In the recently released Notice 2016-66, the IRS identified micro-captive transactions as “transactions of interest” under Reg. 1.6011-4(b)(6). The mandate requires parties involved in certain Internal Revenue Code Section 831(b) arrangements to disclose the transactions to the IRS. In late December 2016, the IRS released Notice 2017-08 to extend the disclosure deadline from January 30, 2017 to May 1, 2017.
The IRS has previously identified certain small captives or micro-captives as abusive structures on its “Dirty Dozen” list of tax scams. The “transactions of interest” designation places a reporting requirement on parties involved with small captive insurance company transactions. Failing to comply with this mandate could lead to significant penalties – fees as high as $50,000 – as well as IRS income tax and promoter examinations.
Under Section 831(b), micro-captives with no more than $1.2 million of net written premiums received ($2.2 million beginning in 2017) may elect to pay tax only on their investment income, and the insured company deducts the premiums as a business expense.
Taking Caution with Transactions of Interest
According to Notice 2016-66, the Department of the Treasury and the IRS believe that micro-captive transactions have the potential for tax avoidance or evasion. Therefore, both groups have identified certain small captive transactions as transactions of interest to gather more information about why and how small captives are being formed and operated. The notice also states that the Treasury Department and the IRS understand that the Section 831(b) election may be used for risk management purposes that do not involve tax avoidance.
Based on Notice 2016-66, captive arrangements that constitute a transaction of interest consist of the following:
- “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) 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 Section 831(b) to be taxed only on taxable investment income; and
- A, Insured, or one or more persons related (within the meaning of Section 267(b) or 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.
Additionally, either one or both of the following tests must apply:
- The 70% Test. Liabilities for insured losses and expenses are less than 70% of the premiums earned less policyholder dividends paid by Captive.
- The Financing Test. Captive has made available as financing or otherwise conveyed or agreed to make available or convey to A, Insured, or a related person in a transaction that did not result in taxable income or gain to the recipient, such as through a guarantee, a loan, or other transfer of Captive’s capital.
Staying in the Lane of Reporting Requirements
Notice 2016-66 states that retroactive reporting is required for captives that have conducted transactions of interest within the last five years. Entities must disclose the following information on Form 8886:
- a detailed account of the transaction that does the following:
- provides the IRS with an understanding of the transaction‘s tax structure;
- identifies all of the parties involved in the transaction; and
- details when and how the taxpayer learned of this type of transaction;
- whether the disclosure is a result of the 70% Test or the Financing Test;
- the authority under which the captive was chartered;
- the types of coverage provided during the year(s) of participation;
- the manner in which premiums were determined, including the contact information for any actuary or underwriter who assisted;
- a description of paid claims, amounts, reasons for, and reserves reported on the annual statement; and
- an overview of the assets held by the captive, including (but not limited to) investments and joint ventures with related parties.
The requirements of the disclosure should be followed closely. The IRS may treat an incomplete disclosure as a nondisclosure and, therefore, subject an entity to penalties and/or an examination.
The following are examples of typical scenarios in which Form 8886 would need to be filed:
- Company A is owned by Individual B. B forms Captive C (a micro-captive) as an insurance cell of a larger business, Captive D (not a micro-captive, but considered an “intermediary” in the notice). A purchases insurance from D. D reinsures A’s risks to C. C’s liabilities for losses and expenses are less than 70% of the premiums received. All four parties must file Form 8886.
- Individual B owns several companies. B forms Captive C to provide insurance to A. C’s liabilities for losses, and expenses are less than 70% of the premiums received. B, C, and all of the companies purchasing insurance must file Form 8886.
The insured companies, captives, intermediaries, and any material advisors must report the transaction to the IRS and/or the IRS Office of Tax Shelter Analysis. If the transaction of interest was in place on a return of a prior tax year, then Form 8886 is due by January 30, 2017. Additionally, all parties will file the form with their tax returns beginning with those for the 2016 tax year.
An Alternate Route for Material Advisors
Material advisors must also report the transaction of interest by filing Form 8918, and they are subject to additional list maintenance requirements. A material advisor is any person who provides any material aid, assistance, or advice with respect to organizing, managing, promoting, selling, implementing, insuring, or carrying out any reportable transaction. Additionally, a material advisor derives gross income greater than the $10,000 threshold amount (or $25,000 for C-corporations) for such aid, assistance, or advice.
A captive manager is an example of a material advisor.
The material advisor should disclose the expected tax treatment and potential tax benefits in detail any others that have advised with respect to the transaction. The advisor can file one Form 8918 for similar transactions.
Call CRI to Get the Green Light for Your Notice 2016-66 Compliance
Following the stipulations of Notice 2016-66 may seem like driving continuously in a traffic circle. However, CRI’s insurance team is ready to direct you toward any measures you may need to implement to comply with the IRS’ directive. Contact us today!