Friday, April 1, 2022
This week, I have been discussing captive insurance. Part One set forth the definition of captive insurance and how a captive insurance company is treated for income tax purposes as well as how it might be used for estate planning and business succession. Part Two examined IRS concerns with captive insurance and the results of litigation involving the concept. Today, in Part Three, I take a look at some recent IRS administrative issues concerning captive insurance and the attempts of the IRS to “crack-down” on the use of the concept to achieve income tax savings and estate planning benefits. On this point, the most recent developments have not gone well for the IRS.
Captive insurance and recent administrative/regulatory issues – it’s the topic of today’s post.
2015 IRS Notice. Abusive micro-captives have been a concern to the IRS for several years. IRS initiated forensic audits of large captive insurance providers at least a decade ago which resulted in certain transactions making the “Dirty Dozen” tax scam list starting in 2014. In 2015, the IRS issued a news release that notified taxpayers that it would be taking action against micro-captive insurance arrangements it believes are being used to evade taxes. IR 2015-16 (Feb. 3, 2015). Since that time, the IRS has been litigating the micro-captive insurance issue aggressively.
2016 IRS Notice. In 2016, the IRS issued a Notice which identified certain micro-captive transactions as having the potential for tax avoidance and evasion. Notice 2016-66, 2016-47 IRB 745. In the Notice, the IRS indicated that micro-captive insurance transactions that are the same as, or substantially similar to, the transactions described in the Notice would be considered “transactions of interest.” Under the Notice, these transactions require information reporting as “reportable transactions” under Treas. Reg. §1.6011 and I.R.C. §§6011 and 6012 for taxpayers engaging in the transactions and their “material advisers.” Thus, persons entering into micro-captive transactions were required to disclose such transactions to the IRS via Form 8886 and “material advisors” also had disclosure and maintenance obligations under I.R.C. §§6111-6112 and the associated regulations. In addition, a “material advisor” had to file a disclosure statement (Form 8918) with the IRS Office of Tax Shelter Analysis by January 30, 2017, with respect to such transactions entered into on or after November 2, 2006. Failure to make the required disclosures came with possible civil and/or criminal penalties. On December 30, 2016, the IRS extended the disclosure deadline for micro-captive transactions to May 1, 2017. Notice 2017-08.
Note: After the issuance of the Notice, the IRS audits of micro-captive arrangements and litigation ramped up substantially.
A manger of captive insurance companies subject to the disclosure requirements challenged Notice 2016-66 in early 2017. The Notice would have forced the manager to incur substantial compliance costs. The manager claimed that the Notice constituted a legislative-type rule and, as such, was subject to the mandatory notice-and-comment requirements of the Administrative Procedures Act (APA). 5 U.S.C. §553, et seq. The manager also claimed that the Notice was invalid as being arbitrary and capricious, and that the IRS failed to submit the rule contained in the Notice to Congress and the Comptroller General as the Congressional Review of Agency Rule-Making Act required. 5 U.S.C. §801. The manager sought a declaration under the Declaratory Judgment Act (28 U.S.C. §2201) that the Notice was invalid and that an injunction barring the IRS from enforcing the disclosure requirements of the Notice should be issued.
Note: Since 2019, the IRS has offered a settlement framework for taxpayers under audit on micro-captive insurance arrangements. IR 2019-157 (Sept. 16, 2019). In 2020, the IRS made the settlement framework more restrictive and increased the number of examinations. IR 2020-26 (Jan. 31, 2021) and IR 2020-241 (Oct. 22, 2020). Under the 2020 framework, taxpayers are offered reduced accuracy-related penalties of 5, 10 or 15 percent (instead of 20 or 40 percent). In exchange, a taxpayer must agree to have 90 percent of the premium deductions disallowed for all open tax years, as well as any captive-related expenses such as management fees. The captive insurance company must also be liquidated, or else there will be a deemed distribution to the owners for the amount of premiums paid to the captive during all years.
The trial court denied the plaintiffs’ motion for a preliminary injunction, reasoning that the plaintiffs were not likely to succeed on the merits because the claims were likely barred by the Anti-Injunction Act (AIA). 26 U.S.C. §7421.
