Group Raises Concerns With Guidance on Micro-Captive Transactions

November 27, 2017

David Kautter
Assistant Secretary, Tax Policy
United States Department of Treasury
Acting Commissioner
Internal Revenue Service
Department of the Treasury
1500 Pennsylvania Avenue NW, Room 3120
Washington, D.C. 20220

Dana Trier
Deputy Assistant Secretary, Tax Policy
Department of the Treasury
1500 Pennsylvania Avenue NW, Room 3120
Washington, D.C. 20220

Re: Follow-up from meeting with respect to Small, Captive Insurance Companies

Dear Dave and Dana:

Thank you for being willing to meet and discuss our concerns with respect to Notice 2016-66 (“Notice”). This letter provides some background on the issue, and reviews these main concerns.

General Background

By way of background, captive insurance companies have been recognized by the IRS and legitimately utilized for at least 50 years, and allow companies — including many small businesses — to reduce insurance costs and improve risk management. Allstate Insurance Company, for example, was initially formed as a captive insurance company for Sears, Roebuck & Co. before Sears completely spun-off Allstate in 1995. Today, captive insurance companies are widely utilized by companies small and large (e.g., ExxonMobile, ADM, Verizon, AT&T).

Additionally, as discussed further below. Congress has historically been very supportive of captive insurance companies that utilize the election for small insurance companies under Internal Revenue Code (“Code”) section 831(b) (“Microcaptives”) to be taxed only on their investment income. In 2015, for example. Congress in the PATH Act significantly increased the amount of premiums that a Microcaptive may have and remain eligible for the election, and pegged this amount to inflation.

Notice Generally

In contrast, the Notice made all transactions involving Microcaptives a “transaction of interest” for purposes of sections 6111 and 6112 of the Code, and Treasury Regulation 1.6011-4. While the significant chilling effects of this Obama Administration midnight regulation have been felt for months, beginning May 1, 2017, the designation caused the industry to begin to be required to observe ongoing, burdensome, and complicated information reporting obligations. Failure to exactly meet these obligations results in significant monetary penalties — without any regard for whether or not the affected person is otherwise fulfilling all of his/her/its other federal tax obligations.

Operation of the Notice

Affected Taxpayers. In greater detail, the Notice makes any transaction regarding a small captive a “transaction of interest” where:

Based upon the rules described above, determining even the applicability of the Notice to a Microcaptive transaction is obviously quite technical — and likely beyond the expertise of many persons required to report. For practical purposes, it is my understanding that there are thousands of small captives — as well as the businesses that utilize them and advisors that render professional services with respect to them — that are captured by this regulatory dragnet.

These significant reporting and/or record-keeping requirements and the burdensome penalties that flow from non-compliance, will undoubtedly catch many unsuspecting persons, including numerous small businesses and small business owners who have no idea that their non-abusive connection to or utilization of a Microcaptive requires them to abide by these reporting and/or record-keeping requirements.

Participant Reporting Obligations. Treasury Regulation 1.6011-4 requires every “taxpayer that has participated” in a transaction described by the Notice to file a disclosure statement (IRS Form 8886) with their tax return for every year where their tax return “reflect[s] the consequences” of a transaction described in the Notice. In the context of the Notice, this reporting applies to an owner of the business and/or captive (including an indirect owner), the insured business, the captive, and any intermediary insurance company.

For this “participant” reporting, IRS Form 8886 must be included with the person's yearly tax return, as well as any amended return, for every tax year in which the person participates in the transaction and for every transaction that the person participates in.

The participant taxpayer must also retain all documents and records “related to” a transaction of interest until the expiration of the statute of limitations for the final taxable year that the person is required to file the disclosure statement with respect to. Treas. Reg. sec. 1.6011-4(g)(1).

Additionally, for the initial filing year (i.e., the first year a person becomes a participant or the first filing following the designation of the transaction as a transaction of interest), the Form 8886 must also be provided to the Office of Tax Shelter Analysis (“OTSA”) in Ogden, Utah. Treas. Reg. sec. 1.6011-4(d)-(e); Internal Revenue Service, Instructions to Form 8886 (Revised March 2011).

