Notice 2016-66 have — Internal Revenue Bulletin 2023-17

Department’s and the IRS’s understanding of micro-captive transactions, including the scope of participation. Further, in the three section 831(b) micro-captive cases decided on their merits since the publication of Notice 2016-66, the U.S. Tax Court held that the micro-captive transactions at issue did not meet the requirements for treatment as insurance for Federal income tax purposes. See Avrahami v. Commissioner, 149 T.C. at 144; Syzygy v. Commissioner, T.C. Memo. 2019-34; and Caylor v. Commissioner, T.C. Memo. 2021-30; see also Reserve Mechanical Corp. v. Commissioner, 34 F.4th at 881 (concluding transactions entered into by company filing as a tax-exempt entity under section 501(c)(15) did not meet the requirements for treatment as insurance for Federal income tax purposes using similar analysis). Taking into account only the years in issue in these decisions, the information included in the Court’s opinions indicates that the transactions at issue had the elements that would require disclosure under Notice 2016-66. Accordingly, the Treasury Department and the IRS have determined that certain micro-captive transactions are abusive tax avoidance transactions and certain other micro-captive transactions have the potential for tax avoidance or evasion.

As further discussed in sections B.1. through B.3. of this Explanation of Provisions, the Treasury Department and the IRS have determined that two categories of micro-captive transactions, described in proposed §1.6011-10(c)(1) and (c)(2), are tax avoidance transactions, and thus propose to identify such transactions as listed transactions. The transactions in both categories involve related parties, including a Captive, at least 20 percent of the voting power or the value of the outstanding stock or equity interest of which is owned, directly or indirectly, by an Insured, an Owner, or persons Related to an Insured or an Owner. See proposed §1.6011-10(b)(1)(iii). The first category of these transactions is identified by the presence of a financing factor, described in proposed §1.6011-10(c)(1). The second category of these transactions is identified by a loss ratio factor that falls below 65 percent based on a Loss Ratio Computation Period of ten taxable years, as

comment procedures); Green Rock, LLC v. IRS, No. 2:21-cv-01320-ACA, 2023 U.S. Dist. LEXIS 17670 (N.D. Ala. Feb. 2, 2023) (holding that notice and comment procedures were required before issuance of Notice 2017-10).

In light of the decision by the district court in CIC Services, the IRS will not enforce the disclosure requirements or penalties that are dependent upon the procedural validity of Notice 2016-66. Thus, the Treasury Department and the IRS are issuing these proposed regulations to identify certain micro-captive transactions as Micro-captive Transactions of Interest. In addition, this document obsoletes Notice 2016-66 (as modified by Notice 2017-08). The obsoletion of the notice, however, has no effect on the merits of the tax benefits claimed from the transactions themselves and related litigation, or income tax examinations and promoter investigations relating to micro-captive transactions.

The Treasury Department and the IRS disagree with the Sixth Circuit’s decision in Mann Construction and the Tax Court’s decision in Green Valley and are continuing to defend the validity of notices identifying transactions as listed transactions in circuits other than the Sixth Circuit. However, to help allow for consistent enforcement throughout the nation, the Treasury Department and the IRS are proposing to identify certain other micro-captive transactions as Micro-captive Listed Transactions by regulation.

Explanation of Provisions

A. Micro-captive Listed Transactions and Micro-captive Transactions of Interest

This section generally describes the micro-captive transactions that are the focus of the proposed regulations and why the Micro-captive Listed Transactions are abusive and the Micro-captive Transactions of Interest have the potential for abuse. This section also describes the proposed regulations identifying Micro-captive Listed Transactions and Micro-captive Transactions of Interest.

