Notice 2016-66, 2016-47 IRB
IRS has identified “micro-captive transactions” as “transactions of interest”. A micro-captive transaction is a type of transaction in which a taxpayer attempts to evade taxation by entering into contracts with a related company that is treated as a captive insurance company, using inflated premiums, and taking advantage of Code Sec. 831(b)’s election to have small insurance companies be taxed only on their investment income.
Background—election by nonlife insurance companies. Nonlife insurance companies with net written premiums, or direct written premiums if greater, not in excess of $1,200,000 in the tax year may elect to be taxed, at regular corporate rates, only on taxable investment income, instead of being taxed on both investment and underwriting income. (Code Sec. 831(b)) For tax years beginning after Dec. 31, 2016, the $1,200,000 maximum amount of annual premiums will be increased to $2,200,000 and adjusted for inflation ($2,250,000 for 2017).
Background—tax shelter reporting requirements. Under Code Sec. 6011 and its regs, taxpayers must disclose their participation in reportable, tax-shelter-type transactions by attaching an information statement to their income tax returns. Under Code Sec. 6111, material advisors must disclose reportable transactions (e.g., identify and describe them and the claimed tax benefits), and, under Code Sec. 6112, material advisors must prepare and maintain lists for reportable transactions (e.g., identifying each person with respect to whom the advisor acted as a material advisor for the transactions). Regs provide that reportable transactions include several categories of transactions including listed transactions and transactions of interest.
A listed transaction is a transaction that is the same as or substantially similar to one of the types of transactions that IRS has determined to be a tax avoidance transaction and identified by notice, reg, or other form of published guidance as a listed transaction. Several of the disclosure rules described above have stricter provisions for listed transactions than for other reportable transactions.
A transaction of interest is a transaction that is the same as or substantially similar to one of the types of transactions that IRS has determined to be a transaction of interest and identified by notice, reg, or other form of published guidance as a transaction of interest. (Reg. § 1.6011-4(b)(6))
Background—micro-captive transactions. Broadly speaking, a micro-captive transaction is a transaction 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 a captive insurance company. Each entity that the parties treat as an insured entity under the contracts claims deductions for premiums for insurance coverage. The related company that the parties treat as a captive insurance company elects under Code Sec. 831(b) to be taxed only on investment income and therefore excludes the payments directly or indirectly received under the contracts from its taxable income.
In the micro-captive transaction, A, a person, directly or indirectly owns an interest in an entity (or entities) (“Insured”) conducting a trade or business. A, persons related to A, or both, also directly or indirectly own another entity (or entities) (“Captive”).
In some cases, Captive enters into a contract (or contracts) (the “Contract”) with Insured. In these cases, Captive may enter into a reinsurance or pooling agreement under which a portion of the risks covered under the Contract are treated as pooled with risks of other entities, and Captive assumes risks from other entities. In other cases, Captive indirectly enters into the Contract by reinsuring risks that Insured has initially insured with an intermediary, Company C.
Insured, Captive, and, if applicable, Company C, treat the Contract as an insurance contract for federal income tax purposes. Insured claims a deduction for the premiums paid under Code Sec. 162. Captive excludes the premium income from its taxable income by electing under Code Sec. 831(b) to be taxed only on its investment income. Captive uses the premium income for purposes other than administering and paying claims under the Contract, generally benefitting Insured or a party related to Insured. For instance, Captive may use premium income to provide a loan to Insured.
However, if the transaction does not constitute insurance, Insured is not entitled to deduct the amount of that payment under Code Sec. 162 as an insurance premium. In addition, if Captive does not provide insurance, Captive does not qualify as an insurance company, and Captive’s elections to be taxed only on its investment income under Code Sec. 831(b) and to be treated as a domestic insurance company are invalid.
Micro-captive transactions are transactions of interest. IRS believes that micro-captive transactions have a potential for tax avoidance or evasion. See IR 2016-25 (discussing characteristics of an abusive micro-captive insurance structure). However, IRS lacks sufficient information to identify which Code Sec. 831(b) arrangements should be identified specifically as a tax avoidance transaction and may lack sufficient information to define the characteristics that distinguish the tax avoidance transactions from other Code Sec. 831(b) related-party transactions.