This requirement has a “springing” effect on taxpayers who are now required to report Microcaptive transactions: Treasury Regulation 1.6011-4(e)(2)(i) provides that a copy of the Form 8886 must be provided to the OTSA for each open tax year of the taxpayer — even if the taxpayer would otherwise have no reporting obligation with respect to the tax year the Notice was promulgated (i.e., because the taxpayer is would no longer be considered a “participant” in the transaction in tax year 2016). Additionally, the Notice makes any transaction a transaction of interest if it was entered into after November 1, 2006. This ten-year lookback rule is unprecedented, and runs counter to the letter and intent of section 7805(b).¹

In general, to be considered complete, the participant disclosure must (in addition to providing all of the general information otherwise required on Form 8886):

See Treas. Reg. sec. 1.6011-4(d). The Notice provides additional specific information that affected persons must provide in order to be in compliance. What is considered “sufficient detail” for the IRS to be able to understand what is occurring is not detailed in the applicable Treasury Regulation (or, for that matter, in any binding IRS guidance we could find).

If the disclosure form is incomplete in any way (including because it lacks “sufficient detail”) the person is not considered to have complied with the disclosure requirements with respect to that year, and is subject to the strict liability monetary penalty provided in Code section 6707A. Treas. Reg. sec. 1.601l-4(d); sec. 6707A(a), (d)(2); Treas. Reg. sec. 301.6707A-l(a) (specifically noting a failure to include “any information” that is required to be disclosed as subjecting a taxpayer to the penalty).

Material Advisor Reporting Obligations. In addition to participant reporting. Code sections 6111 and 6112 require any “material advisor” with respect to a transaction described in the Notice to file a return (IRS Form 8918) with respect to the transaction and keep lists of every person with respect to whom the advisor acted as a material advisor with respect to a transaction described in the Notice. In this case, a material advisor is any person that provides “any material aid, assistance, or advice with respect to organizing, managing, promoting, selling, implementing, insuring, or carrying out” a transaction described in the Notice, where the advisor “directly or indirectly derives” gross income above a threshold amount for the material aid, assistance, or advice.

The Notice also specifically lowers the monetary standard for when a professional advisor becomes a “material advisor” with respect to a Microcaptive transaction to the same level as that of a so-called “listed transaction” — which is a transaction that specifically entails tax avoidance. As a result, many more advisers will be considered “material” advisors for purposes of the Notice than would otherwise for a “normal” transaction of interest.

For material advisor reporting, IRS Form 8918 must (within the required time) be provided — initially, and on a yearly basis — to the OTSA in Ogden, Utah. Treas. Reg. sec. 301.6111-3(d)-(e); Internal Revenue Service, Instructions to Form 8918 (Revised December 2011). The significant amount of information required to be provided on Form 8918 tracks that required by Form 8886, as does the “sufficient detail” requirement. Compare Treas. Reg. sec. 301.6111-3(d)(1) with Treas. Reg. sec. 1.6011-4(d).

And like Form 8886, any Form 8918 that does not contain “sufficient detail” is considered incomplete, and a material advisor would be subject to the strict liability penalty under Code section 6707(a) for failure to report. Treas. Reg. sec. 301.6011-3(d)(1); sec. 6707(a); Treas. Reg. sec. 301.6707-1(a)(1) (specifically noting “incomplete information” on Form 8918 as subjecting a material advisor to the penalty).

Separately, material advisors must prepare and maintain the following “list” of information with respect to every transaction it has acted as a material advisor with respect to:

See Treas. Reg. sec. 301.6112-1(b)(3). Failure to maintain and/or provide this “list” to the IRS within 20 days upon request also subjects a material advisor to a daily penalty, and incomplete “lists” are treated as if no list had been provided — subjecting the material advisor to the penalty. See Treas. Reg. sec. 301.6708-l(a); Treas. Reg. sec. 1.301.6112-1(e)(l). It is not clear where the list must be sent, but presumably since the IRS must request the list in writing that request would specify where to send it. See Treas. Reg. sec. 301.6112-1(e)(1).

Reporting Penalties. Sections 6707, 6707A, and 6708 impose penalties with respect to the disclosure required by the Notice. Under Code section 6707A, non-compliance with the participant reporting obligations results in a per-transaction penalty of 75 percent of the decrease in tax shown on the return as a result of the transaction, with a minimum penalty of $10,000 ($5,000 for individuals) and a maximum penalty of $50,000 ($10,000 for individuals). Section 6707(a) imposes a per-transaction penalty for failure to make the material adviser reporting of $50,000. Section 6808 imposes a per-list penalty $10,000 per day, per required list, for every list of advisees that is not complete and provided to the IRS by the 20th day following the IRS's request of such list. Thus, material advisors confront even more onerous reporting penalties than participants.