In general

The Treasury Department and the IRS are aware of a micro-captive transaction,

in which a taxpayer attempts to reduce the aggregate taxable income of the taxpayer, persons related to the taxpayer, or both, using contracts that the parties treat as insurance contracts and a related Captive. In some cases, Captive enters into a contract with a related entity that the parties treat as an insurance contract. In other cases, Captive and a related entity enter into separate contracts with one or more unrelated intermediaries. For example, the related entity and an intermediary may enter into a contract that the parties treat as an insurance contract, and Captive may then enter into a separate contract with the intermediary that the parties treat as a reinsurance contract covering the “risks” under the contract between the related entity and the intermediary. Each entity that makes payments to an intermediary or Captive under these contracts treats the payments as insurance premiums that are within the scope of §1.162-1(a) and deducts the payments as ordinary and necessary business expenses under section 162. Captive treats the payments received from the related entity or intermediary under a contract treated as an insurance contract or reinsurance contract as premiums for insurance coverage.

Captive asserts that it is taxable as a nonlife insurance company under the Code and, if it is not a domestic corporation, makes an election under section 953(d) of the Code to be treated as a domestic corporation for purposes of the Code. Captive makes an election under section 831(b) to be taxed only on taxable investment income (defined in section 834). Captive accordingly excludes from the computation of its taxable income the payments received from the related entity or intermediary treated as premiums. For each taxable year in which the micro-captive transaction is in effect, the transaction is structured so that Captive does not have net premiums written (or, if greater, direct premiums written) that exceed the statutory limit. For taxable years beginning after December 31, 2016, the statutory limit is $2,200,000, adjusted annually for inflation ($2,650,000 for taxable years beginning in 2023).

Since the publication of Notice 201666, examinations of taxpayers and promoters and information received through disclosures filed in response to

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described in proposed §1.6011-10(c)(2). The proposed regulations therefore identify transactions that are the same as, or substantially similar to, the Micro-captive Listed Transaction described in proposed §1.6011-10(a) as listed transactions for purposes of §1.6011-4. As noted previously, a transaction is “substantially similar” if it is expected to obtain the same or similar types of tax consequences and is either factually similar or based on the same or similar tax strategy, even though it may involve different entities or use different Code provisions.

As further discussed in sections B.1. and B.3. of this Explanation of Provisions, the Treasury Department and the IRS have also determined that a third category of micro-captive transactions, described in proposed §1.6011-11(c), has a potential for tax avoidance or evasion, and thus propose to identify such transactions as transactions of interest. This category of micro-captive transactions also involves related parties as described in proposed §1.6011-10(b)(1)(iii) and is identified by the presence of a loss ratio factor that falls below 65 percent over a shorter Transaction of Interest Computation Period, generally because Captives involved have been in operation for a shorter period of time. With respect to this third category of transactions, the Treasury Department and the IRS require more information to determine if the transactions are being used for tax avoidance or evasion. The proposed regulations therefore identify transactions that are the same as, or substantially similar to, the Micro-captive Transaction of Interest described in proposed §1.6011-11(a) as transactions of interest for purposes of §1.6011-4(b)(6).

Abuses

In Micro-captive Listed Transactions and Micro-captive Transactions of Interest, related parties claim the Federal income tax benefits of treating the contracts as insurance (or reinsurance) contracts. Insured deducts premiums paid to Captive under section 162, while the related Captive excludes the premium income from its taxable income by electing under section 831(b) to be taxed only on its taxable investment income.

Neither the Code nor the regulations thereunder define the terms “insurance” or “insurance contract.” The Supreme Court has explained that for an arrangement to constitute insurance for Federal income tax purposes, both risk shifting and risk distribution must be present. Helvering v. Le Gierse, 312 U.S. 531 (1941). The risk transferred must be risk of economic loss. Allied Fidelity Corp. v. Commissioner, 572 F.2d 1190, 1193 (7th Cir. 1978). The risk must contemplate the fortuitous occurrence of a stated contingency, Commissioner v. Treganowen, 183 F.2d 288, 290-91 (2d Cir. 1950), and must not be merely an investment or business risk. Rev. Rul. 2007-17, 2007-2 C.B. 127. In addition, the arrangement must constitute insurance in the commonly accepted sense. See, e.g., Rent-A-Center, Inc. v. Commissioner, 142 T.C. 1, 10-13 (2014).

