IRS Issues Tax Notice for Micro-Captive Transactions

Some Micro-Captives Now Require IRS Reportable Transaction Disclosures

The IRS will require participants in micro-captive transactions to file disclosures due to captive insurance arrangements identified as transactions of interest in IRS Notice 2016-66.

What is a micro-captive?

Generally, a captive insurance company is one that insures certain risks of its owners or risks of one or more parties related to its 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 must be disclosed to the IRS?

Notice 2016-66 describes reportable micro-captive transactions by providing a fact pattern that triggers the disclosure requirement. The disclosure requirement applies regardless of whether or not the transaction has any of the following characteristics the IRS has identified as potentially problematic or abusive:

1. A business owner (Owner), or a party related to Owner, owns an interest in a captive insurance company (Captive).
2. Captive, directly or indirectly, insures risks of the business owned or part-owned by Owner (the Business) in exchange for premium payments.
3. Captive makes a section 831(b) election.
4. Owner or the Business, or one or more related parties, owns at least 20 percent of Captive by vote or value.
5. Either:

• 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
• 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.

Who should 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 November 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 January 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: 75 percent of the tax reduction attributable to the transaction with a minimum penalty of $10,000 ($5,000 for an individual).

Problematic Characteristics

This IRS notice also lists some characteristics of micro-captive arrangements that the IRS considers potentially problematic. These include, for example:

1. Coverage of risks that are implausible or unrelated to the insured’s business
2. Duplicative or vaguely described coverage
3. Premium amounts determined without an underwriting or actuarial analysis that conforms to insurance industry standards
4. Premiums that exceed amounts that unrelated insurers would charge
5. Captives that fail to comply with insurance laws or regulations, or lack defined claims administration procedures
6. Captives with inadequate capital
7. Failure to file claims for insured losses

Taxpayers should consult their tax advisors regarding the status of their captive insurance arrangements and whether they must file Forms 8886 disclosing the arrangements.

To learn more about the Brady Ware Dealership Services Team, or how we can your dealership establish an entire system of strong internal controls, please contact Sam Agresti at sagresti@bradyware.com or 614.384.8410.

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