Notice 2016-66: Is the IRS repeating the mistakes of the past or learning from them?

The Internal Revenue Service (IRS) issued Notice 2016-66 on 1 November 2016, classifying micro captive arrangements as transactions of interest. These arrangements involve captive insurers that have made an election under Internal Revenue Code (IRC) Section 831(b), to be treated as a small insurance company, and hence, subject to tax solely on their investment income, rather than on their investment and underwriting income.

The purpose of the notice is to identify situations in which the IRS perceives there may be some form of abuse of the election. It seeks to accomplish this by imposing detailed disclosure requirements on electing companies.

In the last two decades, the US Treasury and the IRS have issued significant guidance regarding the tax treatment of captive insurance arrangements. Some of this guidance is designed to address questions about various captive insurance fact patterns, including questions involving brother-sister arrangements and coverage of third-party risk. Other guidance, such as Notice 2002-70, sought to curb what the IRS perceived as the use of captives for purposes other than to provide insurance coverage. The results of such efforts, however, have been mixed. As a result of this history, there are significant questions about whether the IRS’s latest effort through Notice 2016-66 to address a perceived abuse will be accomplish the intended goal.

Prior guidance efforts

In 2002, the IRS designated certain insurance arrangements as abusive via issuing Notice 2002-70, which dealt with producer-owned reinsurance companies (PORCs), including them among other listed transactions that were subject to heightened reporting requirements. The IRS and Treasury were concerned that these arrangements were not being used for legitimate insurance and risk management purposes but as investment vehicles. In issuing Notice 2002-70, the IRS and Treasury cast a wide net across the entire insurance industry. This wide net had the effect of subjecting some traditional insurance carriers, not just PORCs, to the disclosure requirements. This occurred because of a broad definition of “substantially similar” transactions that resulted in many common, long-accepted insurance arrangements getting caught up in the rules. The notice met strong resistance from the industry, including a large number of negative comments from a highly diverse group of taxpayers.

Ultimately, the IRS issued Notice 2004-65, which removed PORCs from the listed transactions. According to the IRS: “[E]xaminations have revealed fewer abusive transactions than anticipated.” Since the experience with Notice 2002-70, the IRS and Treasury have sought to find ways to address concerns surrounding specific captive insurance transactions without casting a similarly wide net that would cause the effort to be easily attacked as overly broad.

It is against this backdrop that the IRS has turned its attention to the use of micro captives for purposes beyond traditional risk management. The IRS is concerned that these companies are being used, for example, as wealth transfer instruments, not as risk transfer and management entities. During tax filing season, the IRS typically issues the list of “dirty dozen” abusive tax transactions that it is concerned with, including this perceived misuse of micro captives. In addition, the IRS is currently challenging a micro captive arrangement in court. Congress even got into the act in 2015, when it modified Section 831(b), in part to curb the use of this provision for non-insurance risk transfer purposes by related parties as part of the Protecting Americans from Tax Hikes Act.

Issuance of Notice 2016-66

Despite the fact that Congress has already stepped in to address this, the IRS issued Notice 2016-66, which established Section 831(b) micro captives as a “transaction of interest”. There are two things significant about Notice 2016-66 that differ from Notice 2002-70. First, the transaction is not a “listed transaction”, but rather, a “transaction of interest” that the IRS is looking to learn more about through the required disclosure process. Second, the IRS limited the inquiry to parties involved in transactions that specifically involved captives that made the election to be treated as a small company under Section 831(b). Moreover, the IRS acknowledged that there are micro captives that are truly legitimate insurance companies and that those companies will have a reporting requirement even though they are not the companies the IRS is concerned with. The IRS and Treasury appear to be trying to address some of the concerns raised in response to Notice 2002-70. The outstanding question is whether they have achieved the desired result.

It should be no surprise that the reaction from the industry, particularly those working with micro captives, was swift and negative. The sentiment by some in the industry was that the IRS has neither articulated what its precise concerns with micro captives are, nor provided taxpayers and the captive insurance industry with substantive guidance that would enable industry participants to distinguish between those types of transactions the IRS would perceive as abusive and those it would respect as being legitimate.

To the contrary, because the informal guidance offered to date implicates legitimate micro captives within its grasp, the notice continues to provide a clouded view of what the IRS would consider to be legitimate and improper structures.

Regardless of the opinions surrounding Notice 2016-66, the additional disclosure requirements for micro captive transactions are already resulting in significant administrative burdens on small businesses. Because Notice 2016-66 designates the transaction as a “transaction of interest”, taxpayers face additional paperwork and must contend with uncertainty surrounding which taxpayers are subject to reporting. Also, as originally issued, Notice 2016-66 required all of the above to happen by 31 January 2017, an almost impossible deadline given that the notice was issued in November 2016. In response to multiple comments, the IRS and Treasury issued Notice 2017-08, extending the disclosure date by 90 days to 1 May 2017.