In many micro-captive transactions, however, the manner in which the contracts are interpreted, administered, and applied is inconsistent with arm’s length transactions and sound business practices. Captive typically does not behave as an insurance company commonly would, indicating that Captive is not issuing insurance contracts and the transaction does not constitute insurance for Federal income tax purposes. For example, Captive may fail to adequately distribute risk or fail to employ actuarial techniques to establish premium rates that appropriately reflect the risk of loss and costs of conducting an insurance business. Captive may also use its premium income for purposes other than administering and paying claims under the contract(s), including routing funds that have not been taxed to the Insured or a person related to the Insured or its owners. A micro-captive transaction may share other characteristics with the purported insurance transactions considered by the Tax Court in Avrahami, Syzygy, and Caylor, or with the transactions considered in other cases in which the courts determined the transactions were not insurance for Federal income tax purposes. See, e.g., Reserve Mechan- ical Corp. v. Commissioner, 34 F.4th 881 (10th Cir. 2022). The net effect of participating in this transaction is that the Insured claims a tax deduction for transferring amounts treated as premiums to Captive, which is owned by parties related

to Insured, and Captive is not taxed on the corresponding income.

If the transaction does not constitute insurance, Insured is not entitled to deduct under section 162 as a trade or business expense the amount treated as an insurance premium. In addition, if Captive does not actually provide insurance, it does not qualify as an insurance company and its elections to be taxed only on its taxable investment income under section 831(b) and to be treated as a domestic insurance company under section 953(d) are invalid.

These proposed regulations inform taxpayers that participate in transactions described in proposed §§1.6011-10(c) and 1.6011-11(c), and substantially similar transactions, and persons who act as material advisors with respect to these transactions, and substantially similar transactions, that they must disclose in accordance with the rules provided in §1.6011-4(a) and section 6111(a), respectively. Material advisors must also maintain lists as required by section 6112.

As previously noted, the IRS intends to challenge the claimed tax benefits from Micro-captive Listed Transactions, and may challenge the claimed tax benefits from Micro-captive Transactions of Interest. Examinations of these micro-captive transactions may result in adjustments including full disallowance of claimed micro-captive insurance premium deductions, inclusion in income of amounts received by Captive, imposition of withholding tax liability under section 1461 of the Code for failing to deduct and withhold tax on payments made to a foreign Captive, imposition of a 20 percent or 40 percent penalty for lack of economic substance under section 6662(b)(6) or (i)(1) of the Code, which may not be avoided by a reasonable cause exception, and imposition of other applicable taxes and penalties.

Micro-captive Listed Transactions

Proposed §1.6011-10(a) provides that transactions that are the same as, or substantially similar to, transactions described in proposed §1.6011-10(c) are identified as listed transactions for purposes of §1.6011-4(b)(2), except as provided in proposed §1.6011-10(d). Proposed §1.6011-10(b) provides definitions

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of terms used to describe Micro-captive Listed Transactions, including Captive, Financing Computation Period, Loss Ratio Computation Period, Contract, Insured, Intermediary, Recipient, and Related. In particular, Captive is defined as an entity that elects under section 831(b) to be taxed as an insurance company only on its taxable investment income; issues a Contract to an Insured, reinsures a Contract of an Insured issued by an Intermediary, or both; and has at least 20 percent of its assets or voting power or the value of its outstanding stock or equity interests directly or indirectly, individually or collectively, owned by an Insured, an Owner, or persons Related to an Insured or Owner. The term Related is defined in proposed §1.6011-10(b)(8) by reference to sections 267(b), 707(b), 2701(b)(2)(C), and 2704(c)(2). The definition incorporates the constructive ownership rules in those sections. Proposed §1.6011-10(b) also provides the rules for persons that hold derivatives and for the treatment of beneficiaries of trusts and estates. The treatment of beneficiaries of trusts in proposed §1.6011-10(b) does not affect the application of Subpart E of Subchapter J of Chapter 1 of Subtitle A, which provides rules concerning when a grantor or another person is treated as the owner of a portion of that trust.