Notice 2016-66 provides that micro-captive transactions and substantially similar transactions are transactions of interest for purposes of Reg. § 1.6011-4(b)(6), Code Sec. 6111 and Code Sec. 6112. Notice 2016-66 also alerts persons involved in such transactions to certain responsibilities and penalties that may arise from their involvement with these transactions.
IRS sets out the characteristics of the transactions that IRS is making transactions of interest. The following transaction is identified as a transaction of interest under the Notice:
- A, a person, directly or indirectly owns an interest in an entity (or entities) (“Insured”) conducting a trade or business;
- An entity (or entities) directly or indirectly owned by A, Insured, or persons related to A or Insured (“Captive”) enters into a contract (or contracts) (the “Contracts”) with Insured that Captive and Insured treat as insurance, or reinsures risks that Insured has initially insured with an intermediary, Company C;
- Captive makes an election under Code Sec. 831(b) to be taxed only on taxable investment income;
- A, Insured, or one or more persons related (within the meaning of Code Sec. 267(b) or Code Sec. 707(b)) to A or Insured directly or indirectly own at least 20% of the voting power or value of the outstanding stock of Captive; and
- One or both of the following apply:
- The amount of the liabilities incurred by Captive for insured losses and claimed administration expenses during the “Computation Period” (see below) is less than 70% of the following:
- Premiums earned by Captive during the Computation Period, less
- Policyholder dividends paid by Captive during the Computation Period; or
- Captive has at any time during the Computation Period directly or indirectly made available as financing or otherwise conveyed or agreed to make available or convey to A, Insured, or a person related (within the meaning of Code Sec. 267(b) or Code Sec. 707(b) ) to A or Insured (collectively, the “Recipient”), in a transaction that did not result in taxable income or gain to Recipient, any portion of the payments under the Contract, such as through a guarantee, a loan, or other transfer of Captive’s capital.
The Computation Period is
- The most recent five tax years of Captive or
- If Captive has been in existence for less than five tax years, the entire period of Captive’s existence.
For purposes of the preceding sentence, if Captive has been in existence for less than five tax years and Captive is a successor to one or more Captives created or availed of in connection with a transaction described in the Notice, tax years of such predecessor entities are treated as tax years of Captive. A short tax year is treated as a tax year.
Effective date and related rules. Transactions that are the same as, or substantially similar to, the transaction described under “IRS sets out…” above are identified as transactions of interest for purposes of Reg. § 1.6011-4(b)(6), Code Sec. 6111 and Code Sec. 6112 effective Nov. 1, 2016. Persons entering into these transactions on or after Nov. 2, 2006 (the effective date of the initial transaction of interest rules, see Notice 2009-59, 2009-31 IRB) must disclose the transaction as described in Reg. § 1.6011-4. Material advisors who make a tax statement on or after Nov. 2, 2006, with respect to transactions entered into on or after Nov. 2, 2006, have disclosure and list maintenance obligations under Code Sec. 6111 and Code Sec. 6112.
Independent of their classification as transactions of interest, transactions that are the same as, or substantially similar to, the transaction described under “IRS set out…” above, may already be subject to the requirements of Code Sec. 6011, Code Sec. 6111, Code Sec. 6112 or the regs thereunder. When IRS has gathered enough information regarding potentially abusive Code Sec. 831(b) arrangements, IRS may take one or more actions, including removing the transaction from the transactions of interest category in published guidance, designating the transaction as a listed transaction, or providing a new category of reportable transaction. In the interim, IRS may challenge a position taken as part of a transaction that is the same as, or substantially similar to, the transaction described under “IRS sets out…” above, under other provisions of the Code or judicial doctrines such as sham transaction, substance over form, or economic substance.
For rules regarding the time for providing disclosure of a transaction described under “IRS sets out…”, see Reg. § 1.6011-4(e) and Reg. § 301.6111-3(e) (which provide timing requirements for reporting of tax shelter transactions by participants and advisers, respectively). However, if, under Reg. § 1.6011-4(e), a taxpayer is required to file a disclosure statement with respect to a transaction described under “IRS sets out…” after Nov. 1, 2016 and before Jan. 30, 2017, that disclosure statement will be considered to be timely filed if the taxpayer files the disclosure with the Office of Tax Shelter Analysis by Jan. 30, 2017.
For more information on taxation of microcaptives, contact Scott Rogers.