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On November 1, 2016, the Internal Revenue Service released Notice 2016-66, identifying “micro-captive transactions” (including certain small captive insurance companies) as transactions of interest. Involvement in such transactions can, under Treas. Reg. § 1.6011-4, necessitate heightened reporting requirements, both for participants and for their advisors. More important from an overarching perspective, however, may be the Notice continuing the Service’s trend of elevated scrutiny for captive insurance companies, supporting a greater likelihood of prospective challenges to such transactions.
In the Notice, the Service describes the micro-captive transaction as follows: an individual owns (directly or indirectly) a business entity (the “insured company”), and a captive insurance company is separately owned by the individual (or persons related to that individual). The captive enters into a contract with the insured company regarding insurance (or, in other cases, the captive indirectly enters into a contract by reinsuring risks that the company insures with an intermediary). Typically, the captive either only offers coverage to persons related to the insured company or, if additional coverages are offered, makes coverage available to other entities represented by persons promoting the micro-captive transaction.
As typically occurs in captive arrangements, the insured company makes payments to the captive under the contract, and the insured treats the payments as deductible insurance premiums. The captive limits the amounts of net premiums written to ensure it is permitted to make an election under § 831(b) (allowing the captive to receive premiums free of tax).
Where transactions meet the description provided in Section 2.01 of the Notice (largely described above, but containing additional requirements such as the use of a “computation period”) or are substantially similar to the same, the transactions are classified as transactions of interest as of November 1, 2016. Persons entering into these transactions on or after November 2, 2006 must disclose the transaction, and material advisors also must comply with disclosure and list maintenance obligations. The Notice further states: “When the Treasury Department and the IRS have gathered enough information regarding potentially abusive § 831(b) arrangements, the IRS and the Treasury Department 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, the IRS may challenge a position taken as part of a transaction that is the same as, or substantially similar to, the transaction described in section 2.01 of this notice under other provisions of the Code or judicial doctrines such as sham transaction, substance over form, or economic substance.”
As made clear by the Service, not every captive insurance transaction will fall under the scope of Notice 2016-66. The Service states that “the Treasury Department and the IRS lack sufficient information to identify which § 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 §831(b) related-party transactions.” Individuals participating in captive insurance transactions thus should seek further information from their advisors on the applicability of the Notice to their specific situation.
As mentioned previously, Notice 2016-66 continues the Service’s active pursuit of captive insurance transactions which it deems to be abusive (though, as indicated above, it appears even the Service has not definitively settled upon standards for what is considered abusive in the captive context). Independent of Notice 2016-66, 2016 marked the second straight year § 831(b) captive insurance transactions were part of the Service’s “dirty dozen” list of purported tax scams. See IRS, Abusive Tax Shelters Again on the IRS Dirty Dozen List of Tax Scams for the 2015 Filing Season, https://www.irs.gov/uac/newsroom/abusive-tax-shelters-again-on-the-irs-dirty-dozen-list-of-tax-scams-for-the-2015-filing-season. Both Notice 2016-66 and the “dirty dozen” list are emblematic of the Service’s view of captives; audits of captives are becoming common, with an even higher level of audits expected moving forward. Given this, absolute caution is required in the context of captive formation. For those with existing captives, being cognizant of the chances of prospective audit (and being in position to defend against such an audit through the use of experienced counsel if and when such audit occurs) is highly advisable.
Patrick J. McCormick is an associate with the firm. He earned his J.D. from Vanderbilt University Law School in 2008, and his LL.M. from New York University School of Law in 2009. Mr. McCormick specializes in the areas of international taxation, tax compliance, and offshore reporting obligations. Mr. McCormick is licensed to practice in the States of New Jersey, Florida, and Georgia, and the Commonwealth of Pennsylvania. He has published national articles and given numerous national and local presentations on assorted areas of tax and estate planning law, including international tax and offshore compliance issues.