IRS Places Micro Captive Insurance Companies under the Microscope

microscopeOn November 1, 2016, the IRS issued Notice 2016-66 imposing reporting requirements on certain transactions by small captive insurance companies. The notice places heightened scrutiny on micro-captives by describing them as “transactions of interest.” That designation subjects them to additional reporting requirements for 2016 returns as well as earlier years.

Generally, captive insurance companies are corporations that are formed to insure related businesses. The related business (the insured) pays premiums to the captive insurance company in exchange for property and casualty-type insurance coverage. These arrangements are often established to provide coverages that might not otherwise be available commercially. Under section 831(b) of the Code, so-called small or “micro” captives can elect to exclude up to $1.2 million of premiums received from income and only pay tax on investment income. The premiums exclusion is set to go up to $2.2 million beginning in 2017. The premiums paid by the related business that set up the captive also may be deducted as a business expense under section 162.

IRS Notice 2016-66 identifies certain small captives, and substantially similar transactions, as a “transaction of interest.” The new “transaction of interest” designation throws small captive insurance company transactions, and their advisors, into a tax reporting regime that can potentially lead to penalties and examinations. The notice applies the “transaction of interest” tag to small captives that (1) have liabilities for covered losses and expenses in an amount less than 70 percent of the total premiums earned, or (2) provide premium payments as financing to an insured or related party in a transaction nontaxable to the recipient (e.g., loans).

Taxpayers will have to report the small captive “transaction of interest” annually by filing a Form 8886 with their tax returns beginning with the 2016 tax year. The disclosure information suggested by the notice includes (1) whether liabilities incurred are less than 70 percent of premiums (minus certain dividends and loans); (2) whether any loan or other financing arrangement has occurred between the captive and related parties; (3) the captive’s jurisdiction; (4) a description of the types of coverage(s); (5) how the premium(s) was/were determined, including the names and contact information for any actuary or underwriter involved; (6) a description of the claims paid; and (7) a description of the captive’s assets.

Taxpayers may also have to report separate Forms 8886 for each prior year. The Notice requires retroactive reporting for described captives that were formed on or after November 2, 2006, the date the “transaction of interest” regulations first went into effect. Under existing regulations, those prior year disclosures may be due by January 30, 2017.

Each unfiled or late-filed Form 8886 is subject to a penalty in the amount of $50,000, or $10,000 for natural persons, under section 6707A. Material advisors must also file Form 8918 and are subject to additional list maintenance requirements. Under section 6707, an unfiled or late-filed Form 8918 is subject to a penalty in the amount of $50,000 and further potential penalties.

The Taxman Cometh: IRS Announces Plans to Focus Audit Resources on Middle Market Companies

In a recent speech at the mid-year conference of the Tax Executives Institute, IRS Deputy Commissioner Steven T. Miller laid out the framework for the future of IRS corporate audits. To borrow Mr. Miller’s own assessment, this is bad news for large corporate taxpayers in the CIC (Coordinated Industry Case) program (i.e., the IRS is not going away) and it is also bad news for so-called middle market companies because they will be the new focus of the Internal Revenue Service’s audit scrutiny.

The new strategy Mr. Miller announced will use existing programs geared at CIC taxpayers, such as the IIR (Industry Issue Resolution) program, CAP (Compliance Assurance Process) and Schedule UTP (Uncertain Tax Positions), to increase transparency among large companies and thereby reduce the resources required to examine those companies. The strategy is to take revenue agents currently assigned to large corporations (those with over $1 billion in assets) and redeploy them to auditing taxpayers with revenues or assets between $10 million and $250 million. Miller went on to outline in some detail the steps the IRS will be taking to accomplish this new mission.

There are a number of takeaways here. At least three changes can be expected immediately. The incremental changes that large corporate taxpayers have been experiencing in recent years will continue. The IRS will expect more information, sooner, and more quickly. Mr. Miller was clear. If information requested in an IDR (Information Document Request) is not forthcoming, the IRS Summons power will be used to enforce revenue agent’s demands. Second, the IRS intends to bring its influence to bear upon the Office of Appeals. The IRS will request that Appeals Officers return cases to exam where new facts or arguments are raised for the first time in an Appeals Conference. This signals a further encroachment on the autonomy of an Appeals function that is already restricted in its consideration of coordinated issues, tiered issues and issues of interest. Third, The importance of Schedule UTP will only grow as the IRS reviews and refines its use of this tool to encourage taxpayer disclosures. Mr. Miller noted that those taxpayers who provided inadequate concise descriptions of positions on their 2010 Schedule UTP will be contacted by the IRS and should expect to have future returns reviewed.

The changes will not all be immediate however. The IRS is a large vessel and it cannot turn on a dime. However, once this ship changes course, as it appears it has committed to do, then the impact on the middle market will be significant. Mr. Miller mentioned a focus on companies with operations and assets of less than $250 million but there are still a number of companies in the $250 million to $1 billion range that also should expect to see increased audit activity. These likely will be the first companies to face new IRS examinations if only because they have already filed at least one Schedule UTP giving the IRS a good starting point. Once those companies with less than $100 million in assets are required to include a Schedule UTP with their Form 1120 (beginning in 2012 for those with $50 million in assets), many more corporate taxpayers can expect to hear from revenue agents wanting to open multi-year audits. The new direction is not limited to middle market corporate filers. Mr. Miller also made it clear that the new direction for LB&I will include an emphasis on pass through entities and financial products. Change is on the horizon.

Corporate Taxes: Tax Foundation Video

We don’t get a lot of opportunities to post a video around here so when we do we’re going to take advantage of it. This video provides a pretty direct and succinct explanation of where U.S. Corporate Tax policy has been over the course of the last 25 years. As the title of the video suggests, standing still as a policy has put us behind.

Thanks to The Tax Foundation for producing this video. Check out their Tax Policy Blog too.

Dallas Mavericks Owner on Taxes and Patriotism

The often outspoken, but unquestionably successful, businessman and owner of the NBA’s Dallas Mavericks, Mark Cuban shared his thoughts on making money (“a boatload of it”) and paying taxes (“lots of taxes”) on his blog a couple of months ago (Sept 19). In short, his take was that the most patriotic thing you could do was to make money, spend money, and pay your taxes.

He followed that post up a couple of weeks ago with his views on corporate taxation. The latter post provoked several comments and the front page of Mr. Cuban’s blog (in post strangely dated September 20) now offers a more detailed explanation of his ideas on the federal government, taxes and small businesses with a list of 10 things that the government should do.

It all makes for fun reading (at least for tax geeks like us) and is shared here for the point that tax policy (or at least strong ideas on tax policy) is increasingly becoming part of the national conversation. It also gives us a chance to post this cool photo of Dirk Nowitzki and Kobe Bryant which is at best tangentially related to anything else on this blog.