by Chandra Wallace
The microcaptive reportable transaction regulations proposed April 10 mean a whole new set of transactions are now listed transactions — considered abusive by the IRS and subject to challenge — tax advisers warn.
The proposed regs ( REG-109309-22 ) designate two microcaptive transaction types as “listed transactions” and one as a “transaction of interest” — categories that require disclosures to the IRS Office of Tax Shelter Analysis. But the proposal defines transactions subject to its requirements to include transactions “substantially similar to” those described in the notice.
Transactions structured to get around a prior version of disclosure obligations for microcaptives — the now-obsolete Notice 2016-66 , 2016-47 IRB 745 — may fall within the scope of these proposed regs if the IRS considers them substantially similar to those described in the regs, according to David J. Slenn of Akerman LLP.
“Now that this is a listed transaction, you’d better be really confident” that a transaction isn’t “wrapped up into the ‘substantially similar’ designation, because if it is, you’re going to be facing pretty stiff penalties,” Slenn said.
Sequencing New Regs
In prior years, Treasury and the IRS issued notices on reportable transactions under existing regulations at reg. section 1.6011-4(b)(2) through (b)(6), but those notices were challenged on procedural grounds, Slenn explained.
Notably, Notice 2017-10 for syndicated conservation easement transactions and Notice 2016-66 for microcaptive transactions were both sidelined by court rulings that the government failed to comply with the formal notice and comment process mandated by the Administrative Procedure Act.
The government put “those notices out there under those categories and thought that was okay — and obviously it wasn’t,” Slenn said.
Slenn expects the IRS to continue adding to the regulations defining reportable transactions under section 6011 . The IRS is “now sequentially going, starting with dash 9 for conservation easements . . . dash 10 for listed [ microcaptive transactions], and dash 11 for” microcaptive transactions of interest, he said.
In December 2022 Treasury and the IRS issued proposed reg. section 1.6011-9 defining and identifying syndicated conservation easements as listed transactions. The current proposed regulations add reg. section 1.6011-10 and reg. section 1.6011-11, setting out microcaptive transactions that the government now considers to be listed transactions and transactions of interest, respectively.
“You can expect the same sequential process to occur for other transactions” the IRS considers to be abusive or potentially abusive, Slenn said.
Issuance of proposed regs moves the IRS and Treasury away from fighting over the procedural validity of their scrutiny of microcaptives and into focusing on the substance of the transactions, according to David J. Warner of Holtz, Slavett & Drabkin APLC.
One substantive characteristic of some microcaptive transactions that the government spotlighted for listed transaction treatment is the inclusion of a financing element.
“IRS is clearly more concerned with microcaptive transactions involving financing like loans or other means of returning deducted premiums to related parties and, as such, has made these listed transactions that will be challenged by IRS,” Beckett G. Cantley of Cantley Dietrich told Tax Notes .
“They’ve determined that you’re in the worst category automatically if you’ve made a loan back within the last five years,” Charles J. Lavelle of Dentons said. He noted that such loans are probably significantly less common than before Notice 2016-66 was issued, and that there have been cases in which microcaptive arrangements that included loans back to the insured company passed muster with the IRS.
Cantley, who chairs the Captives Subcommittee of the American Bar Association Section of Taxation, noted that “the e^ect of the splitting of microcaptive transactions into listed transactions and transactions of interest generally sorts transactions into ‘bad guys’ and ‘maybe bad guys.’”
Despite that sorting, Cantley expects microcaptive reporting “to be looked at with heavy skepticism inside IRS for both transaction categories.”
The IRS “intends to challenge” the microcaptive listed transactions described in reg. section 1.6011-10 and “may challenge” the transactions of interest identified in reg. section 1.6011- 11, according to the proposed regs. The government “may also challenge the purported tax benefits from these transactions based on the economic substance, business purpose, or other rules or doctrines if applicable based on the facts of a particular case.”
Captive insurance arrangements depend on the intersection of two tax treatments. First, companies can generally claim tax deductions for the cost of insurance coverage premiums.
Second, nonlife insurance companies that meet the criteria in section 831(b) can elect to pay an alternative tax based on their taxable investment income only — not including premium income received. The statute caps the amount of premium they can receive and still qualify to make the election at $2.2 million, indexed for inflation.
In captive insurance arrangements, companies enter into insurance (or reinsurance) contracts with related entities that elect alternative tax treatment under section 831(b) . The related entity is referred to as a “captive” or “ microcaptive ” because it is at least partially owned by the company it is insuring, and the premium cap under section 831(b) means that the related entities are generally small companies.
The insured company deducts its payments to the related entity as insurance premium — reducing its taxable income — but the related entity doesn’t include the payments it receives in its taxable income.
And while some companies use the section 831(b) election as a tax benefit to reduce the cost of insurance, according to Treasury, others abuse the election to claim a tax benefit without any true insurance activity or purpose underlying the arrangement.
What Is Insurance?
This leaves regulators with the difficult task of parsing what a true insurance arrangement is for federal income tax purposes. Neither Congress nor Treasury has formulated a definition of insurance in this context, despite acknowledgement by IRS officials of the long-term problem.
Courts look to whether the arrangements bear hallmarks of what people commonly consider to be insurance, whether there is an insurance risk, and whether there is a shifting or distribution of risk. But the case that defined that analysis, Helvering v. LeGierse , 312 U.S. 531 (1941), was decided more than 80 years ago.