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The IRS, on November 1, 2016, issued Notice 2016-66 identifying a specified captive insurance company design qualified under Internal Revenue Code section 831(b) as a “transaction of interest.” As such those captive insurance companies have a disclosure obligation that, if not done or not done properly, can potentially lead to significant penalties. Those taxpayers owning and using any 831(b) captive need to be aware of this obligation to determine if they might be covered by it and, if so, what they need to do now and going forward.
When the IRS views a transaction to be yielding tax benefits that abuse the law to achieve ends that the IRS views as inappropriate it has a process of classifying that transaction as an abusive tax shelter, referred to as a “reportable transaction” and sometimes a “listed transaction.” Sometimes, before it is capable of making the determination that it is or is not abusive the IRS identifies a transaction (and “substantially similar” transactions) as a “transaction of interest” as it gathers sufficient data. At the end of this study period it might decide that the transaction is not abusive in which case nothing more happens. Or it might conclude it is in fact abusive and will therefore subject taxpayers participating in that transaction to various reporting rules and potential penalties.
Generally, captives are insurance companies that are formed to insure related businesses, and the insureds pay premiums for that coverage. A subset of captives is governed by section 831(b) which allows certain small captives (what the IRS is calling “micro captives”) to elect to exclude from income up to $1.2 million of premiums received ($2.2 million beginning in 2017) and pay tax only on their investment income. Also, the premiums are deducted by the insured as a business expense.
It is important to note that no captive insurance company has yet been classified as an abusive tax shelter in this Notice. The captive arrangement identified in the Notice is only a transaction of interest. Also not all captives are transactions of interest, only 831(b) captives. And, while technically not all 831(b) captives are transactions of interest, as a practical matter it is likely that almost all fit within the specified, albeit broad, parameters to qualify as one. So while this might “only” be a transaction of interest, even if the transaction is ultimately determined not to be abusive there is still the disclosure filing requirement that accompanies classification as a transaction of interest and the associated failure to file penalties.
WHAT CAPTIVES ARE COVERED?
The criteria that are considered to be the hallmark of the type of captive arrangement that has piqued their interest, stated broadly, are:
Parsing through all this, the captive insurance company that is now considered a transaction of interest is one owned substantially by a limited group that has either paid out claims less than 70% of premiums as adjusted or round trips the premiums received or its other capital. As a practical matter this would likely bring in all 831(b) captives.
WHAT MUST BE DONE IF A CAPTIVE IS A TRANSACTION OF INTEREST AND WHEN?
If a captive insurance company is structured in a manner that classifies it as a transaction of interest then several parties related to that structure have a reporting requirement. While any transaction that has a design that is not supported by the law would have potential tax deficiencies and penalties separate and apart from this classification as a transaction of interest, simply having and fulfilling this new reporting requirement does not mean or even imply that there is any additional tax required or that there is any penalty at this time for underpaying tax.
However the reporting obligation itself is fairly onerous and applies to the captive itself, its owners, the insured company and, if there is one, the fronting company. All of these may be considered participants. Each participant (potentially three or more for each captive) must file a Form 8886:
It appears from the Notice that in determining the applicable prior years we basically have to perform a decision flow chart:
The Form 8886 for all participants must contain a description of the transaction in sufficient detail for the IRS to be able to understand the tax structure, including when and how the taxpayer became aware of the transaction, and the identity of all parties involved. In addition, the Form 8886 for the captive must also include detailed information including, among others, the actuarial basis for the premium, a description of the risks covered, its claims paid history and a description of its investments.
For each year that an entity fails to file a complete Form 8886 or files it late there can be a penalty equal to 75% of the tax reduction, but not less than $10,000 nor more than $50,000. For each year that a natural person fails to file a complete Form 8886 or files it late there can be a penalty equal to 75% of the tax reduction, but not less than $5,000 nor more than $10,000
For those tempted to ignore this filing requirement on the assumption that they might not be found, note that any captive manager or other adviser who advised participation in the captive is also required to submit a detailed list of its clients.
Finally, taxpayers need to check if their State has a similar filing requirement.
WHAT DOES ALL THIS MEAN?
