Micro-Captives and Mega Headaches: The US IRS Designates Micro-Captive Insurers as Listed Transactions
On April 10, 2023, the Internal Revenue Service (“IRS”) issued proposed regulations further tightening the circle around micro-captive insurance transactions.1 The release of these proposed regulations appears to have been prompted, or at least expedited, by a March 2022 Tennessee federal district court decision that vacated an IRS notice on micro-captive transactions (Notice 2016-66, 2016-47 IRB 745).2 Although the proposed regulations make Notice 2016-66 obsolete, the IRS stated that the obsoletion of the notice “has no effect on the merits of the tax benefits claimed from the transactions themselves and related litigation, or income tax examinations and promoter investigations relating to micro-captive transactions.” Does that also apply to the horse we rode in on? The proposed regulations identify certain micro-captive transactions as “listed transactions” and certain other micro-captive transactions as “transactions of interest.” Both types of transactions must be reported on an IRS Form 8886 Reportable Transaction Disclosure Statement for each year in which the insurance transaction is open.
I. Effective Dates
The proposed regulations are not immediately effective. These regulations will become effective as of the date that they are published in the Federal Register as final regulations.3 Once the proposed regulations are issued in final form, however, taxpayers who have engaged in micro-captive transactions described in the final regulations must file IRS Form 8886 for each prior year for which an assessment is not barred by the statute of limitations.4 Material advisors who “made a tax statement” about a listed micro-captive in any of the six years preceding the year in which the proposed regulations are finalized must also disclose their participation to the IRS.5 Taxpayers should keep in mind that the IRS will assess penalties for any year in which the taxpayer fails to file a disclosure statement.
The preamble to the proposed regulations states that reporting is limited to the insured, the Captive (described further below), and material advisors. Accordingly, affiliates of the insured who may have participated in the captive transaction are being spared from the obligation to file IRS Form 8886.
II. Captive Transactions Affected by the Proposed Regulations
At the heart of the issue is the following typical fact pattern: a taxpayer attempts to reduce its US taxable income (or the taxable income of an affiliate, or both) by insuring certain risks with a related counterparty that the parties treat as a non-life insurance company, i.e., a “Captive.” More specifically, the taxpayer pays $2.2 million or less in tax deductible insurance premiums to the Captive.6 On the other hand, the Captive makes an election under Section 831(b) of the Internal Revenue Code of 1986, as amended (the “Code”), to be treated as small insurance company, and excludes these premiums from its taxable income. Sounds good, so what’s the problem?
Well, the issue appears to be the IRS’s position, now sustained in three separate court decisions, including most recently Caylor Land & Development Inc. v. Commissioner, T.C. Memo. 2021-30 (2021), that many of the micro-captive transactions do not constitute legitimate insurance transactions for federal income tax purposes.7 And in Caylor, supra, the IRS successfully asserted the imposition of accuracy-related penalties in a Code § 831(b) transaction.
The proposed regulations generally describe a Captive triggering the reportable transaction rules as any entity that (i) makes a Code § 831(b) election to exclude premiums from taxable income, (ii) issues risk protection to a person that is engaged in a trade or business under a contract that the parties treat as an insurance (or reinsurance) contract for federal income tax purposes, in exchange for insurance premiums, and (iii) the insured and/or an insured affiliate owns at least 20% of its assets or the voting power or value of its outstanding stock.8
The proposed regulations then identify three types of micro-captive transactions – the first two are labeled “listed transactions” and the third is treated as a transaction of interest.9 Listed transactions and transactions of interest are each a type of “reportable transaction.” A transaction designated as either triggers tax reporting and disclosure to the IRS.10 Concomitantly, each material advisor with respect to a reportable transaction also has tax reporting and disclosure obligations to the IRS.11 Participants and material advisors that fail to comply with the required tax reporting and disclosure requirements associated with reportable transactions may incur substantial penalties.
The first type of listed transaction involves any transaction in which a Captive, at any time during the five most recent taxable years, “round trips” the premiums back to the insured or an affiliate in a non-taxable transaction. The round-tripping of the premiums includes any direct or indirect financing made available to any insured, an owner of the insured, or any person related to the insured or an owner of the insured (a “recipient”), in a transaction that did not result in taxable income or gain to the recipient. Any amounts that the Captive makes available as financing or otherwise conveys or agrees to make available to convey to the recipient are presumed to be portions of the premiums to the extent those amounts are in excess of the Captive’s cumulative after-tax investment earnings minus any outstanding financings or conveyances.