Many in the industry are experiencing a sense of history repeating itself, as they view Notice 2016-66 as casting a broad net, subjecting legitimate transactions to its reporting requirements. Many wonder if this notice will suffer the same fate as Notice 2002-70, with it being revoked by the IRS and Treasury in a few years due to a similar type of ineffectiveness in identifying perceived abuses. In the meantime, taxpayers will have spent countless hours and resources complying with the notice.

Practical challenges of compliance


Overall, the notice requires identified parties to file a reportable transaction disclosure statement, Form 8886, with sufficient details of the transaction so that the IRS can understand the transaction steps and details needed to determine if the transaction raises any concerns. The disclosure also must identify all parties involved in the transaction. As noted above, the notice is broad, and there is ambiguity about who should or should not report (including possibly third-party fronting commercial carriers), and what constitutes a “substantially similar” transaction.

Disclosure is required for the lesser of the most recent five taxable years of the captive, or the period for which the captive has been in existence. If the captive has been in existence for less than five years and is a successor to one or more captives created or availed of in connection with the notice, then taxable years of the predecessor entities are treated as taxable years of the captive for purposes of the disclosure.

Persons entering into these transactions on or after 2 November 2006 must disclose the transaction as required by the IRC and the accompanying regulations. This includes material advisers who make a tax statement on or after 2 November 2006, with respect to transactions entered into on or after 2 November 2006.

Reporting persons

Reporting persons are the participants in the transaction and are defined in the notice as: (i) “A” (for example, the owner of a captive, either direct or indirect), (ii) an insured, (iii) the micro captive, and, if applicable, (iv) “Company C” (for example, a third-party fronting commercial carrier). All of these are required to prepare a statement for each year in which their respective tax returns reflect tax consequences or a tax strategy of the micro captive transaction of interest. Participants must file Form 8886 with a description of the transaction in sufficient detail, stating when and how the taxpayer became aware of the transaction.

Reporting persons face a number of questions as they develop their description of the transaction. For example, what constitutes the reflection of tax consequences or a tax strategy of the micro captive transaction? Similarly, although loans may not be reportable on the participant’s tax returns, will the failure to report loan proceeds as dividends (if the participant is in the ownership chain) be considered a tax consequence or a tax strategy? What is the consequence for a participant that is outside of the ownership chain and has received a portion of the captive’s capital in a manner that the notice indicates may give rise to a reporting requirement? Are individuals more vulnerable to reporting errors because they may not have reflected (or failed to reflect) tax consequences of a financial arrangement with a micro captive?

Is a dividend payment a “tax consequence”? For example, in the case of a dividend paid by the micro captive to the shareholders of an offshore micro captive that elected to be treated as a US insurance company, shareholders may have reflected the dividend on their returns, but shareholders of domestic micro captives may not. As a result, US shareholders receiving distributions may be identically taxed regardless of whether the arrangement is taxable under section 11(a), 831(a), or 831(b), depending on whether the micro-captive is still treated as a corporation under the tax law.

Is the receipt of fees, commissions or other taxable income that arises as a result of the implementation or ongoing activities of the transaction considered to be a tax consequence? The notice does not exempt a taxpayer from reporting because its taxable income increased through participation.

Accordingly, the intermediary companies, such as fronting arrangements and, potentially, captive managers, may need to consider whether they are pulled into the disclosure requirements. Material advisers are subject to the same reporting thresholds that apply for listed transactions.

With regard to not-for-profit entities, other grey areas exist. Generally, no tax benefit would be derived from a micro captive transaction by a not-for-profit owner and/or insured. Does any participant in such case, including the micro captive, even have a reporting requirement? A plain reading could suggest ‘no’. But the language of the notice is silent on the subject and so gives no indication on how the notice should be interpreted by taxpayers having such structures, especially considering that the notice uses terms “consequence” and “strategy” rather than “benefit”.


Failure to comply with the notice could result in significant penalties. For example, a participant that fails to properly disclose the transaction may be subject to a penalty of 75 percent of the tax benefits, with a maximum of $50,000 for entities and $10,000 for individuals. The minimum for entities would be $10,000, while individuals would face a minimum of $5,000. In addition, the IRS may impose other penalties on participants in these transactions. A material adviser failing to report may also be subject to a penalty, and failure to provide the required list of advisees to the IRS when requested may result in an additional penalty.

Small businesses

A common concern of small businesses is that the notice attempts to undermine important public policies set forth by Congress by perhaps unwittingly targeting small businesses. Some have argued that the process employed by the IRS in issuing the notice in a way appears to effectively administratively repeal section 831(b). This is somewhat of a common argument mentioned in multiple publicly disclosed comment letters issued on the subject, both in the small-business community and outside of it.