Identification as a transaction of interest does not necessarily mean that the transaction is a tax abuse. While the ultimate determination of the IRS cannot be predicted it is possible, based on other information in the Notice, they might be looking for some combination of additional factors, including implausible risks, mismatch of coverage to actual risks, overpriced coverage and failure to interact in the manner expected of an insurance company.
SHOULD I STAY OR SHOULD I GO?
There is nothing specifically in this Notice that should force any captive insurance company into immediate dissolution. Doing so will not remove the Form 8886 filing obligation for 2016 and prior years, which is already carved in stone. Staying or leaving in the short run, to put it colloquially, should not increase or reduce one’s risks. Yet there may be reasons to keep the structure intact or to terminate it that differ on a case by case basis.
A well informed captive insurance company and related parties will seek appropriate legal advice as to filing the Form 8886, the likelihood that its structure should be respected for tax purposes and, if not, the best actions going forward. The Law Office of David Neufeld advises on reportable transaction reporting requirements and represents captives and its owners on tax compliance issues and controversies. If you would like independent advice concerning how to comply with the reporting requirements required by this IRS notice, please contact David Neufeld at 609-919-0919 or David@DavidNeufeldLaw.com.
David Neufeld, an estate planning and tax attorney in Princeton, NJ, explains the various practical uses of trusts, including how trusts can be used for asset protection, federal and state estate tax mitigation and ensuring that the right people receive assets, in an interview reported in UBS' online Insights Magazine in an article titled "Use a Trust for the Things You Care About."
I'll be speaking at the "Private Placement Life Insurance and Variable Annuities Forum 2016" in Boston May 17 & 18. If you're interested you can use my 15% speaker discount code FKN2476EMSPKLI or click here: http://www.ppliconference.com/FKN2476EMSPKLI
Let me know that you're going.
I was again honored with an invitation to discuss tax law matters on Kurtis Baker's radio program, this time to discuss the issues surrounding the ownership of accounts and assets outside the US. Kurt is the principal at Certified Financial Wealth and Investments in Princeton NJ.
Listen here: http://rockwebsystems.com/1077Thebronc/MYF_092015.mp3.
David Neufeld (R) with Kurtis Baker
On September 18, 2015 I had the honor of speaking about the intricacies of captive insurance companies on a panel in Chicago at the annual Joint meeting of the American Bar Association's Tax Section and RPTE Section. The panel included former IRS Commissioner Steven Miller, Jay Adkisson and panel chair David Slenn, all deeply involved with the cutting edge issues surrounding captives. The audience came away with new insights as this quickly evolving field develops.
(L-R) Dave Slenn, David Neufeld, Steven Miller, Jay Adkisson
My latest article from the June 20, 2015 issue of Tax Notes Magazine--Webber: Are Insurance Dedicated Funds Superfluous? is now available on my website. The Webber case favorably cites an earlier article I published in Tax Notes in 2003, also on my website, and hints in dicta that the Court might find that section 817(h) has superseded the IRS' requirements for insurance dedicated funds. But let's not get too excited; it is only dicta and that issue was not before this court. Nevertheless this is the most direct and most authoritative indication that my 2003 thesis seems to have been on the right track.
Citing to an article I published in 2003,* Judge Lauber of the US Tax Court in Webber v. Commissioner, 144 T.C. No. 17 (June 30, 2015) found that the taxpayer, the owner through a grantor trust of private placement life insurance policies, was taxable on all income earned by the policies because he exercised too much control over the investments owned within the policies.
While an important case given the rarity of guidance in this area, it is also a fairly obvious result. There are two types of investor control:
(1) one is the type of direct control over the investment assets and decisions exercised by Mr. Webber,
(2) the other derives from an interpretation of more oblique factors (such as whether the underlying investment funds are publicly available) that may or may not indicate investor control and, depending on who you believe, may be largely supplanted by section 817(h).
In finding that Mr. Webber made the investment decisions that should have been reserved to the investment manager employed by the insurance company--the first test recited above--the Court held that the taxpayer was clearly in violation of the investor control doctrine. Judge Lauber called this “the bedrock ‘investor control’ principles enunciated in Revenue Ruling 77-85.” No surprise there; the fact that the case was litigated is more surprising.
