The U.S. Department of the Treasury has finally proposed regulations to deal with so-called microcaptive transactions. You can read the proposal here. You can read the IRS press release in IR-2023-74 (April 10, 2023), here. In a nutshell, microcaptives are for the most part insurance companies that attempt to qualify for treatment under section 831(b) of the Internal Revenue Code by way of a shared risk-pool arrangement which only superficially provides risk sharing and risk distribution for tax purposes, and whose real purpose is to provide inflated deductions for the businesses that the microcaptives are insuring.
Note that these are proposed regulations, and Treasury will be required to hold a public hearing before promulgating the regulations in accordance with the Administrative Procedures Act (APA). It was Treasury’s initial failure comply with the notice and hearing requirements of the APA which resulted in the embarrassing fiasco of Notice 2016-66 being invalidated. The public hearing is set for July 19, 2023, and the proposed regulations provided detailed instructions for those wishing to submit written comments, attend the hearing or even testify at the hearing.
The proposed regulations consist of 62 pages of double-spaced text, most of which involves Treasury’s authority to issue regulations to deal with tax shelters, and not an insignificant amount of, basically, trying to explain away the Notice 2016-66 fiasco. I’ll spare readers all of that stuff, which you read for yourself if face with insomnia, and go right to the regulations being proposed.
The regulations start with a blockbuster: Microcaptive transactions will henceforth be a full-blown listed transaction, i.e., a “presumed tax shelter” much like the notorious Son of Boss transaction. This is highly significant for several reasons.
First, making microcaptive transactions a listed transaction does away with the utter confusion wrought by Notice 2016-66 which simply listed such deals as a “transaction of interest”. Nobody knew then exactly what a “transaction of interest” meant, and nobody knows now. Presumably, the IRS’s use of the phrase was something like a caution sign of possible construction that warned folks that something might, or might not, be later classified into something more serious. Here, the regulations dispense with that silliness and simply designate microcaptives as a listed transaction — a designation that tax professionals clearly understand. Having said all that, the “transaction of interest” does still survive in part, as I will relate below.
Second, by marking microcaptive transactions as a listed transaction a whole slew of statutory reporting requirements for participants, promoters and material advisors (attorneys, tax preparers, actuaries and underwriters) immediately comes into play. All these folks need to make special filing that will flag the IRS that a tax shelter is being entered into, and the promoters and material advisors have to keep lists of all the participants that they provided services to.
Third, merely by designating a microcaptive as a listed transaction, a very significant deterrent to those desiring such transactions, or desiring to make money off of them, comes into play. Again, a listed transaction is just another way of saying “presumed tax shelter”. Since there are huge penalties for tax shelters, and not just for the taxpayers who participate in them but also the promoters and material advisors, being involved with such a transaction amounts to little short of a financial death wish. Stated otherwise, the designation of a listed transaction will render microcaptives into a financial Chernobyl that nobody with any sense will want to get near in any aspect. Or even more simply, if the microcaptive industry wasn’t dead before, it’s dead now.
Moving along, the next thing we come to is a definition of a “captive”. The use of this term is unfortunate, since the regulations only deal with a very small subset of captives, as will be further explained, that are known as “microcaptives”. Why the drafters did not use “microcaptive” instead is not explained.
Anyway, a captive for purposes of the regulations is one that meets several requirements. The captive is an insurance company has made the election to be treated under IRC § 831(b), which treats small insurance companies (by contrast, § 831(a) treats large insurance companies and so this regulation has no bearing § 831(a) companies generally). The insurance company is owned at least 20%, directly or indirectly, including through a trust, by a person who also owns the business being insured by the captive. There are a series of complex rules that go into whether this 20% has been met.
The regulations also define an intermediary as a party that stands in the middle of a transaction between the captive and its insured business, and there can be multiple intermediaries. This is really a reference to risk pools, which provide insurance and charge premiums to the business, and then the insurance risks and the premiums pass through to the captive.
Now the regulations get super interesting as we get to the description of the transaction. While the U.S. Tax Court, and the U.S. Tenth Circuit Court of Appeals have blown apart microcaptive deals based on the vacuum of risk shifting and risk distribution inherent in those arrangements, here Treasury takes a different approach.