Certain Issues Apparent on the Face of the Notice

As the above recitation of the implications of the Notice demonstrates, the designation of Microcaptive transactions as a “transaction of interest” imposes significant (and likely materially adverse) ongoing burdens for all “participants” in these transactions — regardless of whether or not the participant is sophisticated enough to be aware of such obligations and regardless of whether or not such transaction is a legitimate and completely non-abusive business transaction.

In order to better understand the burden placed upon law-abiding businesses by the Notice, it is important to reflect on certain of the important aspects of its structure. Among other things, the preamble section states the IRS's aim in issuing the Notice: to request information on a transaction that “has a potential” for tax avoidance. In explaining this request, however, the Notice acknowledges that it “may” already possess sufficient information to describe the characteristics of Microcaptive transactions that are abusive, and those that are not.

Section 1 describes these characteristics and arrangements, which broadly involve small “captive” insurance companies that are issuing coverage that would not be considered “insurance” under current tax law, receive premiums which far exceed the third-party cost of coverage, do not comply with rules for insurance companies, and are inadequately capitalized. The IRS also acknowledges, however, that it does not believe that all (or even many) Microcaptive transactions are ones that involve tax avoidance.

As described below. Section 2 clarifies which Microcaptive transactions are designated by the Notice as a transaction of interest. In making this designation, the IRS does something that is both astonishing, and unprecedented: it explicitly acknowledges that non-abusive transactions will be forced to bear the burden of being designated a transaction of interest:

“A transaction described in this section 2.01 is identified as a transaction of interest regardless of whether the transaction has the [potential tax avoidance] characteristics described in section 1 of this notice.”

(emphasis added)

A brief examination of the five other extent IRS Notices that designate a transaction of interest underscores how remarkable this admission is. Included as Annex A is a chart that briefly details the topics these IRS Notices addressed (from most recent to oldest Notice).

None of these IRS Notices include the startling admission by the IRS that transactions lacking any of the potentially abusive characteristics described in the first part of the relevant IRS Notice would nevertheless be designated as “of interest.” Rather, these IRS Notices all (even the revoked Notice 2015-48) limit their application to transactions that are the “same as or substantially similar to” the facts of the potentially abusive transaction described in the first part of the applicable IRS Notice.²

In contrast, the Notice describes in its first part one narrow set of potentially abusive facts that the IRS is concerned about, but then in describing in the next part the actual “transaction” that the Notice designates as “of interest,” describes an even broader set of facts that are entirely unrelated to the potentially abusive or concerning facts (which happened to describe effectively all transactions involving an 831(b) captive).

In other words, the Notice took a pool of transactions that based upon certain criteria could potentially be abusive, but for which the IRS claims to lack sufficient information with respect to, and expanded the pool to include transactions based upon an entirely different set of criteria that has nothing to do with (and bears no relationship to) the potential for abuse.

Further underscoring the problems with this approach, in one of the other IRS Notices, Notice 2015-74,³ the IRS went out of its way to limit the applicability of Notice 2015-74 to transactions that could actually be abusive (i.e., it took the pool of potentially abusive or concerning facts and further narrowed the designation to include only those transactions it was really worried about).

In short, the IRS admits in the Notice that it is aware that Microcaptive transactions that have no tax avoidance will also be considered transactions of interest, but wants them to be so treated notwithstanding. I cannot think of an occasion previously where the IRS plainly admitted it did not care that innocent taxpayers would be saddled with an onerous, draconian reporting and penalty regime.

In other words, for the sake of ferreting out a few bad actors, the IRS has forced nearly every small business in America using captive insurance to incur tremendous legal and compliance costs or face heavy penalties. The small businesses blithely targeted by the IRS are the least able to defend themselves from this overreach.

In addition, advisors of legitimate, non-abusive transactions face even greater legal and compliance costs — at the same time their livelihoods are being harmed by virtue of the “chilling” effects that have resulted from Microcaptive transactions being added to the reportable transaction list.

This direct impact on material advisors has a feedback effect on businesses who want to use these transactions for legitimate reasons, as many reputable advisors who (wisely) choose to avoid subjecting themselves to the risks and challenges of material advisor reporting become unwilling to advise or assist businesses with completely non-abusive Microcaptive transactions.

Legislative History of 831(b) Shows Support for Microcaptives

These burdensome externalities run directly against the Congressional support for Microcaptives evidenced by recent changes to Code section 831(b), and are clearly within the spirt (if not the letter) of EO 13789. As stated in this Executive Order:

[N]umerous tax regulations issued over the last several years have effectively increased tax burdens, impeded economic growth, and saddled American businesses with onerous fines, complicated forms, and frustration. Immediate action is necessary to reduce the burden existing tax regulations impose on American taxpayers and thereby to provide tax relief and useful, simplified tax guidance.

