In November 2016, the IRS promulgated Notice 2016-66 designating certain microcaptive transactions to be “transactions of interest,” mandating certain reporting requirements.
To be a microcaptive involves two components: “Captive” insurance is an insurance relationship between an insurer that accepts the risk of its owner or related party. Captive insurance does not properly refer to arrangements where the underlying risk derives only from unrelated third parties.
The use of the prefix “micro” refers to the size of the company, and primarily whether the captive makes an election under 831(b) of the Internal Revenue Code. This election is only available for property and casualty companies. It is irrevocable once made, and it permits the insurance company to be taxed only on its investment income, not its premium income. To qualify, the company must not have more than $1.2 million in annual premium ($2.2 million as of 2017).Behind the Notice
To understand the background of the notice, on February 3, 2015, the IRS published its “Dirty Dozen” list of questionable tax transactions (Notice IRS-2015-19). The IRS stated, in part, “In the abusive structure, unscrupulous promoters persuade closely held entities to participate in this scheme by assisting entities to create captive insurance companies onshore or offshore, drafting organizational documents and preparing initial filings to state insurance authorities and the IRS.”
This language was directed to two separate concerns: (1) coverages that move risks from traditional insurers to captives, especially if this results in a higher premium than would be paid in the regular market, and (2) “esoteric, implausible risks.” The Dirty Dozen listing also noted, “Total amounts of annual premiums often equal the amount of deductions business entities need to reduce income for the year; or, for a wealthy entity, total premiums amount to $1.2 million annually to take full advantage of the Code provision.”
In Notice 2016-66, the IRS took the next step in its approach. In Section 1 of the notice, the IRS describes in greater detail the same abusive captive insurance practices described in the “Dirty Dozen” announcement. The agency indicated its intention to raise questions about:
- Legitimacy of the risks being insured
- Pricing of the premiums
- Risk sharing mechanism
- Proper capitalization
In Section Two of the Notice, the Service listed the factors that would trigger a requirement to report participation as a “transaction of interest,” requiring the submission of Form 8886 by participants. TOI status is determined by a three-part test:
- The insurance company has made an election under IRC § 831(b) (captive).
- There is a 20% (or greater) owner of the captive who is also an owner of a company (insured) which transfers risks to the captive, directly or through an intermediary.
- The captive has a loss ratio of less than 70% and/or has loaned any portion of the payments under insurance policies or reinsurance agreements to the Insured or a related party.
Typical automotive F&I programs are well outside the extreme and obviously abusive examples described in Section One of the notice. But Section Two sets out the “transaction of interest” test and designation; it expressly states that even if the transaction is not as described in Section One, it can still fall within Section Two.
The IRS amplified that participants in F&I reinsurance programs will be considered within the notice if the dealership and reinsurance company have common ownership and if the dealership is an obligor or otherwise can be considered “insured” under the program structure. The IRS indicated that it considered dealer obligor arrangements in service contracts other breakdown protection, and GAP waivers, to be within the scope of the notice.
This created a significant filing requirement. Filings and annual returns, along with a “catch-up” filing with the Office of Tax Shelters Analysis, were due by May 1, 2017. The May 1 deadline saw thousands of forms filed with the IRS. The IRS has just recently announced that it has started to review those responses.
The agency has stated that it is merely in information-gathering mode and that, after review, it will eventually consider the industry’s arguments as to whether GAP and other F&I products merit continued treatment as TOIs.Amendments to §831(b)
The Protecting Americans from Tax Hikes Act of 2015 (PATH Act) makes several important changes to the provisions of §831(b), effective beginning on Jan. 1, 2017. Among them are:
- The maximum annual premium limitation has increased from $1.2 million to $2.2 million with a provision for inflation adjustments in future years.
- There is a new “diversification” test that must be met, in one of two specified ways.
The first diversification test is as follows: No more than 20% of the net written premiums (or, if greater, direct written premiums) of such company for the taxable year is attributable to any one policyholder. In general, it is expected that the typical F&I structures will meet this test, because the underlying risk in F&I products is unrelated third-party risk. There is prior tax authority regarding this position, and there is also a pending amendment to the PATH Act to put this “look-through” principle into statute.
The second diversification test is complex but essentially involves keeping the ownership structure of the reinsurance company and the ownership of the insured business essentially equal.
Some aspects of the amendment, and its implications for reporting requirements with the IRS, remain unclear. The practitioner industry has been focused on Notice 2016-66 compliance, but will now turn to challenges, and opportunities, presented by the amendments to 831(b).The Task Force
On January 31, 2017, the IRS announced that it was launching a “Micro-Captive Insurance Campaign.” Quoting from the announcement:
“This campaign addresses transactions described in Transactions of Interest Notice 2016-66, in which a taxpayer attempts to reduce aggregate taxable income using contracts treated as insurance contracts and a related company that the parties treat as a captive insurance company. Each entity that the parties treat as an insured entity under the contracts claims deductions for insurance premiums. The manner in which the contracts are interpreted, administered, and applied is inconsistent with arm's length transactions and sound business practices. LB&I has developed a training strategy for this campaign. The treatment stream for this campaign will be issue-based examinations.”
While it is far too early to tell much about this initiative, it is likely that the task force will conduct at least some examinations of F&I reinsurance companies. The typical program should be able to readily respond to an IRS examination, but it is important for the industry to immediately engage tax professionals familiar with this industry to respond to any audit. The law in this area is complex and these audits should not be handled by professionals new to this subject. It will be important for the Task Force to be educated about the history of these programs, the relevant favorable IRS rulings on the topic, and other material that will show that this is not an industry that engages in the abusive conduct that has triggered IRS concern.