New Disclosures Required Immediately for Micro-Captives and Their Participants (article)
On Nov. 1, 2016, the IRS unveiled a new obligation to disclose information pertaining to certain transactions made by captive insurance companies that have made the election under Code Section 831(b) to exempt premiums earned from income. The disclosure requirement applies to all parties that have “participated” in these transactions, as well as material advisors. Disclosure filings generally must be made by Jan.30, 2017.
In most cases, reporting is required if a participant entered into a transaction after Nov. 2, 2006 (the date the IRS issued the attendant “disclosure” regulations), but as of November 1, reporting is limited to years for which the statute of limitation for assessment remains open. Parties participating in these transactions should immediately review these new rules to ascertain what reporting or other obligations they now have.
Under Section 831(b) insurance companies (other than life insurance companies) can elect to have income generated from underwriting premiums excluded from taxation when such income for the year is less than $1.2 million. This threshold increases to $2.2 million in 2017.
These insurance companies may be owned directly or indirectly by the same taxpayer operating a trade or business that is insured by the company making the Section 831(b) election. The captive insurance companies benefit from the income exclusion under Section 831(b), while the insured trade or business still deducts its premium payment.
The IRS is concerned about this type of arrangement, particularly when features include coverage for an implausible risk, coverage that does not match a business need or risk of the insured trade or business, coverage that is vague or illusory or duplicative coverage already provided to the insured trade or business. In response, the IRS issued Notice 2016-66 which classified these arrangements as “transactions of interest” thereby imposing a reporting obligation on parties that have participated in this type of transaction on or after November 2, 2006. Under Notice 2016-66, to be a transaction of interest all of the following criteria must exist:
- A business owner directly or indirectly owns an interest in an entity conducting a trade or business (the Insured);
- Another entity (the Captive) that is directly or indirectly owned by the business owner, the Insured, or persons related to either, enters into contracts that the parties treat as insurance coverage or the Captive reinsures the existing risks of the Insured);
- The Captive makes an election under Section 831(b);
- The business owner, the Insured, or persons related to either, own at least 20 percent of the voting power or stock value of the Captive; and
- During a 5-year computation period (or the entire life of the Captive if less than 5 years), one or both of the following apply:
- The Captive’s liability for losses and administrative claims expenses is less than 70 percent of earned premiums (reduced by policyholder dividends); or
- The Captive directly or indirectly makes, or agreed to make, any portion of its underwriting premiums available to the business owner, the Insured, or persons related to either, as financing proceeds or proceeds from some other transaction that does not produce taxable income to the recipient.
Parties ”participating” in such a transaction include the business owner, the Insured, and the Captive (including any intermediary fronting the Captive), where such party’s tax return reflects a tax consequence or a tax strategy of a transaction of interest as defined in the Notice. Material advisors involved with the promotion, management or implementation of these transactions are likewise subject to the new disclosure rules. Reporting is required for any transaction that is the same as, or substantially similar to, the described transaction. A limited exception to reporting is made available for insurance companies providing employee compensation or benefits that have received a “Prohibited Transaction Exemption” from the Employee Benefits Security Administration.
Disclosure is completed on Form 8886, Reportable Transaction Disclosure Statement, to the IRS Office of Tax Shelter Analysis (OTSA). For transactions involving prior years that are within the scope of reporting, Form 8886 must be filed on or before January 30, 2017. For current year and prospective participation, a properly-completed Form 8886 must be attached with the tax return, and a duplicate copy must be sent to OTSA if the transaction is being disclosed for the first time.
A taxpayer that does not comply with the disclosure rules is subject to a penalty equal to 75 percent of the tax benefits obtained from reporting the transaction on the taxpayer’s return (capped at $50,000 for entities and $10,000 for individuals), where the minimum penalty is $10,000 for entities and $5,000 for individuals. Parties participating in these “micro-captive” transactions must develop an immediate strategy to comply with the January 30, 2017 reporting date that will impact many arrangements. Contact your CBIZ MHM tax professional to make sure that you are in compliance with these new reporting requirements.
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