The President's description of a burdensome, complicated, and business-chilling tax regulatory environment perfectly captures the conundrums caused by the Notice.

Furthermore, as noted briefly above, the Notice runs against the grain of Congressional support for legitimate Microcaptive transactions. Rather than constricting Microcaptives, Section 333 of the Protecting Americans from Tax Hikes Act of 2015 (“PATH Act”) increased the amount of premiums small insurance companies can write and still qualify for Code section 831(b)'s alternative tax regime, nearly doubling the amount, from $1,200,000 to $2,200,000.

In addition, the PATH Act indexed this dollar limitation for inflation. The legislative history to S. 905 (114th Congress), the bill upon which the changes to Code section 831(b) is based, expresses Congress's concern about the “limiting” effect of prior Code section 831(b)'s “$1,200,000 ceiling on net or direct written premiums,” which had not been adjusted for inflation since 1986.⁴

Section 333 of the PATH Act addressed this congressional concern by raising the limit and permanently indexing the limit for inflation — ensuring the continued future relevance of the small insurance company exception. The PATH Act changes to Code section 831(b) also addressed Congress's concerns with respect to the potential for abuse of Code section 831(b).

The original draft of S. 905, introduced by Senate Finance Committee Chairman Orrin Hatch on April 14, 2015, included a provision that restricted property and casualty insurance companies from making the 831(b) election if more than 20 percent of the company's net written premiums was attributable to any one policyholder (the so-called “diversification requirement”), and required the captive to make reports to the IRS relevant to this restriction.⁵

The Committee Report accompanying S. 905 indicated that this provision was intended to “narrow eligibility to elect the alternative tax in a manner intended to address abuse potential. . . .”⁶ In other words, S. 905's authors included the diversification requirement in order to address whatever concerns it had with respect to taxpayers abusing the small insurance company exception.

The Senate Finance Committee, however, reported a different version of S. 905, which did not include the diversification requirement, but instead included a provision requiring the Secretary of the Treasury to deliver a report to Congress “on the abuse of captive insurance companies for estate planning purposes” which would include “legislative recommendations for addressing any such abuses.”⁷

The Finance Committee's concern with the diversification requirement included its potential to “cause problems for certain States,” and the Finance Committee's inclusion of the Treasury Department study requirement was intended to enable “Congress [to] better understand the scope of [the estate planning abuses of the small insurance company exception] and whether legislation is necessary to address it”⁸

Thus, in both instances (i.e., the draft bill and the reported version), Congress clearly evidenced its intent to both expand the availability of the small insurance company exception, and also its desire to be directly involved in crafting the rules intended to curb any potential for abuse of the provision.

While S. 905 was reported favorably out of the Senate Finance Committee by voice vote (i.e., it was non-contentious and bipartisan),⁹ the measure was not taken up by the full Senate. S. 905's changes to Code section 831(b), however, resurfaced as section 333 of the PATH Act, which passed Congress on December 18, 2015 by a vote of 316 to 133 in the House of Representatives and a vote of 65 to 33 in the Senate.¹⁰ Then-President Barack Obama signed the bill into law the same day.

When S. 905's changes to Code section 831(b) resurfaced as section 333 of the PATH Act, Congress reverted to the original draft bill's language, including the diversification requirement and dropping the Treasury Department study. This version became law in December 2015, and is reflected in current Code section 831(b).¹¹ A reasonable inference of this decision was that Congress considered the diversification requirement sufficient to address its concerns with respect to the potential for abusing Code section 831(b).

It is thus quite surprising (and concerning) that after the enactment of these changes to Code section 831(b), the IRS unilaterally — and without notice or comment — promulgated guidance labelling captive small insurance companies that utilize Code section 831(b) to be transactions that have “a potential for tax avoidance or evasion.” Not surprisingly, this about-face took the Microcaptive industry for surprise.

Main Issues with the Notice

While there are myriad issues with the Notice, the industry's immediate concerns are as follows:

• The Notice explicitly acknowledges that “related parties may use captive insurance companies that make elections under sec. 831(b) for risk management purposes that do not involve tax avoidance,” and further goes on to state that the IRS is only aware of “cases” in which the arrangement is abusive. While the Notice does not directly say so, a clear inference is that the IRS would acknowledge that the vast majority of Micro-captive transactions have nothing to do with tax avoidance.

