Often when the IRS suffers a setback in litigation, a tendency exists to prematurely declare victory on the issue. That was certainly the reflex when the Tax Court first blessed a midco tax shelter in Starnes v. Commissioner, T.C. Memo. 2011-63. But a dozen years and several definitive circuit court opinions later, that abusive scheme had been dispatched. Similarly, promoters of micro-captive insurance arrangements undoubtedly rejoiced at first news of the result in CIC Services, LLC v. IRS, 529 F. Supp. 3d 677, 687-88 (E.D. Tenn. 2022), vacating Notice 2016-66, which had targeted such deals. Ding-dong! The Witch is dead!
Without conceding the District Court’s ruling on the failure to observe the Administrative Procedures Act, the IRS last year issued a proposed regulation obsoleting Notice 2016-66 and providing that it will not enforce its disclosure requirements. REG-109309-22. But the IRS also sounded loud and clear that such obsoletion has no effect upon the merits of the transaction itself or upon any IRS action in that regard. So, advisors may need to dial back on any “irrational exuberance” inspired by the promoters and carefully parse the language of the proposed regulation in toto.
The proposed regulation in fact raises the temperature in this area by identifying some deals as “listed transactions”; Notice 2016-66 had only classified its described deals as “transactions of interest.” From the IRS’s perspective, it might be said that the former category is more suggestive of abuse due to its attributes while the latter is less so but still subject to scrutiny. In any event, falling into either category means becoming subject to reporting requirements, under either I.R.C. §§ 6707, 6662A, or 6707A.
For a micro-captive “listed transaction,” the definition depends on either having a “financing factor” (financing by guarantee, loan, or other transfer of the captive insurance company’s capital), Prop. Treas. Reg. § 1.6011-10(c)(1), or a “loss ratio factor” below 65 percent, Prop. Treas. Reg. § 1.6011-10(c)(2). That test is met when total insured losses and claim administration expenses are less than 65 percent of total premiums earned less policyholder dividends. Thus, broadly, if an insurance company pays $60 in claims for every $100 in collected premiums, its loss ratio is 60 percent with a profit ratio of 40 percent. See michigan.gov/difs.) Under Notice 2016-66, the applicable marker was 70 percent.
Now the computation period during which such loss ratio is measured has been elongated under the proposed regulation supposedly to allow for some lenity. As the purpose of the proposed regulation is to “identify transactions involving circumstances inconsistent with insurance in the commonly accepted sense,” the pricing of premiums “far in excess of what is reasonably needed to fund insurance operations results in a lower loss ratio and is a strong indicator of abuse.” In the Federal Register explanation of the proposed regulation, the IRS accepts the possibility, however, that a captive insurance company with a loss history of fewer than ten taxable years could have a loss ratio below 65 percent, which result may not be due to abuse. Using a computation period of ten taxable years or greater in determining the loss ratio factor “allows Captives significant time to develop a reasonable loss history that supports the use of Captive for legitimate insurance purposes.”
Thus, for a captive insurance company in existence fewer than ten taxable years, including short taxable years and taxable years of predecessor entities, these “listed transaction” provisions do not apply. But while a captive insurance company in existence fewer than ten taxable years may avoid the definition of a micro-captive “listed transaction,” it may still default to a “transaction of interest,” because the applicable computation period is “the most recent nine taxable years, or the entire period of the Captive’s existence if Captive has been in existence for less than nine taxable years.” Prop. Treas. Reg. § 1.6011-11(b)(2).
The proposed regulation also expands on Notice 2016-66’s definition of a captive by providing that derivatives and interests in the assets of the captive are now to be taken into account in meeting the 20 percent related-interest threshold. Prop. Treas. Reg. §§ 1.6011-10(b)(1)(A)-(C) and 1.6011-11(b)(1). The IRS had found transactions were being structured so that the insured company, the owners, or related persons without a direct or indirect interest in the captive’s voting power or value or its outstanding stock or equity interests, were nonetheless obtaining substantially similar benefits and risk, and so improperly avoiding the 20 percent threshold.
Probably the most dramatic change in the proposed regulation is the creation of an exception for Consumer Coverage arrangements. Prop. Treas. Reg. §§ 1.6011-10(d)(2) and 1.6011-11(d)(2). According to the professional literature, the provision was primarily lobbied for by automobile dealer groups, and, hence, they are specifically mentioned in the text of the regulation, along with references to “extended warranties.” But the broad intent behind the exception appears to be that where the unrelated customer is the ultimate beneficiary, the risk of abuse is low. See IRS Hearing Transcript on Microcaptive Transactions, Tax Notes Today, July 19, 2023. But it is a good question of whether this exception is anything but a king-size “comfort ruling” dearly paid for by an industry group, as such covered scenarios would have likely fallen outside the general definitions anyway.
The IRS hinted that the proposed regulation would be finalized before the end of 2023, which did not come to pass. So, once again, taxpayers are in limbo, both the place and the game.