On April 10, 2023, the IRS and Treasury issued proposed regulations (REG-109309-22) identifying micro-captive transactions as listed transactions and certain other micro-captive transactions as transactions of interest. Micro-captive transactions are those where a taxpayer attempts to reduce taxable income by treating certain contracts between related parties as insurance contracts, and the parties treat one of the companies as an insurance company (the “Captive”). Learn more about micro-captives and why they’re on the IRS’ Dirty Dozen list in our FORsights™article, “IRS Continues Enforcement Focus on Abusive Micro-Captive Insurance Companies.”
This may not seem newsworthy initially since micro-captives have been classified as transactions of interest by the IRS since 2016 when IRS and Treasury issued Notice 2016-66. But there is a story of procedure behind all this that makes this something taxpayers should know about as the IRS is re-classifying micro-captive type transactions as reportable transactions but with a bit more bite this time.
What Are Listed Transactions & Transactions of Interest?
A listed transaction is a type of reportable transaction but comes with higher penalty amounts for failure to disclose. Transactions of interest are another category of reportable transactions—think of it as a rung leading up to listed transaction status since these are transactions Treasury and the IRS consider to have a potential for tax avoidance or evasion, but don’t yet have enough information to determine if the transactions of interest should rise to the level of a listed transaction.
Taxpayers participating in a reportable transaction must include a disclosure statement with their tax return, e.g., Form 8886, and send a copy of the disclosure statement to the IRS’ Office of Tax Shelter Analysis for the initial year of disclosing the transaction. In addition, anyone who provides material assistance or advice to a taxpayer participating in a reportable transaction must file a Form 8918, Material Advisor Disclosure Statement, by the last day of the month that follows the end of the calendar quarter in which the advisor became a material advisor with respect to the transaction.
Why this matters: Failure to disclose a listed transaction or transaction of interest exposes taxpayers to penalties under Internal Revenue Code (IRC) Section 6707A. The minimum penalty amount is $5,000 for individual taxpayers and $10,000 for all other taxpayers. For listed transactions, the maximum penalty amount is $100,000 for individual taxpayers and $200,000 for all other taxpayers. For other reportable transactions, including transactions of interest, the maximum penalty is $10,000 for individual taxpayers and $50,000 for all other taxpayers. There also is an extended statute of limitations period under IRC §6501(c)(10).
Why Are Treasury & IRS Re-Issuing Prior Notices as Proposed Regulations?
A series of recent court cases made certain notices obsolete by holding that listed transactions constitute a legislative rule and, therefore, Treasury and the IRS designating something as a listed transaction should be subject to the Administrative Procedure Act (APA) notice and comment procedures. The APA requires federal agencies to publish a notice about a proposed rule, give time for the public to comment on the rule, and then, after considering the comments and making changes accordingly, the agency can publish a final rule. This was not historically the practice followed by the IRS and Treasury in identifying certain transactions as reportable transactions.
Mann Construction v. United States, 27 2 F.4th 1138 (6th Cir. 2022), focused on the validity of Notice 2007-83, which designated certain employee benefit plans featuring cash-value life insurance policies as listed transactions. In Mann Construction, the Sixth Circuit held that Notice 2007-83 was a legislative rule because it mandated a new duty on taxpayers to provide information to the IRS that they were not bound to do prior to the issuance of the notice. Taxpayers who didn’t comply with the notice faced penalties and criminal sanctions. As such, because the agency was not merely interpreting a statute but instead imposing new duties on taxpayers, the court held that the IRS should have followed the APA notice and comment procedures before classifying certain employee benefit plans as listed transactions.
Relying on Mann Construction, in CIC Services, LLC v. IRS, 2022 WL 985619 (E.D. Tenn. March 21, 2022), as modified by 2022 WL 2078036 (E.D. Tenn. June 2, 2022), a U.S. District Court in Tennessee found Notice 2016-66 to be invalid because the Notice was a legislative rule and the IRS had not followed the notice-and-comment procedures under the APA.
Similarly, and relying on Mann Construction, in Green Valley Investors, LLC v. Commissioner, 159 T.C. No. 5 (2022), the U.S. Tax Court found Notice 2017-10 invalid as well, yet again for not following APA notice-and-comment procedures. This notice identified certain syndicated conservation easements as listed transactions. In response, in December 2022, the IRS issued proposed regulations identifying certain syndicated conservation easement transactions and substantially similar transactions as listed transactions.
Although Treasury and the IRS disagree with these court decisions, they must still comply with these holdings and are accordingly re-issuing and updating some of these invalidated notices, but this time following the APA notice-and-comment procedures.
