Micro-Captive Proposed Regulations: Listed Transaction vs. Transaction of Interest

Micro-Captive Proposed Regulations: Listed Transaction vs. Transaction of Interest

May 15, 2023

On April 11, 2023 the IRS published proposed regulations designating some micro-captive insurance transactions as listed transactions and others as transactions of interest.

The preceding rule to the proposed regulations was Notice 2016-66, in which the IRS identified certain micro-captive insurance transactions as transactions of interest. Due to recent court decisions the validity of Notice 2016-66 has been put into question, and as a result the IRS has issued these new proposed regulations. The IRS has indicated that they plan to finalize the proposed regulations in 2023, after receiving comments from the public (comments due June 12) and holding a public hearing (scheduled on July 19).

The proposed regulations are similar in nature to the guidance in Notice 2016-66. One important change is the separating of micro-captive insurance transactions into two categories. First, those that are considered listed transactions and second, those that are considered transactions of interest. Previously, Notice 2016-66 treated all micro-captive insurance transactions as transactions of interest.

General Background: Listed Transaction vs. Transaction of Interest

The IRS has defined listed transactions and transactions of interest as follows:

• Listed Transaction – “A transaction that is the same as or substantially similar to one of the types of transactions that the Internal Revenue Service (IRS) has determined to be a tax avoidance transaction.”
• Transaction of Interest – “Transactions that the IRS and the Treasury Department believe to have the potential for tax avoidance or evasion, but lack sufficient information to determine whether the transaction should be identified specifically as a tax avoidance transaction.”

The definitions above can be interpreted as the IRS viewing a listed transaction as likely being used for tax avoidance, while viewing a transaction of interest as possibly being used for tax avoidance.

It is important to note that whether a transaction is a listed transaction or a transaction of interest, both are considered “reportable transactions” to the IRS and the same disclosure form (Form 8886) needs to be filed with the IRS for each year the transaction is present. For micro-captive transactions under the proposed regulations, for both transactions of interest and listed transactions, the information required to be reported is very similar to the previous guidance under Notice 2016-66.

Micro-Captive Insurance Transactions: Listed Transaction vs. Transaction of Interest

20% Ownership Requirement

The first element that must be present to be considered a reportable transaction is that the insured entity, its owners, or other related persons own at least 20% of the voting power or outstanding stock of the micro-captive. The proposed regulations extend the 20% ownership requirement to also include ownership of micro-captive assets by related persons, but otherwise this element remains unchanged from Notice 2016-66.

Elements of a Micro-captive Insurance – Listed Transaction

If the 20% ownership requirement is met, the next step would be to determine whether the micro-captive is participating in a listed transaction, a transaction of interest, or neither. Under the proposed regulations a micro-captive insurance company would be considered as participating in a listed transaction if one of the following elements is present:

• If, in the previous five years (or over the life of the micro-captive if less than five years), the micro-captive has provided financing to related parties in a transaction that did not result in taxable income to the recipient. The most common example of this would be a loan made by the micro-captive to related parties, which is a non-taxable transaction for the recipient, or
• If the micro-captive has a loss ratio of less than 65% over the most recent 10-year period. Note that micro-captives that have been in existence less than 10 years cannot meet this requirement.  

Elements of a Micro-captive Insurance – Transaction of Interest

If neither of the above elements is present, the micro-captive will be considered as participating in a transaction of interest if the micro-captive has a loss ratio of less than 65% over the most recent 5-year period (or over the life of the micro-captive if less than five years).

Summary

The proposed regulations show that the IRS will continue to scrutinize micro-captive insurance transactions, despite the results of recent court cases decided in favor of taxpayers. By labeling some micro-captive transactions as listed transactions, I believe the IRS is trying to help identify taxpayers that are using a micro-captive transaction for tax avoidance.

With that said, this doesn’t mean that all micro-captive insurance companies that meet the requirements of a listed transaction are abusing the system, but the language in the proposed regulations indicates that the IRS believes participants are guilty until proven innocent: “The Treasury Department and the IRS have determined that [micro-captive transactions that are considered listed transactions] are a tax avoidance transaction.”

My expectation is that once the proposed regulations are finalized, the IRS will use the new disclosure requirements to focus their audit efforts on those transactions that are considered listed transactions. As such, taxpayers that are participating in micro-captive listed transactions, as defined in the proposed regulations, should consider following the IRS’ recent invitations to “consider filing amended returns to bring themselves back into compliance if warranted.”