Tax Alert: Small Captives and Their Advisors May Have New Reporting Requirements Due May 1, 2017

In November, the IRS issued Notice 2016-66 laying out new reporting and disclosure requirements for certain captive insurance companies, related persons and material advisors. In the notice, the IRS explained it had become aware of a type of transaction (“micro-captive transaction”) in which a taxpayer and/or related persons treat a related company as a captive insurance company in an attempt to reduce taxable income for primarily tax-motivated reasons. The basic structure is as follows: each entity that the parties treat as an insured entity under the contracts claim deductions for premiums for insurance coverage. The related company that is treated as a captive insurance company makes an election under Section 831(b) to be taxed only on investment income and exclude insurance premiums from income.

The IRS stated it believes the micro-captive transaction has the potential for tax avoidance and evasion. Because the terms of the contracts and the manner in which they are set up and administered are not consistent with arm’s length standards and sound business practices, the IRS argues that the contracts are not insurance, and thus the premiums paid by the insured entity are not deductible. Further, the captive does not qualify as an insurance company and therefore cannot exclude those payments from income under Section 831(b).

The IRS did acknowledge that it lacked sufficient information to properly identify which captive insurance company arrangements should be specifically identified as micro-captive transactions. Therefore, it issued Notice 2016-66 to identify this type of transaction as a “transaction of interest” under Sections 6011 and 6012. This is part of its effort to collect information which it will use to properly assess micro-captives, possibly resulting in these becoming listed transactions.

The immediate consequence of the notice is the additional reporting and disclosure requirements on affected participants. Failure to timely comply with the reporting requirements can result in significant penalties.

IRS Description of a Micro-Captive Transaction

The notice goes into some detail to explain the types of transactions that are the subject of its focus and some of their characteristics. These include contracts where coverage involves an implausible risk, does not match a business need or risk of the insured, contains only a vague description of the scope or where the coverage duplicates coverage that already exists, often with a smaller premium. Examples of payments made to the captive the IRS considers indicative include those where the premium amounts are designed to provide a deduction of a particular amount, those determined with no underwriting or actuarial analysis, those not made consistently with the schedule in the contract, and those exceeding the premium from unrelated insurers, among others. The IRS also pointed to certain practices of claims procedures and management: the captive fails to comply with insurance company laws and regulations, it doesn’t issue policies or binders in a timely manner consistent with the industry, it does not have defined claimed administration procedures or the insured does not file claims for each loss event covered by the contract.

The IRS acknowledged that not all captive insurance arrangements are targets: “The Treasury Department and the IRS recognize that related parties may use captive insurance companies that make elections under Section 831(b) for risk management purposes that do not involve tax avoidance…” However, despite the IRS providing some rather specific items it considered indicators of potential abuse, the notice used a rather broad brush to identify the types of captive transactions that would now be transactions of interest requiring reporting. The IRS criteria are focused very much on objective measures rather than the presence of tax avoidance motive or intent. Here is a summary of the IRS’ definition of a transaction of interest for a micro-captive:

  • A taxpayer (“A”) owns directly or indirectly an interest in one or more entities (“Insured”) conducting a trade or business
  • Another entity directly or indirectly owned by the taxpayer, insured or related persons (“Captive”) enters into a contract with Insured, or reinsures Insured’s risks through an intermediary company
  • Captive makes an election under Section 831(b) to be taxed only on investment income. (The maximum amount of annual premiums that can be excluded are $1,200,000 for 2016; for tax years beginning after December 31, 2016, the maximum amount rises to $2,200,000 (the limit for 2017 adjusted for inflation is $2,250,000)
  • A, Insured or one or more related persons directly or indirectly own 20% of the voting power or value of the stock of Captive and
  • One of both of the following apply:
    • The amount of liabilities incurred by Captive for insured losses and claim administrative expenses during the computation period (generally the last 5 years, but less if the Captive was in existence less than 5 years) is less than 70% of the excess of the premiums earned less policy holder dividends paid or
    • The Captive has at any time during that period made available as financing, directly or indirectly – to A, Insured or any related person – any portion of the payments under the contract (such as through a guarantee, loan or other transfer of Captive’s capital).

