Reportable transaction disclosures now required for micro-captives
IRS designates some captive insurers ‘transactions of interest’
TAX ALERT |
Participants in micro-captive transactions will be required to file disclosures with the IRS because the IRS has identified these captive insurance arrangements as transactions of interest in Notice 2016-66.
What is a micro-captive?
Generally, a captive insurance company is one that insures certain risks of its owner (or owners), or risks of one or more parties related to its owner (or owners). Micro-captives validly electing under section 831(b) of the Tax Code are exempt from tax on their insurance income. Other income of the captive generally remains subject to tax. To maintain the exemption of their insurance income, micro-captives must not exceed an annual insurance premium limit—generally $1.2 million ($2.2 million for taxable years beginning after Dec. 31, 2016).
Which micro-captives are transactions of interest that must be disclosed to the IRS?
Notice 2016-66 describes reportable micro-captive transactions by providing a basic fact pattern that triggers the disclosure requirement. The disclosure requirement applies regardless of whether the transaction has any of the characteristics the IRS has identified as potentially problematic or abusive. The fact pattern in the notice, simplified, is:
- A business owner (Owner), or a party related to Owner, owns an interest in a captive insurance company (Captive).
- Captive (directly or indirectly) insures risks of the business owned (or part-owned) by Owner (the Business) in exchange for premium payments.
- Captive makes a section 831(b) election.
- Owner or the Business (or one or more related parties) owns at least 20 percent of Captive by vote or value.
- Either –
a. Liabilities incurred by Captive for insured losses and claim administration during a five-year computation period (or shorter period if the Captive has existed for less than five years) is less than 70 percent of the excess of (i) premiums earned by Captive over (ii) policyholder dividends paid by Captive; or
b. Captive loans (or otherwise makes available) a portion of the premium payments it receives to Owner, the Business, or a related party in a transaction that does not result in taxable income or gain.
The notice provides an exception, however, for captive insurance companies that provide employee compensation or benefits and that have received a Prohibited Transaction Exemption from the Employee Benefits Security Administration of the U.S. Department of Labor. Transactions with such captives are not transactions of interest under the notice.
Who may be required to file disclosures with the IRS and what is the disclosure requirement?
Business owners, businesses, captive insurance companies and intermediaries may be required to disclose their participation in micro-captive transactions.
Taxpayers who have entered into a reportable micro-captive transaction after Nov. 2, 2006, must disclose the transaction to the IRS. There are limited exceptions for situations in which the statute of limitation for tax assessment has closed for all relevant tax years. Disclosure is made by filing Form 8886, Reportable Transaction Disclosure Statement. It must identify and describe the transaction in sufficient detail for the IRS to be able to understand its tax structure and the identity of all parties involved in the transaction. In addition, the disclosure should include when and how the taxpayer became aware of the transaction.
Taxpayers who have participated in a micro-captive transaction during years for which they have already filed tax returns must file an initial disclosure statement with the IRS’ Office of Tax Shelter Analysis (OTSA) by Jan. 30, 2017. Subsequent filings will require a disclosure statement for each taxable year for which the taxpayer participates in a micro-captive transaction, and the disclosure must also be filed with OTSA if it is the first Form 8886 filed by the taxpayer with respect to the transaction.
Taxpayers who fail to timely file a disclosure may be subject to a penalty. The penalty is 75 percent of the tax reduction attributable to the transaction with a minimum penalty of $10,000 ($5,000 for an individual).
In addition, a person acting as a material advisor will have a disclosure requirement using Form 8886. Generally, a material advisor is defined as a person providing advice or assistance with respect to organizing, managing promoting or carrying out any reportable transaction, and derives gross income in excess of $50,000.
What characteristics of micro-captives does the IRS find potentially problematic?
Notice 2016-66 lists some characteristics of micro-captive arrangements that the IRS considers potentially problematic. These include, for example:
- Coverage of risks that are implausible or unrelated to the insured’s business
- Duplicative or vaguely described coverage
- Premium amounts determined without an underwriting or actuarial analysis that conforms to insurance industry standards
- Premiums that exceed amounts that unrelated insurers would charge
- Captives that fail to comply with insurance laws or regulations, or lack defined claims administration procedures
- Captives with inadequate capital
- Failure to file claims for insured losses
The IRS has previously described micro-captive transactions it considers abusive in IR-2016-25.
As noted above, transaction of interest status applies to micro-captive transactions described in the notice regardless of whether abusive features are present. Taxpayers should consult their tax advisors regarding the status of their captive insurance arrangements and whether they must file Forms 8886 disclosing the arrangements.