A transaction is described in proposed §1.6011-10(c) if it is described in proposed §1.6011-10(c)(1), or (c)(2), or both. Proposed §1.6011-10(c)(1) describes transactions that involve a Captive that, at any time during the Financing Computation Period, directly or indirectly made available as financing or otherwise conveyed or agreed to make available or convey to a Recipient, in a transaction that did not result in taxable income or gain to the Recipient, any portion of the payments under the Contract, such as through a guarantee, a loan, or other transfer of Captive’s capital, including such financings or conveyances made prior to the Financing Computation Period that remain outstanding as of the taxable year in which disclosure is required. Any amounts that a Captive made available as financing or otherwise conveyed or agreed to make available or convey to a Recipient are presumed to be portions of the payments under the Contract to the extent such

amounts when conveyed or made available are in excess of Captive’s cumulative after-tax net investment earnings minus any outstanding financings or conveyances. See section B.2. of this Explanation of Provisions. The Financing Computation Period is the most recent five taxable years of Captive, or all taxable years of Captive, if Captive has been in existence for less than five taxable years. For purposes of determining the Financing Computation Period, each short taxable year is a separate taxable year and taxable years of predecessor entities are treated as taxable years of Captive.

Proposed §1.6011-10(c)(2) describes transactions that involve a Captive for which the amount of liabilities incurred for insured losses and claim administration expenses during a Loss Ratio Computation Period is less than 65 percent of the amount equal to premiums earned by Captive during the Loss Ratio Computation Period less policyholder dividends paid by Captive during the Loss Ratio Computation Period. See section B.3. of this Explanation of Provisions. The Loss Ratio Computation Period is the most recent ten taxable years of Captive, each short taxable year is a separate taxable year, and the taxable years of predecessor entities are treated as taxable years of Captive. Proposed §1.6011-10(c)(2) does not apply to any Captive that has been in existence for less than ten taxable years, including taxable years of predecessor entities.

Proposed §1.6011-10(d) provides that a transaction described in proposed §1.6011-10(c) is not classified as a listed transaction if the transaction (1) provides insurance for employee compensation or benefits and is one for which the Employee Benefits Security Administration of the U.S. Department of Labor has issued a Prohibited Transaction Exemption, or (2) is a Consumer Coverage reinsurance arrangement described in proposed §1.6011-10(d)(2). See section B.6. of this Explanation of Provisions.

Proposed §1.6011-10(e)(1) provides the rules for determining who is a participant in a listed transaction described in proposed §1.6011-10(a). Proposed §1.6011-10(e)(2) provides a safe harbor from the disclosure requirements for certain persons. See section B.5. of this Explanation of Provisions.

Proposed §1.6011-10(f) describes information that participants must provide to satisfy the disclosure requirements of §1.6011-4(d). See section B.4. of this Explanation of Provisions.

Proposed §1.6011-10(g) provides the applicability date for the proposed regulations.

Micro-captive Transactions of Interest

Proposed §1.6011-11(a) provides that transactions that are the same as, or substantially similar to, transactions described in proposed §1.6011-11(c) are identified as transactions of interest for purposes of §1.6011-4(b)(6), except as provided in proposed §1.6011-11(d). Proposed §1.6011-11(b) provides definitions of terms used to describe Micro-captive Transactions of Interest by reference to the relevant definitions in proposed §1.601110(b), except for the definition of the computation period. Proposed §1.601111(b)(2) defines the Transaction of Interest Computation Period for Micro-captive Transactions of Interest as the most recent nine taxable years, or the entire period of Captive’s existence if Captive has been in existence for less than nine taxable years. For this purpose, each short taxable year is a separate taxable year, and the taxable years of predecessor entities are treated as taxable years of Captive.

A transaction is described in proposed §1.6011-11(c) if it involves the issuance of a Contract to an Insured by a Captive, or the reinsurance by a Captive of a Contract issued to an Insured by an Intermediary, and involves a Captive for which the amount of liabilities incurred for insured losses and claim administration expenses during the Transaction of Interest Computation Period is less than 65 percent of the amount equal to premiums earned by Captive during the Transaction of Interest Computation Period less policyholder dividends paid by Captive during the Transaction of Interest Computation Period. See section B.3. of this Explanation of Provisions.