The transaction is defined as a captive arrangement where, basically, there is a 35% or greater untaxed profit realized from the transaction. This is calculated by the regulations by taking the total amount of the premiums paid to the captive, deducting off policy liabilities and claims expenses, and then further deducting the amount that was distributed to the captive’s owner or owners (which would be taxable to them as a dividend). To look at it from the other side of the coin, the regulations basically say that an untaxed profit of the transaction of less than 35% will not ipso facto be a listed transaction.
Limiting the captive to an untaxed profit of 35% or less will kill the tax benefits of all but a very few microcaptive deals. First, the risk/reward calculation has been reduced by about 2/3rds which make the idea of entering into a microcaptive deal to saves taxes that much less attractive. Second, the remaining 1/3rd will largely be eaten up by the transaction expenses, e.g., the costs of forming and maintaining the captive, which costs pretty expensive compared to other tax shelters, since a captive requires the payment of management fees to its captive manager, licensing fees, actuarial fees, annual audit fees, licensing fees paid to the state, and tax preparation fees. Good luck selling that to anybody who has even a minimal grasp of math and economics.
So that is what the regulations make a listed transaction. Now, let’s look at the two exclusions from the regulations, meaning the 831(b) companies that will not be listed transactions. The two exclusions encompass broad categories where microcaptives are generally not used in an abusive fashion, or are not particularly amenable to such misuse. The exclusions are for benefit captives (captives which provide employee benefits) warranty captives (captives used to provide product warranties).
Certainly, there are other types of 831(b) captives which exist that are also not generally considered to be abusive in the tax sense, such as farmers’ co-operative captives, which is where a group of farmers get together to form a captive that provides the entire group with crop insurance. The reason why there is no stated exception in the regulations for these other types of non-abusive captives is likely because they rarely, if even, get close to the definition of “transaction” anyway, since usually at the end of the year they distribute out any taxable profits to their owners, i.e., their non-taxed profits will almost always be less than 35%.
We now come to the the disclosure rules for those captives which fall into the definition of “transaction” but do not meet any exclusion. These disclosure requirements are basically the same as for any other listed transaction: The business paying the premiums and its owners, the captive and its owners, and pretty much anybody else who materially participates in the deal must file the IRS Form 8886 for tax shelters or similar forms.
I mentioned earlier that while the vast majority of microcaptive transactions will henceforth be a full-blown listed transaction, the concept of a “transaction of interest” still survives in part. The regulations use “transaction of interest” to describe microcaptive deals that do not technically fall into the description of “transaction”, but “are the same as, or substantially similar to” those deals that do meet the definition of transaction. In other words, if it walks like a transaction and quacks like a transaction, then even if it isn’t quite a listed transaction it will still be a “transaction of interest” that will require everybody involved to make additional disclosures, i.e., file the Form 8886 tax shelter form.
It should also be mentioned that the disclosure requirements for both the listed transaction and the transaction of interest varietals go back six years, i.e., if the taxpayer, captive, promoter, material advisor, etc., had not been filing the Form 8886 all along pursuant anyway (as a caution should Notice 2016-66 have survived), then they will have to go back at least six years now.
Finally, there is sort of a grandfathering in here in favor of the IRS of what has gone on before, in the sense that the new regulations will not operate to justify or vitiate anything that has gone on before. If a captive is already under examination or before the U.S. Tax Court, etc., or there is a promoter examination ongoing, none of that will be affected by these regulations.
This is the final nail in the coffin, the wooden stake through the heart, for microcaptive transactions. Maybe there is a captive out there, or several of them, who can still win before the U.S. Tax Court, but these regulations will be terminal for future microcaptive transactions, at least for anybody with a functioning brain. Going forward, there is not going to be a truly independent advisor who blesses a microcaptive that fits within the definition of “transaction” or even gets close to it. Without that independent blessing as a cover against penalties, the risk/reward of this tax shelter now has a very unbalanced large risk side.
The regulations are much more complicated than I have related here, but this should give readers a solid flight level 41 view of what they are all about. Again, should you desire to read them for yourself, click here, but have the aspirin handy.
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