At this point, however, the 1 May 2017 extension remains effective until further notice, which may be a rather last-minute event, leaving taxpayers with the administrative burden already undertaken. While all affected taxpayers are preparing the required disclosures, small businesses continue to face the most significant challenges. Not having the internal resources to analyse and potentially prepare the required disclosure requires such entities to spend more on using outside advisers than larger businesses that have in-house capabilities.

Moreover, recordkeeping challenges may result in significantly more time lost by a small business in gathering the required information than by a larger organisation that has more on-site storage and more modern technology to manage information.

IRS audits

The IRS has included micro captives described in Notice 2016-66 among its most recently announced audit campaigns: “The IRS will be specifically looking for micro captive transactions 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 [the large business and international division of the IRS] has developed a training strategy for this campaign. The treatment stream for this campaign will be issue-based examinations.”

Multiple comment letters noted that the information document requests issued in these nationally coordinated audits are extraordinarily broad and essentially demand every single record related to the micro captive from the time the micro captive transaction was first discussed or considered until the present.

Next steps

The notice outlines possible next steps after the Treasury and the IRS have gathered enough information regarding potentially abusive 831(b) arrangements. The IRS and the Treasury may take one or more actions, including removing the transaction from the transactions of interest category in published guidance, designating the transaction as a “listed transaction”, or providing a new category of reportable transaction. In the interim, the IRS may challenge a position taken as part of a transaction that is the same as, or substantially similar to, the transaction described in Section 2.01 of the notice under other provisions of the IRC or judicial doctrines such as sham transaction, substance over form, or economic substance.

The IRS clearly intends to pursue micro captive transactions that it believes to be abusive both through the audit process and through litigation. The captive industry has also made it clear that it will pursue all avenues to repeal the notice, including litigation and seeking legislative changes.

The IRS and Treasury tried to thread a needle with the issuance of Notice 2016-66 by targeting micro captives specifically and designating the arrangements as transactions of interest instead of listed transactions. But the broad scope of the notice and the potential reach to unsuspecting and uninformed third parties, as well as the lack of details to clarify whether to report, and what to include in the report, raise serious questions about whether the government will be successful in its current effort, or whether Notice 2016-66 will ultimately go the way of Notice 2002-70.

History of Notice 2016-66

1 November 2016
The IRS issued Notice 2016-66, designating a new transaction of interest relating to certain captive insurance companies that make the election under 831(b) to be taxed only on taxable investment income (micro captive). Notice 2016-66 applies retroactively to transactions entered into on or after 2 November 2006. Under the notice, taxpayers who have participated in the transaction for any return year with an open statute of limitations would have to disclose participation by 30 January 2017. Material advisers to such transactions were required to disclose them by 31 January 2017.

17 November 2016
The Self-Insurance Institute of America (SIIA) sent a formal request to the IRS, Treasury, and Congress, asking for modifications and a reporting extension for the notice. SIIA commented that the requirements set forth in the notice are “too broad, resulting in little useful new information versus the tremendous cost of compliance to the taxpayers and loss of revenue to states”. SIIA met with the IRS in December 2016 to discuss these concerns.

28 December 2016
CIC Services, a captive manager, filed a lawsuit seeking an injunction from the federal district court that would prohibit the IRS from enforcing Notice 2016-66. The lawsuit contended that the notice is a “legislative-type rule” that was not in compliance with the Administrative Procedures Act (APA). CIC complained that the Treasury and the IRS did not provide proper notice to the public or an opportunity for public comment.

29 December 2016
The IRS issued Notice 2017-08, revising Notice 2016-66, by extending the original deadline for filing required disclosures to 1 May 2017, for both participants and material advisers. This extension includes certain disclosure statements required to be filed with respect to micro captive insurance transactions after 1 November 2016, and prior to 1 May 2017. In addition, for purposes of disclosure of transactions in which a captive enters into a contract with the insured, the 90-day period provided in Treasury regulations was extended to 180 days.

3 January 2017
CIC temporarily withdrew its lawsuit, as the captive manager was hoping that the IRS would consider withdrawing the notice once the new presidential administration took office. CIC said it will consider reinstating the lawsuit before 1 May if the notice is not withdrawn.

27 March 2017
CIC, joined by Ryan, followed through on its prior commitment to litigate the issue and filed its second lawsuit concerning the implementation of Notice 2016-66 with the US District Court for the Eastern District of Tennessee. In addition to the lawsuit, CIC and Ryan are planning to set a date for a hearing with attorneys of the Captive Insurance Defense Coalition in Washington DC.

The views expressed are those of the authors and do not necessarily reflect the views of any member firm of the global EY organisation.
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