Effective Date and Action Required

The Notice is effective on November 1, 2016, but extends back much further. Persons entering into these transactions on or after November 2, 2006, must disclose the transaction as described in the regulations under Section 6011. However, disclosure will generally be required only for tax years where the statute of limitations is still open as of the effective date. Therefore, for individual taxpayers this would most likely mean that prior-year filings for 2013-2015 would be required, as years before that would be beyond the general three-year statute of limitations period. (Taxpayers should be aware that the statute of limitations may be extended without notice from the IRS from three years to six years if there is a “substantial” understatement of gross income in the return.) Material advisors who make a “tax statement” on or after November 2, 2006, also have disclosure and maintenance obligations under Sections 6111 and 6112.

Persons required to file Form 8886, Reportable Transaction Disclosure Statement, would include Insured, Captive, related parties and potentially their owners. Material advisors are required to file Form 8918, Material Advisor Disclosure Statement. The minimum penalty for failure to disclose is $10,000, which can go up to $50,000 for a filer other than a natural person. The filer of Form 8886 must identify the transaction of interest and describe it in sufficient detail for the IRS to be able to understand the tax structure and the identity of all parties involved in the transaction. This would include, specifically, an explanation of whether the captive was reporting because it did not meet the 70% threshold or because it had made available a financing to A, Insured or a related party.

Other information required includes detail on the amount of liabilities incurred and premiums earned by the captive, policyholder dividends paid and any financing made available to owners, insured or related parties. Required disclosures would also include information on how the premiums were determined and whether an underwriter or actuary was involved in that analysis. In addition, detail would be required on any claims paid by the Captive during the years of participation, the amount and reason for any reserves reflected in the captive’s financial statements and a description of the assets held and how the captive has used its income. The notice lists additional detail for items to be included in the Form 8886 filing.

Note that only a taxpayer who is a “participant” in a micro-captive transaction is required to file a report. If you have a captive insurance arrangement that does not meet the criteria outlined above, the filing requirement to report this as a transaction of interest probably does not apply to you. Furthermore, a report is required only for years in which the tax return reflects “tax consequences or a tax strategy” of the described transaction. This means, generally, that if there is no pass-through of income, deduction, credit or other items affecting taxable income as a result of the transaction, a taxpayer would not be considered a participant and would not be required to file.

Careful attention should be paid, however, to properly assess whether this exception for indirect participants applies as the rules are quite complex. If a captive insurer does meet the above criteria, its owners must disclose the transaction to the IRS by filing Form 8886, Reportable Transaction Disclosure Statement. In addition, material advisors who assist in setting up such a captive insurer on or after November 2, 2006, are required to disclose the transaction by filing Form 8918, Material Advisor Disclosure Statement.

Due Dates for Disclosure Statements

Notice 2016-66 contained a January 30, 2017, due date for prior year disclosures, however, that date was extended to May 1, 2017, with the issuance of Notice 2017-08. For prior year submissions (through 2015), a Form 8886 or 8918 is required to be filed with the Office of Tax Shelter Analysis (OTSA) not later than May 1, 2017. With respect to 2016 tax returns, the due date for submissions to OTSA is also May 1, 2017, however, it is also required that a Form 8886 be attached to the participant’s tax return. If a participant’s tax return is extended, the Form 8886 must be attached to that return and a copy should be filed with OTSA on that same day.

We Can Help

If you have a captive insurance company in your structure, you should look now at whether their transactions meet the definition of a transaction of interest as laid out in Notice 2016-66 and if a disclosure would be required. Because the detail required for the Form 8886 submission is quite substantial, and because the penalties for not complying are so significant, it is important to address right away how to comply with the reporting requirements. If you believe you may have to file Form 8886 or Form 8918 and need assistance with these filings, contact your Elliott Davis Decosimo tax advisor immediately.