Proposed §1.6011-11(d) provides that a transaction described in proposed §1.6011-11(c) is not classified as a “transaction of interest” if the transaction (1) provides insurance for employee compensation or benefits and is one for

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which the Employee Benefits Security Administration of the U.S. Department of Labor has issued a Prohibited Transaction Exemption, or (2) is a Consumer Coverage reinsurance arrangement described in proposed §1.6011-11(d)(2). See section B.6. of this Explanation of Provisions. Additionally, proposed §1.6011-11(d)(3) provides that a transaction described in proposed §1.6011-11(c) is not classified as a “transaction of interest” if the transaction is identified as a “listed transaction” in proposed §1.6011-10(a). Under proposed §1.6011-11(d)(3), a transaction that would (but for that subsection) be identified as both a “listed transaction” under proposed §1.6011-10 and a “transaction of interest” under proposed §1.6011-11, is identified as a “listed transaction” only, and participants in the transaction must disclose it as such. Material advisors that are uncertain about whether the transaction they are required to disclose should be reported as a Micro-captive Listed Transaction or as a Micro-captive Transaction of Interest should disclose the transaction as a Micro-captive Listed Transaction, and will not be required to disclose the transaction a second time if it is determined later that the transaction should have been disclosed as a Micro-captive Transaction of Interest.

Proposed §1.6011-11(e)(1) provides the rules for determining who is a participant in a transaction of interest described in proposed §1.6011-11(a). Proposed §1.6011-11(e)(2) provides a safe harbor from the disclosure requirements for certain persons. See section B.5. of this Explanation of Provisions.

Proposed §1.6011-11(f) describes information that participants must provide to satisfy the disclosure requirements of §1.6011-4(d) by reference to the information described in proposed §1.6011-10(f). See section B.4. of this Explanation of Provisions.

Proposed §1.6011-11(g) provides the applicability date for the proposed regulations.

B. Changes to Transaction Identified in Notice 2016-66

Examinations of taxpayers and promoters and information received through disclosures filed in response to Notice

2016-66 have clarified the Treasury Department’s and the IRS’s understanding of micro-captive transactions, including the scope of participation. Based on such information, the Treasury Department and the IRS have determined that certain changes to the micro-captive transaction identified in Notice 201666 are appropriate for the proposed regulations. The transactions described in proposed §1.6011-10 and proposed §1.6011-11 share common features with the micro-captive transactions described in Notice 2016-66, but with modifications to the scope of the 20-percent relationship factor and the factors used to distinguish between listed transactions, transactions of interest, and transactions that are not reportable transactions under the proposed regulations.

Changes to the Definition of Captive

The Treasury Department and the IRS are aware that some promoters have structured transactions in which Insureds, Owners, or persons Related to an Insured or an Owner do not have a direct or indirect interest in Captive’s voting power or value of its outstanding stock or equity interests, but have a relationship with Captive that provides substantially similar benefits and risks. For example, Captive may issue various types of instruments representing rights to all or a portion of the assets held by Captive but not rights to the voting power or equity interests in Captive. All equity interests and voting stock are held by individuals or entities related to the promoter, not the taxpayers. The promoters thereby seek to avoid the 20 percent related interest in the voting stock or equity interests in Captive necessary for a transaction to be described in Notice 2016-66. The proposed regulations expand the scope of the definition of Captive to clarify that derivatives and interests in the assets of Captive are taken into account. See proposed §§1.6011-10(b)(1) (A) – (C) and 1.6011-11(b)(1).

Changes to the Financing Factor

Transactions in which the financing factor is met based on a computation period of Captive’s most recent five taxable years (or all years of Captive’s existence if Cap

tive has been in existence for less than five taxable years), referred to as the Financing Computation Period in the proposed regulations, are identified as transactions of interest in Notice 2016-66 but are identified as listed transactions in the proposed regulations. See proposed §1.6011-10(c) (1). Presence of the financing factor in related party micro-captive insurance transactions indicates tax avoidance and abuse of Captive’s status as a section 831(b)-electing insurance company.

Changes to the Loss Ratio Factor and Computation Period