

The proposed regulations also significantly reduce the information required to be reported by Captives under Reg. Sec. 1.6011-4(d) as compared to Notice 2016-66. Unlike Notice 2016-66, the proposed regulations do not require Captive participants to identify which factors of the proposed regulations apply, state under what authority Captive is chartered, describe how amounts treated as premiums for coverage provided by Captive were determined, provide the amounts of reserves reported by Captive on its annual statement, or describe the assets held by Captive. The proposed regulations do, however, require Captives to identify the types of policies issued or reinsured, the amounts treated as premiums written, the name and contact information of actuaries and underwriters involved, and the total amount of claims paid by the Captive.

Additionally, Prop. Reg. Sec. 1.6011-10(b)(1) and Prop. Reg. Sec. 1.6011-11(b)(1) include a 20 percent relationship test in the definition of Captive, and the proposed regulations require Captive participants to identify the name and percentage of interest held directly or indirectly by each person whose interest in Captive meets the 20 percent threshold or is taken into account in meeting the 20 percent threshold under Prop. Reg. Sec. 1.6011-10(b)(1)(iii). Also, the proposed regulations require each Insured (as defined in Prop. Reg. Sec. 1.6011-10(b)(4) and Prop. Reg. Sec. 1.6011-11(b)(4)) subject to the disclosure requirements set forth in Reg. Sec. 1.6011-4(d) to provide the amounts treated by Insured as insurance premiums for coverage provided to Insured, directly or indirectly, by Captive.

Disclosure Requirement Safe Harbor

Under the proposed regulations, any person who, solely by reason of their direct or indirect ownership interest in Insured, is subject to the disclosure requirements set forth in Reg. Sec. 1.6011-4 as a participant in a Micro-captive Listed Transaction or a Micro-captive Transaction of Interest, is not required to file a disclosure statement with respect to that transaction provided that person receives written or electronic acknowledgment that Insured has or will comply with its separate disclosure obligation under Reg. Sec. 1.6011-4(a) with respect to the transaction. The acknowledgment can be a copy of the Form 8886 filed (or to be filed) by Insured and must be received by the Owner prior to the time set forth in Reg. Sec. 1.6011-4(e) in which the Owner would otherwise be required to provide disclosure. However, the receipt of an acknowledgment that the Insured has or will comply with its disclosure obligation does not relieve the Owners of Insured of their disclosure obligations if Insured fails to disclose the transaction in a timely manner.

Some Taxpayers May Need to File Amended Returns or AARs

Taxpayers who have filed a tax return (including an amended return (or Administrative Adjustment Request (AAR) for certain partnerships)) reflecting their participation in micro-captive transactions prior to the date the regulations are published as final regulations, and who have not otherwise finalized a settlement agreement with the IRS with respect to the transaction, must disclose the transactions as provided in Reg. Sec. 1.6011-4(d) and (e) provided that the period of limitations for assessment of tax, including any applicable extensions, for any tax year in which the taxpayer participated in the transaction has not ended on or before the date the regulations are published as final regulations.

The IRS noted that some taxpayers may have filed tax returns taking the position that they were entitled to the purported tax benefits of the types of transactions described in the proposed regulations. Because the IRS will take the position that taxpayers are not entitled to the purported tax benefits of the listed transactions described in the proposed regulations, and may take such position with respect to the transactions of interest described in the proposed regulations, the IRS stated that taxpayers should consider filing amended returns or AARs and ensure that their transactions are disclosed properly.

Taxpayers filing an amended individual return should write "Microcaptive" at the top of the first page of the amended return and mail the amended return to: Internal Revenue Service, 2970 Market Street, Philadelphia, PA 19104. Taxpayers filing amended business returns on paper should write "Microcaptive" at the top of the first page of the amended return and mail to the address listed in the instructions for the amended return. Taxpayers filing amended business returns electronically should include "Microcaptive" when explaining the reason for the changes.

For a discussion of micro-captive insurance arrangements, see Parker Tax ¶92,730.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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