What’s New Because of This Latest Guidance?
While recently issued proposed regulations are similar to the rules outlined in Notice 2016-66, there are notable differences. For starters, where Notice 2016-66, as modified by Notice 2017-8, identified micro-captive transactions as transactions of interest, the proposed regulations identify transactions that are the same as—or substantially similar to—certain micro-captive transactions as listed transactions, and certain other micro-captive transactions as transactions of interest.
Specifically, transactions proposed to be identified as listed transactions revolve around related-party structures where at least 20% of its assets or the voting power or the value of the outstanding stock or equity interest is owned—directly or indirectly—by an insured entity, an owner or persons related to an insured entity, or an owner. There are two categories of such transactions that are identified by the proposed regulations:
- The presence of a financing factor, e.g., Captive provides, directly or indirectly, financing through a guarantee, a loan, or other transfer of Captive’s capital during the financing computation period, which is defined as the most recent five taxable years of the Captive; or
- A loss ratio factor that falls below 65% based on a computation period of 10 taxable years, e.g., Captive’s liabilities for insured losses and claim administration expenses are less than 65% of the premiums earned by Captive, less policyholder dividends paid by Captive.
Transactions that are substantially similar to these also will be considered listed transactions. “Substantially similar” means that the transactions result in the same or similar tax consequences and are either factually similar or based on the same or similar tax strategy as the two categories of listed transactions described above.
There also is a third category of transactions addressed in the proposed regulations, but these are categorized as transactions of interest. These transactions also involve related parties and are identified by the presence of a loss ratio factor that falls below 65% over a shorter computation period of nine taxable years (or all taxable years of the Captive if Captive has been in existence for less than nine taxable years). The proposed regulations also modify parts of Notice 2016-66, including:
- Expanding the scope of the definition of “Captive” to include derivatives and interests in the assets of the Captive. The IRS found that some taxpayers were structuring transactions where the insured, the owners, and related parties to the insured and the owners did not have direct or indirect interests in the Captive’s voting power or value of its outstanding stock or equity interest but had a relationship with Captive that provided substantially similar benefits and risks. According to the IRS, this setup helped promoters avoid the 20% related interest threshold in voting power or equity interests in the Captive to rise to the levels in Notice 2016-66.
- Changes to the financing factor. As discussed above, transactions where the financing factor is met based on a computation period of the Captive’s most recent five taxable years are now identified as listed transactions (in Notice 2016-66, these were categorized as transactions of interest).
- Changes to the loss ratio factor and computation periods. Under Notice 2016-66, transactions where the loss ratio factor was less than 70% based on the most recent five taxable years were identified as transactions of interest. Under the proposed regulations, transactions with a loss ratio factor ratio of less than 65% for a computation period of the Captive’s most recent 10 taxable years are identified as listed transactions, and transactions with a loss factor ratio of less than 65% using a computation period of the most recent nine taxable years as transactions of interest.
- Information provided with Form 8886. The proposed regulations continue to require a Captive to identify the types of policies issued or reinsured, the amounts treated as premiums written, the name and contact information of actuaries and underwriters involved, and the total amount of claims paid by the Captive with its Form 8886 filing. However, the prior Notice 2016-66 disclosure requirements for under what authority the Captive is chartered, how amounts treated as premiums for coverage provided by the Captive were determined, the amounts of reserves reported by the Captive on its annual statement, and description of assets held by the Captive are not required under the proposed regulations.
- Disclosure requirement safe harbor for owners. In a favorable development, the proposed regulations provide that any person who, solely by reason of their direct or indirect ownership in the insured would otherwise be subject to disclosure requirements as a participant in a micro-captive listed transaction or transaction of interest, is not required to file a disclosure statement, i.e., Form 8886, with respect to the transaction provided that person receives written or electronic acknowledgment that the insured company will comply with its separate disclosure obligation. Such acknowledgment can be a copy of the Form 8886 filed by the insured company.
- Reporting exception for consumer coverage arrangements. Under Notice 2016-66, certain captives that insure the risks of unrelated customers were potentially considered as falling under the transaction of interest definition and often filed Form 8886 on a protective basis. The proposed regulations provide a limited exception from being classified as a micro-captive listed transaction or transaction of interest for certain consumer coverage reinsurance arrangements where the seller, e.g., a service provider, automobile dealer, lender, or retailer, sells products or services to unrelated customers who purchase insurance contracts in connection with those products or services.
Comments on the proposed rules should be provided to Treasury and the IRS by June 12, 2023. After consideration of public comments, the IRS and Treasury plan to finalize the regulations later in 2023.
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