Captive Review explores the latest proposed regulations surrounding the status of 831(b) micro captives released by the IRS and Treasury department. We hear the views of various industry experts on their scope and look at the pros and cons that could arise for the industry as a result
The IRS is once again fixing its eye on micro captives and the tax they pay.
In the last month, micro captives found their way onto the IRS’ annual ‘dirty dozen’ list. The annual list draws attention to what the IRS says are “abusive tax avoidance schemes”, and this year, along with abusive micro-captive insurance arrangements, it included Puerto Rican and other foreign captive insurance.
On micro captive arrangements, the IRS stated that “these structures often include implausible risks, failure to match genuine business needs and, in many cases, unnecessary duplication of the taxpayer’s commercial coverages”.
In addition, it said “the premiums paid under these arrangements are often excessive, reflecting non-arm’s length pricing”.
Stamping down on any form of abusive micro captive arrangements continues to be a “high-priority enforcement area for the IRS”, it stated.
The IRS followed up this claim by releasing jointly with the Treasury department proposals for new regulations identifying different micro captive arrangements, defined as being those captives that write less than $2.6 million and elect their tax status under section 831(b) of the Internal Revenue Code.
Electing under section 831(b) allows these small non-life insurance companies to pay tax only on their investment income.
The new regulations propose some micro captive transactions would be identified as “listed transactions” and other micro captive transactions as “transactions of interest”, with participants then required to file a Form 8886 with the IRS.
“Listed transactions are abusive tax transactions that must be reported to the IRS. Transactions of interest are tax transactions that have the potential for tax avoidance or evasion that must also be reported to the IRS,” the statement said.
Listed transactions are therefore considered the ‘worse’ of the two and liable to higher penalties. In addition, ‘material advisors’ deemed to have assisted in either type of transaction, made a tax statement and received compensation, will also need to fi le a Form 8918 with the IRS, as well as keep a list of their customers.
The proposed new regulations were not unexpected and come as a replacement to the IRS’ past use of Notice 2016-66 to identify different micro captive transactions.
Recent decisions in the Sixth Circuit and US Tax courts ruled against the IRS’ use of Notice 2016-66, stating the service must instead identify such transactions by following the notice and public comment procedures that apply to regulations.
While the IRS and Treasury disagreed with these rulings, their statement acknowledged the validity of the rulings and said it issued these new proposed regulations so the court decisions “do not disrupt the IRS’ ongoing efforts to combat abusive tax shelters throughout the nation”.
The IRS and Treasury have said they will finalise the proposed regulations this year following a period for public comments. The statement mentioned they would then issue proposed regulations identifying additional listed transactions in the near future.
The proposed regulations have been met with a mixed response from those in the captive sector.
On the one hand, everyone recognises it is right that action is taken to crack down on any abusive schemes entered into purely to avoid tax.
However, the regulations have received some criticism due to the number of participants that could be required to report to the IRS.
“Just like with now-obsolete Notice 2016-66, the proposed regulations may result in certain electing captives that are properly set up for valid business reasons being required to provide additional reporting and disclosures,” says Mikhail Raybshteyn, Americas captive insurance services co-leader at EY.
Chaz Lavelle and Bailey Roese, both partners and captive tax experts at Dentons Bingham Greenebaum, explained the scope of the proposed regulations.
If the captive elects under section 831(b) and is at least 20% owned by the insured (or affiliate of the insured) it will be a reportable transaction if at least one of the remaining two items exist.
- If during the last five years, the captive loans its premium money to the insured (or affiliate of an insured): In this case the transaction is a listed transaction. The same applies if the captive otherwise uses its assets for the benefit of the insured, such as pledging captive premium assets as collateral for a loan to the insured, etc. This would be classed a listed transaction even if the loss ratio exceeds 65%. Loans could be made from the captive’s cumulative after-tax net investment earnings, less outstanding financings or conveyances.
- Where there is a loss ratio less than 65%: If the captive has a loss ratio less than 65% over a 10-year (or longer) period, the transaction is a listed transaction. If the captive has been in existence for less than 10 years and it has a loss ratio less than 65%, then the transaction is deemed as a transaction of interest, with partial years treated as full years.
However, within this scope, the pair said they had heard from those in the market that non-abusive arrangements could end up being unfairly labelled.
“I have heard from many people who believe that will be the case, since even a small loan-back sometime in the last five years will automatically be treated as an abusive transaction, regardless of how well the remainder of the transaction is conducted,” Roese says. “Moreover, I have also heard from quite a few professionals that a loss ratio is not the best indicator of the validity of a transaction.”
For Pete Kranz, a senior vice-president and director at Alliant, the concern is about the disclosure requirements of material advisors, and that the proposed regulations appear to take too broad an approach to defining material advice.
He picks out one section of the regulations in particular as unclear, where they say: “[…] if the person provides a tax statement, which is any statement (including another person’s statement), […] that relates to a tax aspect of a transaction that causes the transaction to be a reportable transaction […]”.
“In that statement alone, there is far too much ambiguity that runs the risk of innocent parties being pulled into a tax advice matter in which they had no involvement,” Kranz says. “I am not a tax advisor, but if I email a document provided by tax counsel, am I suddenly a material advisor and at risk for penalties? There needs to be a much clearer definition of ‘material advisor’, that’s for sure.”
Roese thinks captive owners and material advisors should be vigilant about the developments in this area.
“Captive owners and material advisors should consider supporting efforts to make comments or testify at the IRS hearing,” she says. “This can be done either directly or through the various associations in the captive area.”
Lack of clarity
Of largest concern to Lavelle and Roese is the ongoing “critical inquiry” of whether a captive is an insurance company for federal income tax purposes.
