IRS Issues Notice Identifying Micro-Captives as Transactions of Interest
Author: Jennifer Sanders
On November 1, 2016, the IRS issued Notice 2016-66, Transaction of Interest—Section 831(b) Micro-Captive Transactions, indicating a “micro-captive transaction” may have potential for tax avoidance or evasion. However, the IRS acknowledged it lacked sufficient information to identify which micro-captive arrangements should be labeled as a tax avoidance transaction. The IRS found certain transactions as described or similar to those described in the notice as transactions of interest, which triggers specific reporting requirements to the IRS.
In a micro-captive transaction, a person—directly or indirectly—owns an interest in an entity (Insured) that conducts a trade or business. The persons related to the Insured also directly or indirectly owns another entity, (Captive). The Captive generally enters into a contract with the Insured whereby the Captive provides coverage to the Insured. The Insured and Captive treat the contract as an insurance contract for federal income tax purposes. The Insured treats the premiums paid to the Captive as a deductible ordinary and necessary business expense. The Captive treats the payments from Insured as insurance premiums. If the net premiums written by the Captive are no more than $1.2 million ($2.2 million for taxable years beginning after December 31, 2016), the Captive may elect to be taxed under Internal Revenue Code (IRC) §831(b). With this election, the Captive excludes premium income from its taxable income and is only taxed on its net investment income.
Transaction of Interest
The IRS notice identified this as a transaction of interest:
(a) The Insured and Captive enter into a contract treated as insurance, or the Captive reinsures insurance contracts the Insured purchased from an intermediary insurance company;
(b) The Captive makes an election under IRC §831(b) to only be taxed on its net investment income;
(c) The Insured—or one or more persons related to the Insured—directly or indirectly owns at least 20 percent of the voting power or value of the Captive’s outstanding stock; and
(d) One or both apply:
i. The liabilities for losses and claims administration expenses of the Captive during the “computation period” are less than 70 percent of premiums the Captive earned during the computation period, reduced by dividends the Captive paid during the computation period.
ii. During the computation period, the Captive has, directly or indirectly, made—or has agreed to make—any portion of the payments within the insurance contract(s) available to the Insured or to any party related to the Insured, either as financing or in some other transaction that didn’t result in taxable income or gain to the recipient, such as through a guarantee, loan or other transfer of the Captive’s capital.
The notice defines the computation period as the most recent five taxable years of the Captive, or the period of the Captive’s existence if it’s existed for less than five taxable years. If the Captive has existed for less than five taxable years and is a successor to one or more Captives created or availed of in connection with a transaction described in the notice, taxable years of the predecessor entities are treated as taxable years of the Captive. In determining the computation period, a short taxable year is treated as a taxable year.
A Captive that provides insurance for employee compensation or benefits and for which the Employee Benefits Security Administration of the U.S. Department of Labor has issued a prohibited transaction exemption isn’t identified as a transaction of interest under the notice.
Any Insured, Captive and/or intermediary insurance company entering into a transaction of interest, or substantially similar, on or after November 2, 2006 must disclose the transaction on Form 8886, Reportable Transaction Disclosure Statement. Taxpayers participating in a transaction of interest for a taxable year in which a return has been filed and the statute of limitation remains open as of November 1, 2016, must submit Form 8886 to the IRS Office of Tax Shelter Analysis (OTSA) by January 30, 2017. However, on December 29, 2016, the IRS issued Notice 2017-08, which extended the reporting deadline to May 1, 2017. For taxpayers participating in a transaction of interest for which the return hasn’t yet been filed but is due prior to January 30, 2017, Form 8886 is considered timely if filed with the OTSA by May 1, 2017. Taxpayers currently participating in a transaction of interest also must attach a completed Form 8886 to their federal income tax return for the current tax year and each future tax year in which the taxpayers participate. Failure to file Form 8886 by the required due date or include all required information—or include incorrect information—may result in penalties of up to $50,000 ($10,000 for individuals).
Once the IRS gathers sufficient information regarding potentially abusive micro-captive arrangements, it may remove the transaction as a transaction of interest, designate it as a listed transaction or provide a new category of reportable transaction. In the meantime, the IRS may continue to challenge these transactions during examinations.
The IRS historically has expressed concerns about certain micro-captive arrangements, including listing them on its annual “Dirty Dozen” list for the past two years. The identification of micro-captives as a transaction of interest heightens IRS scrutiny. However, it’s important to note the IRS acknowledges there are captive arrangements created for legitimate risk management or other nontax business reasons. Unfortunately, in its efforts to weed out abusive arrangements, the IRS cast a very wide net with its definition of transaction of interest, which will require almost every taxpayer with a §831(b) captive to report by the May 1, 2017, deadline. Given the significant penalties that may apply for failing to comply with the reporting requirement, it’s imperative for affected taxpayers to take action.
For more information on the notice or its applicability to your organization, please contact your BKD advisor.