The second type of listed transaction involves transactions for which the amount of liabilities incurred for insured losses and claim administration expenses during the 10 most recent taxable years of a Captive is less than 65% of the excess of the amount of the premiums earned by the Captive during that time period minus policyholder dividends paid by the Captive during such period. Note that this category does not apply to any Captive that has been functioning as such for less than 10 taxable years.
The transaction of interest category picks up transactions for which the amount of liabilities incurred for insured losses and claim administration expenses during the nine most recent taxable years of a Captive is less than 65% of the amount the excess of the premiums earned by the Captive during that period minus policyholder dividends paid by the Captive during that period. Note that this category takes into consideration whether a Captive is a successor to one or more other Captives, and if so, treats the taxable years of each other Captive as taxable years of the Captive.
III. The Consumer Coverage Exception
The proposed regulations provide a limited exception from the proposed disclosure rules for certain consumer coverage reinsurance arrangements. In consumer coverage arrangements, a “Seller” (that is, a service provider, automobile dealer, lender, or retailer) sells products or services to unrelated customers who purchase insurance contracts in connection with those products or services (a “Consumer Coverage contract”). The Consumer Coverage contract generally provides coverage for repair or replacement costs if the product breaks down or is lost, stolen, or damaged; coverage for the customer’s payment obligations if the customer dies or becomes disabled or unemployed; coverage for the difference between all or a portion of the value of the product and the amount owed on the product’s financing, including a lease, if the product suffers a covered peril; or a combination of one or more types of market-standard product financing coverage. An entity related to or affiliated with the Seller may issue or reinsure the Consumer Coverage contracts. In these arrangements, an unrelated third party may reinsure the contracts and may then retrocede risk under the contracts to the entity related to, or affiliated with, the Seller.
The IRS determined that, as a general matter, participation in this type of reinsurance arrangement is not a reportable transaction because the insured is not sufficiently related to the insurer or any reinsurer. Generally, the Consumer Coverage contracts insure unrelated customers of the Seller, and neither these customers nor their affiliates directly or indirectly own at least 20% of the voting power or value of the outstanding stock of the insurer or reinsurer.
IV. Takeaways
The proposed regulations, or regulations substantially similar to the proposed regulations, are likely to be adopted by the IRS in the near future. Taxpayers and the persons with whom they worked on these transactions should closely coordinate to ensure that consistent disclosure is provided by each person required to make a disclosure. The IRS Form 8886 disclosures are likely to encounter uncompromising IRS audits, and taxpayers who have undertaken Captive transactions described in the proposed regulations should expect to find themselves under tight scrutiny.
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Mark Leeds (mleeds@mayerbrown.com; 212 506 2499) and Amit Neuman (aneuman@mayerbrown.com; 212 506 2263) are tax lawyers with the New York office of Mayer Brown. Mark and Amit regularly address tax compliance issues with listed transactions in their law practice.
2 The Notice was vacated because the IRS failed to comply with the formal notice and comment procedures under the Administrative Procedure Act. See CIC Services, LLC v. IRS, 2022 WL 985619 (E.D. Tenn. March 21, 2022) as modified by 2022 WL 2078036 (E.D. Tenn. June 2, 2022).
3 Prop. Treas. Reg. § 1.6011-10(g)(1).
4 Prop. Treas. Reg. § 1.6011-10(g)(2).
5 Prop. Treas. Reg § 1.6011-10(g)(3).
6 Note that the statutory limit is adjusted annually for inflation. For taxable years beginning in 2023, the limit is $2.65 million.
7 See also Avrahami v. Commissioner, 149 T.C. 144 (2017) and Syzygy Insurance Co. Inc. v. Commissioner, T.C. Memo. 2019-34 (2019).
8 Note that the proposed regulations include additional nuanced rules used to determine direct or indirect ownership interests. See Prop. Treas. Reg. § 1.6011-10(b)(1), (b)(6), and (b)(8).
9 See Treas. Reg. § 1.6011-10(a); see also Treas. Reg. § 1.6011-11(a).
10 See Treas. Reg. § 1.6011-4.
11 See Treas. Reg. § 301.6111-3(a) and Treas. Reg. § 301.6112-1(e).