• The Notice's description of the micro-captives subject to enhanced disclosure is very technical. When combined with the broad definition of “participant” for purposes of the reporting rules, it is very likely that many taxpayers — including countless small businesses — will be unaware that they are now required to complete a highly technical yearly report — potentially subjecting them to the significant monetary penalties described above.

• The reporting required by the Notice is technical, detailed, and applicable yearly on a per-transaction basis. This disclosure is also very technical, and runs in the hundreds of pages for each captive. Thus, even if the “participant” is aware of its obligation to complete its report on Form 8886, it is very likely that a significant number will be unable to afford the cost of paying a lawyer or accountant to accurately complete this form.

• In addition to the ongoing yearly disclosure described above, disclosure is also required for the year the Notice was issued, and all open tax years, making the requirement retroactive. When viewed in conjunction with the bullets above, the likelihood of persons being inadvertently subject to penalties is highly likely.

• Being designated as a “transaction of interest” has a significant “chilling” effect on the legitimate use of Micro-captives, unnecessarily punishing non-abusive taxpayers for the practices of a minority of others. As noted above, the IRS (and even the Notice) acknowledges the legitimate use of Microcaptives. There are less indiscriminately-harmful ways for the IRS to “define the characteristics that distinguish the tax avoidance [Micro-captive] transactions from other sec. 831(b) related-party transactions.” That the IRS did not continue to pursue these means prior to issuing the Notice suggests that the IRS wishes to chill these transactions entirely, without regard to whether or not they are completely non-abusive.

• Contrary to the IRS's indiscriminate attack on section 831(b), Congress's choice in 2015 to expand section 831(b) demonstrates its support for the provision, underscoring how the Notice is out-of-step with Congressional intent. Furthermore, Congress's choice in 2015 to include diversification requirements for 831(b) in order to resolve Congress's concern with potential abuses of 831(b) indicates that Congress does not want to abdicate oversight responsibility for the provision to the IRS.

• The Notice is exactly the kind of burdensome IRS guidance that EO 13789 is concerned about.

• The IRS's choice to impose reporting requirements on participants of microcaptive transactions as a Treasury Notice — as opposed to via a Proposed (or Temporary) Treasury Regulation — was an “end run” around the APA. The fact that the action was taken in the final days of the prior Administration makes the choice more egregious. Congress (and the current Administration) are both acutely aware of the need for less burdensome (and more open) rulemaking. The Notice is precisely the type of rulemaking they are concerned with.

Administrative Procedures Act

As an aside, we believe the Notice is subject to the Administrative Procedures Act (“APA”), 5 U.S.C. sec. 551 et seq., and the Congressional Review Act (“CRA”), 5 U.S.C. sec. 801 et seq. The APA generally applies to “rule making” by an “agency.” See, e.g., 5 U.S.C. sec. 553(b)-(d). For purposes of the APA, the term “'rule making' means agency process for formulating, amending, or repealing a rule.” 5 U.S.C. sec. 551(5). A “rule” for purposes of the APA “means:

the whole or a part of an agency statement of general or particular applicability and future effect designed to implement, interpret, or prescribe law or policy or describing the organization, procedure, or practice requirements of an agency and includes the approval or prescription for the future of rates, wages, corporate or financial structures or reorganizations thereof, prices, facilities, appliances, services or allowances therefor or of valuations, costs, or accounting, or practices bearing on any of the foregoing. . . .

5 U.S.C. sec. 551(4) (emphases added). An “agency” that is subject to the APA is every “authority of the Government of the United States, whether or not it is within or subject to review by another agency,” with the exception of Congress, the courts, territorial governments, the District of Columbia, courts martial or military commissions, military authorities in the field in wartime, and certain other limited exceptions. 5 U.S.C. sec. 551(1).

The IRS and the Treasury Department are both clearly “agencies” for purposes of the APA. Likewise, an IRS Notice — including the Notice — is clearly a “statement” of an agency that is “designed to implement, interpret, or prescribe law or policy.” In other words, the Notice is subject to the APA.

We make this observation to underscore the fact that the Notice is clearly in scope with respect to the spirit (if not the letter) of Executive Order 13789 on Identifying and Reducing Tax Regulatory Burdens and Executive Order 13771 on Reducing Regulation and Controlling Regulatory Costs.

We appreciate your attention to this important issue, and look forward to discussing possible times to meet and discuss the matter. If you have any questions, please do not hesitate to contact me at (202) 772-2482 or ken.kies@fpgdc.com.

Very truly yours,

Kenneth J. Kies
Federal Policy Group
Washington, DC