The Protecting Americans from Tax Hikes (PATH) Act of 2015 made significant changes to Section 831(b) of the Internal Revenue Code and also included new annual reporting requirements for electing captive insurance companies.
The Protecting Americans from Tax Hikes (PATH) Act of 2015 made significant changes to Section 831(b) of the Internal Revenue Code and also included new annual reporting requirements for electing captive insurance companies. The PATH Act increased the maximum premiums for insurance companies making the election to be taxed solely on investment income from $1.2 million per year to $2.2 million per year, and included certain eligibility requirements for making the election.
On 1 November last year, the Internal Revenue Service (IRS) released Notice 2016-66, which formally labelled micro captives as ‘transactions of interest’. The IRS advised that these transactions have the potential for tax avoidance or evasion. Transactions of interest are a type of reportable transaction first established by the IRS in 2006, and since then only six transactions have been labelled as such, including micro captive transactions. The reportable transaction is part of the larger reporting regime created by the American Jobs Creation Act of 2004 and the corresponding regulations to identify tax shelters.
It is important to note, however, that a reportable transaction is not the same as a ‘listed transaction’, and therefore, the 831(b) captive has not been determined to be a listed transaction.
The purpose of the notice is to provide the details for those disclosures, including which taxpayers are required to submit the disclosures, the timing for that submission and the specific information the IRS is requiring.
Who is required to file these disclosures?
Where applicable, owners of the captive, the captive itself and the insureds of the captive are required to prepare and file the disclosures. These participants are to report the required disclosures on Form 8886, the reportable transaction disclosure statement.
The notice addresses captive insurance transactions making the 831(b) election if the owner of the insured entities or one or more persons related to the owner of those insureds owns more than 20 percent of the voting power or value of the captive and either of the captive’s loss ratio is less than 70 percent (premiums are measured after taking into account any policyholder dividends, or after the captive has provided financing or otherwise conveyed funds to the owner or related parties from the captive’s surplus in a nontaxable transaction).
Under the terms of the notice, the relationship tests are determined utilising the various attribution rules provided in the Internal Revenue Code, which include ownership through partnerships and trusts as well as that by siblings, ancestors, spouses and lineal descendants.
Specifically excluded from the reporting requirements, however, are captive arrangements insuring employee compensation or benefits, which have received a prohibited transaction exemption by the Department of Labor.
Material advisers, defined as an adviser receiving $50,000 or more in fees resulting from the transaction, also have disclosure requirements, which are to be reported on Form 8918, the material advisor disclosure statement.
What information is required to be disclosed, and when are the disclosures required to be filed?
Pursuant to the notice, the following must be disclosed to the IRS:
Form 8886 also requires a description of the tax benefits involved with the transaction, the material advisers to the transaction, as well as a listing of any related parties involved.
The notice originally required these disclosures to be made by 30 January 2017, but after requests from organisations such as the Self-Insurance Institute of America as well as a member of the Senate Finance Committee, the IRS extended the filing deadline to 1 May this year.
Under the terms of the notice, transactions entered into on or after 2 November 2006, need to be considered, and disclosures need to be made for the five most recent tax years.
If the captive has been in existence for less than five years, the disclosures should be completed for each year of its existence.
Why is the IRS asking for this information?
According to the notice, the IRS is requesting this information in order to determine which characteristics of the 831(b) captive arrangements are indicative of “tax avoidance or evasion”.
The IRS also raised concerns around topics including:
Doesn’t the IRS already have this information?
The IRS actually receives most of the information being requested annually when the captive files its tax return. The annual report or statement generally contains information regarding lines of business, losses incurred, the domicile of the captive, as well as investments and other assets held by the captive.
For the several hundred captives currently under examination, the IRS has obtained extensive documentation with regards to all aspects of the captive, its formation and its operations.
This approach is not unusual, however. When the IRS begins an examination, generally their very first request is for copies of the tax returns for the years being audited.
What are the consequences of not filing?
Penalties will be assessed if it is determined that a taxpayer was required to disclose their participation in a reportable transaction but did not.
The penalty is 75 percent of the amount the tax decreased by participating in the transaction, with a maximum penalty of $10,000 for individuals and $50,000 for other taxpayers.
The penalties are essentially a ‘strict liability’ penalty, meaning it is only in few circumstances this penalty will be abated.
