The Internal Revenue Service on November 1, 2016 issued Notice 2016-66 (the Notice) requiring information reporting with respect to certain insurance or reinsurance transactions (often referred to as micro-captive transactions) involving captive insurance companies that claim the benefits of an election under Section 831(b) of the Internal Revenue Code (available to certain small insurance companies). The IRS and the Treasury Department are concerned that taxpayers are entering into potentially abusive micro-captive transactions (for example, by insuring against risks that are implausible or that do not match a business risk of the insured) in order to gain an inappropriate tax advantage, and are seeking information on these types of transactions in order to best formulate a response to this perceived abuse. The Notice identifies the transactions which, together with transactions which are substantially similar to the described transactions, are subject to this reporting. Information reporting for covered transactions would potentially be required for transactions occurring as far back as November 2, 2006.
Acknowledging that related parties may also use micro-captive transactions for legitimate risk management purposes that do not involve tax avoidance, the Notice sets forth the elements of a micro-captive transaction that will trigger the required reporting. A micro-captive transaction will be subject to the required reporting if:
- Either the insured entity or its owners, or one or more persons related to the insured entity or one of its owners, directly or indirectly own at least 20% of the voting power or value of the outstanding stock of the captive; and
- •One or both of the following apply:
- The amount of the liabilities incurred by the captive for insured losses and claimed administration expenses during the most recent five tax years of the captive (or if shorter, the entire period of the captive’s existence) is less than 70% of (A) the premiums earned by the captive during such period, less (B) policyholder dividends paid by the captive during such period; or
- The captive has at any time during such period directly or indirectly made available as financing or otherwise conveyed or agreed to make available or convey to an owner of the insured, the insured, or a person related to any such owner or the insured, in a transaction that did not result in taxable income or gain to such recipient, any portion of the payments under the insurance or reinsurance contract, such as through a guarantee, a loan, or other transfer of the captive’s capital.
Although targeted at identifying the types of transactions that the IRS and Treasury Department consider as having the potential for tax avoidance, these criteria are broadly crafted enough to potentially catch non-abusive transactions as well.
Information reporting and certain related record keeping requirements for covered transactions could potentially be required of the captive insurer, the insured (including potentially fronting companies used in a reinsurance model), and certain owners of the insured, as well as material advisors who provided tax statements with respect to the transaction.
The owners of the insured, the insured, and the captive (and any fronting company used in a reinsurance model) for covered transactions must disclose their involvement to the IRS. These parties are required to annually file Form 8886, “Reportable Transaction Disclosure Statement,” with their tax returns beginning with the 2016 tax year. Retroactive reporting is also required for covered transactions from after November 2, 2006 and before January 1, 2016 (generally due by January 30, 2017). All disclosing parties must describe when and how they became aware of the transaction, and disclosing captives are required to provide certain additional detailed information. The disclosing parties must also retain a copy of all material documents and other records related to the transaction. Failure to disclose on Form 8886 could result in a penalty of 75% of the tax benefit of the transaction, with minimum and maximum penalties ranging from $5,000 to $50,000 depending upon the status of the reporting party.
Material advisors that have made a tax statement on or after November 2, 2006 with respect to covered transactions entered into on or after that date also have disclosure and record keeping obligations. A material advisor is generally a person who provided any material aid, assistance or advice with respect to organizing, promoting, implementing or insuring the transaction, and derives gross income in excess of $250,000 if substantially all of the tax benefits are provided to non-individual taxpayers (or $50,000 if substantially all of the tax benefits are provided to individuals). Material advisors must file Form 8918, “Material Advisor Disclosure Statement,” and maintain a list identifying each person that they acted as a material advisor to regarding such a transaction. Failure to disclose on Form 8918 could result in a penalty of $50,000, and failure to make the list available within 20 business days of a written request could result in daily penalties of $10,000.
Taxpayers utilizing a micro-captive structure should review their structure to determine whether these new reporting and record keeping requirements apply. As stated above, micro-captive transactions that are used for legitimate risk management purposes that do not involve tax avoidance could nonetheless be caught in the broadly crafted criteria of the Notice.
For more information on the matters discussed in this Locke Lord QuickStudy, please contact the author, Christopher M. Flanagan.