While these proposed regulations apply to captives electing section 831(b), they make the point that the same rules for whether a captive is an insurance company for tax purposes apply equally to small captives as they do for large captives.
“Accordingly, if the IRS believes that a premium loan-back automatically makes a micro captive transaction abusive, the IRS might make that same assertion against a large captive; the same can be said of a loss ratio less than 65%,” Roese says.
Sean King, principal and in-house counsel at CIC Services, believes the IRS has generally been guilty across the board, of lacking clarity when it comes to the subject of captive insurance.
As a result, he says it has spread “fear, uncertainty and doubt about the factors that distinguish legitimate captive insurance arrangements from illegal ones”.
“Rather than articulate a meaningful distinction, as is its legal responsibility to do, the service has instead seized every opportunity to blur the lines,” he adds. “It does this primarily by painting with an overly broad brush, by making threats and by fomenting uncertainty as to the extent of the law.”
He explains these latest proposals build upon this practice, with what he says is too much uncertainty regarding the application of the various tests that either trigger disclosure obligations or don’t.
“Taxpayers who structure their transactions to avoid the disclosure obligations that were reinstated in a more limited way by the proposed regulations gain no assurance that their transactions will be respected by the IRS, and transactions that would become reportable under the proposed regulations are, by the IRS’s own admission, not necessarily improper in any way,” he says. “So, in short, the proposed regulations provide no additional clarity or certainty whatsoever and instead intentionally do the opposite.”
For micro captives required to report to the IRS that have formed for valid insurance-related reasons, a significant concern might be the extra compliance costs involved.
However, King notes that, on this point, the new regulations would amount to a “significant net win” for taxpayers compared to the previous more onerous Notice 2016-66 rules.
“Should the proposed regulations become final in their present form, the ‘extra work’ imposed upon affected taxpayers would be similar to, but substantially less, than that previously imposed by the now discredited and disowned IRS Notice 2016-66, with which nearly all affected taxpayers are already familiar,” he says. “In short, far fewer taxpayers are required to file under the new regulations and the amount of information required to be disclosed by those who must file is significantly reduced.”
While he says it was hard to put an exact estimate on what compliance costs might be for non-abusive micro captives, he thinks it is safe to say that complying with the new proposed regulations won’t cost more, and will likely be less, than the costs that affected taxpayers were previously required to bear under IRS Notice 2016-66.
Even still, it’s extra work and costs, nonetheless.
And with the extra scrutiny and attention that comes from the IRS as a result of these regulations, Michael Serricchio, managing director of Marsh Captive Solutions, says this could in turn lead to fewer 831(b) micro captives being formed.
“I think a lot of clients are looking at all of the negativity around 831(b) and the IRS, looking at these proposed regulations, at what happened in the past with the ‘dirty dozen’ list, and looking at the listed transactions, thinking ‘I want to stay as far away from that as possible’. And we will support them in that,” he asserts. “We will help them think about the right type of captive, putting aside the tax status of it.”
Marsh doesn’t promote or directly sell to clients the benefits of electing 831(b). Serricchio explains that assessments will always focus on whether a captive makes sense for insurance-related reasons, with the tax status a secondary consideration.
And increasingly, Serricchio says that even among those clients that could legitimately elect for 831(b) status, there are now various reasons why they may choose against doing so. “There’s a lot of companies we work with that don’t want to hear anything about 831(b) tax status,” he notes. “There are a lot of audit firms that cannot audit them, and don’t want to provide advice on them. For medium or smaller clients that are getting involved in the captive market, they might instead be getting into a rent-a-cell captive, and they may not take any tax position.”
Raybshteyn believes it is hard to predict how these new regulations could impact the appeal of future 831(b) formations, but also points to the fact that it is important for any clients considering doing so to be aware of potential reporting requirements and to seek advice from appropriate tax, actuarial and insurance specialists.
“Just like with all other captive formations prior to these proposed regulations, new market entrants need to make sure the captives are formed for valid business reasons, all supporting documentation is in order, and understanding that forming a captive that may be electing section 831(b) treatment for US income tax purposes may attract extra reporting obligations and scrutiny from the IRS,” he says.
King mentions he has heard of some certified public accountants and advisors making recommendations that all clients terminate their captive insurance companies, should the regulations become final, in order to avoid the reporting requirements.
However, he warned against such blanket recommendations to avoid a “modest disclosure requirement”, and that such decisions should be approached on a case-by-case basis after weighing all the relevant factors and risks.
“That recommendation is arguably reasonable for a subset of extremely risk-adverse clients who are terrified of an audit, but before making such a risk-based decision even those clients and their advisors need to consider all the risks and not just the audit,” he says. “In particular, they need to consider the risk to their business of going without the essential insurance that their captive presently provides.”
While the regulations could lead to a tightening in the number of captives electing for 831(b) status, none of the industry experts Captive Review spoke with see this impacting the appeal of the wider industry.
Serricchio is pleased there will be a process for giving feedback and adds regulation is needed and expected to discourage improper behaviour in the industry.
“We’ve seen tremendous growth in captives, but unfortunately there are abusive structures that are always going to exist,” he says. “Regulatory oversight is good in the long run, because even over the last few years the industry has seen a lot of ‘sham’ 831(b) micro captives, that should have never been set up by others, close down.”
Like King, Serricchio agrees that these proposed regulations mark an improvement on the IRS’ use of Notice 2016-66. Raybshteyn adds it should be viewed as a positive to finally have a conclusion to the prior controversy with the use of this notice.
“In general, additional guidance should be viewed as a positive and, assuming the IRS is receptive to, and considerate of, any comments provided by the industry, the final regulations should offer a higher level of certainty and confidence in the market overall,” Raybshteyn says.