Note: The AIA provides that “no suit for the purpose of restraining the assessment or collection of any tax shall be maintained in any court.” Instead, a tax can be challenged in court only after the plaintiff pays the disputed tax and files a claim for refund.
The IRS moved to dismiss the plaintiffs’ claims. The trial court granted the motion and dismissed the case for lack of subject matter jurisdiction. CIC Services, LLC v. Internal Revenue Service, No. 3:17-cv-110, 2017 U.S. Dist. LEXIS 181482 (E.D. Tenn. Nov. 2, 2017). The appellate court affirmed. CIC Services, LLC v. Internal Revenue Service, 925 F.3d 247 (6th Cir. 2019). On further review, however, the U.S. Supreme Court reversed, vacated the appellate court’s decision, and remanded the case to the trial court. CIC Services, LLC v. Internal Revenue Service, 141 S. Ct. 1582 (2021). The Court unanimously held that the AIA did not bar pre-enforcement judicial review of the Notice. The Court pointed out that while the Notice was “backed by” tax penalties, the plaintiffs’ suit challenged the Notice’s “reporting mandate separate from any tax.” On remand, the trial court set aside the Notice and ordered the IRS to return all documents that it had collected under the Notice. The trial court stated, “While the IRS may ultimately be correct that micro-captive insurance arrangements have the potential for tax avoidance or evasion and should be classified as transactions of interest, the APA requires that the IRS examine relevant facts and data supporting that conclusion.” CIC Services, LLC v. Internal Revenue Service, No. 3:17-cv-00110 (E.D. Tenn. Mar. 21, 2022).
Shortly before the trial court’s remand decision in CIC Services, LLC, the U.S. Court of Appeals for the Sixth Circuit voided IRS Notice 2007-83, 2007-2 CB 960 that established reporting requirements for potentially abusive benefit trust arrangements or face the imposition of civil and/or criminal penalties for engaging in such a “listed transaction.” Mann Construction, Inc. v. United States, No. 21-1500, 2022 U.S. App. LEXIS 5668 (6th Cir. Mar. 3, 2022), rev’g., 539 F.Supp. 3d 745 (E.D. Mich. 2021). With Notice 2007-83, the appellate court concluded that the IRS had developed a legislative rule without going through the APA’s required notice and comment procedures. The Congress had not created any exemption for the IRS from this rulemaking requirement. Indeed, the appellate court pointed out in Mann Construction, Inc. that the U.S. Supreme Court had rejected the notion that tax law deserves a special “carve-out” from the APA’s notice and comment requirement. Mayo Foundation for Medial Education & Research v. United States, 562 U.S. 44 (2011).
Note: Before getting pushed back by the Courts for rulemaking without following the APA’s rulemaking requirements, the IRS gave some indication that it was also looking at captive insurance company variations. See IR-2020-226 (Oct. 1, 2020); FAA 20211701F (Feb. 5, 2021).
In the summer of 2020, the IRS issued I.R.C. §6112 letters to persons it believed to be a “material advisor” that had failed to report themselves for engaging in an “abusive” transaction. Since the courts have now voided Notice 2016-66, the filing of Form 8918 and the associated penalties are currently not in play. But the I.R.C. §6694 preparer penalties are still applicable for taking an unreasonable position on the return. Also, the IRS could follow the APA’s notice-and-comment procedures and properly adopt its position taken in Notice 2016-66 in the future. If IRS does, it appears to have attorneys trained to review captive insurance company issues. Thus, tax practitioners would be well-advised to proceed with caution when engaging with clients interested in captive insurance and examine client files where captive insurance companies have already been established.
The recent developments surrounding micro-captive arrangements have forestalled the IRS from treating them as “listed transactions” at least until the IRS complies with the APA’s notice and comment requirements. That’s a big development on the penalty issue, but it doesn’t mean reporting requirements necessary to avoid penalties won’t come back in the future.
In addition, the caselaw over the past few years provides helpful guidance concerning the proper structuring of captive/micro-captive insurance corporations to provide a more economical means of risk management to business such as farms and ranches. Also, if structured properly, a micro-captive arrangement can be used to accomplish specific income tax as well as estate and business planning objectives of the owner(s).