What was not at issue in this case and was not addressed, except in footnote 19, where my article was cited, was the second type of investor control and the type I have written about repeatedly. While neither adopting nor rejecting the rationale in the article, Judge Lauber’s dicta lends support to my conclusion by stating that “the section 817(h) diversification standards may supersede some aspects of the pre-1984 revenue rulings that discuss publicly available investments held by segregated asset accounts.”
Whether the IRS' rulings delineating the second type of investor control has survived enactment of section 817(h) still awaits a case addressing that issue.
*David S. Neufeld, "The 'Keyport Ruling' and the Investor Control Rule: Might Makes Right?," 98 Tax Notes 403, 405 (2003) available in the Articles page
I was honored to be asked by Kurt Baker of Certified Wealth Management & Investment LLC (www.cwmi.us) here in Princeton, NJ to appear on his weekly radio program broadcast/webcast/podcast on 107.7 FM "The Bronc"...Master Your Finances. For the entire hour we spoke about the issues that folks have when they have homes in multiple states and want to be sure that the state with the lowest tax cost is considered their tax residence. The recording of the interview is here.
On May 29, 2015, the New York State Department of Taxation and Finance issued an Advisory Opinion that a membership interest in a single-member LLC (SMLLC) which is disregarded for income tax purposes is not “intangible property” for New York State estate tax purposes. Thus the New York real estate (in this case a condominium) owned by the SMLLC will be included in a of New York State estate of the non-resident decedent who was the LLC member.
Where a SMLLC is disregarded for Federal income tax purposes, it is treated as owned by the individual owner. However, where a SMLLC makes an election to be treated as a corporation, rather than being treated as a disregarded entity, such ownership interest would then be considered intangible property for New York State estate tax purposes and excluded from the estate of a non-resident. (TSB-A-15(1)M)
As the author of Nevis’ limited liability company law in 1995 it is gratifying that it has long been highly regarded as the standard among LLC laws, blazing new trails that other jurisdictions, even in the US, took years to follow. Even as the years have passed and other jurisdictions enacted similar laws, the Nevis LLC continued at the forefront. But with external legal developments, no law can go without a face lift to avoid looking old and irrelevant.
On May 27, 2015 the Nevis Assembly enacted the Nevis Limited Liability Company (Amendment) Ordinance, 2015, based on a draft I provided at the request of the Nevis government, with the help of Jan Dash, a lawyer in Nevis with Liburd & Dash. Along with several important as well as housekeeping provisions, principal among the provisions as enacted are updated judgment creditor, including charging order, provisions and a new fraudulent transfer section. It is effective July 1, 2015. An unofficial version appears at the top of this blog. This was one of three ordinances passed that day; the others are amendments to Nevis international corporation law and to its international trust law.
Section 43 contains the provisions addressing the rights of a judgment creditor. This is commonly referred to in the US as a charging order provision, although it goes further than simply charging orders. In 1995 this was a state-of-the-art provision limiting the ability of certain creditors of limited liability company members from obtaining rights to property of the limited liability company. The NLLCO is one of the few (and certainly one of the first) to provide that this charging order provision is the sole remedy available to the creditor. Over the years issues have developed concerning how this provision works in the context of foreclosure and other equitable remedies and single member LLCs, among others.
The section is completely revised; the changes are as follows:
New Section 43A deals with fraudulent conveyance issues as they relate to transfers to an LLC, i.e. the ability of creditors of a member to recover a claim against such member from property contributed to the company; this is derived from §24 of Nevis’ international trust law (the Nevis International Exempt Trust Ordinance). This essentially provides that the creditor must prove beyond a reasonable doubt that such transfer was intended to defraud the creditor and that the member was thereby rendered insolvent, considering all of his assets including the full fair market value of the LLC interest. The claim must be made within a two year window.
What is not in the amended law is as important as what is included. The draft amendments included provisions that would have permitted Nevis LLCs to have series, making what is already a primary offshore entity law even more formidable. In addition, the Nevis government has draft amendments to its insurance laws permitting cell captives. These series provisions were excluded as were the cell captive amendments to Nevis’ insurance laws at the same time as other jurisdictions have seen value in enacting such provisions.