In Nov. 2016, Notice 2016-66 was released by the Treasury Department and the Internal Revenue Service (IRS) identifying certain captive insurance company transactions as a “transactions of interest” and outlining these identified “micro-captive transactions” as having the potential for tax avoidance or evasion. Dealerships entering into a captive insurance arrangement that is identified as a transaction of interest as defined below, will now be required to file certain disclosures. In addition, if a taxpayer entered into any such transaction after Nov. 2, 2006, and before Nov. 1, 2016, they may have to retroactively file disclosures with the IRS. Retroactive disclosures are due by May 1, 2017.
Transaction of interest
According to the notice, in this type of transaction, a taxpayer attempts to reduce the taxable income of the taxpayer, related persons, or both, using contracts that the parties treat as insurance contracts and a related company that the parties treat as a captive insurance company. The entity that the parties treat as an insured entity under the contracts claims deductions for premiums for insurance coverage, while the captive insurance company elects, under section 831(b) of the Internal Revenue Code, to be taxed only on investment income and therefore excludes the payments directly or indirectly received under the contracts from its taxable income.
The following transaction is identified as a transaction of interest:
- A, a person, directly or indirectly owns an interest in an entity (or entities) (“Insured”) conducting a trade or business;
- An entity (or entities) directly or indirectly owned by A, Insured, or persons related to A or Insured (“Captive”) enters into a contract (or contracts) (the “Contracts”) with Insured that Captive and Insured treat as insurance, or reinsures risks that Insured has initially insured with an intermediary, Company C;
- Captive makes an election under 831(b) to be taxed only on taxable investment income;
- A, Insured, or one or more persons related (within the meaning of 267(b) or 707(b)) to A or Insured directly or indirectly own at least 20 percent of the voting power or value of the outstanding stock of Captive; and
- One of more of the following apply:
- The amount of liabilities incurred by the Captive for losses and claim administrative expenses during the last five years is less than 70 percent of premiums earned less policy holder dividends paid; or
- During the last five years the captive insurance company made financing available to A, Insured or related parties in a way that did not result in taxable income or gain to the recipient.
A transaction that falls within the definitions above are now identified as transactions of interest and persons participating in these transactions will now be required to disclose the transactions by filing Form 8886 (Reportable Transaction Disclosure Statement). A copy also needs to be filed with the parties’ income tax return. Taxpayers entering into such transactions after Nov. 2, 2006 and before Nov. 1, 2016, must disclose such transactions to the IRS if any tax return that reported the effect of the micro-captive transaction remains open under the statute of limitations. Taxpayers who have participated in a micro-captive transaction during years for which they have already filed tax returns must file an initial disclosure statement with the IRS’s Office of Tax Shelter Analysis (OTSA) in Ogden Utah by May 1, 2017. Transactions that affect the 2016 tax return must be disclosed with the first return due after November 1, 2016. If 2016 is the first year of the transaction, a copy of the initial disclosure must also be sent to OTSA.
A taxpayer has participated in a transaction of interest if the taxpayer's return reflects the tax consequences of the transaction.
Individual A directly or indirectly owns an interest in a dealership. Individual A or persons related to Individual A directly or indirectly own a captive insurance company which enters into insurance contracts with the dealership. Dealership makes premium payments to captive insurance company and deducts payments as expense. Captive insurance company is structured to have no more than $1.2 million in premiums written in a given take year (increasing to $2.2 million in 2017). Captive insurance company makes election under 831(b) to only be taxed on investment income and exclude premiums from taxable income. Individual A, related persons, or the dealership directly or indirectly own at least 20 percent of the voting power or value of the stock of the captive insurance company.
Scenario 1: The amount of liabilities incurred by the captive insurance company for losses and claim administrative expenses during the last five years is less than 70 percent of premiums earned less the policy holder dividends paid. This is considered a reportable transaction and the micro-captive is required to file Form 8886 as well as the participants in this transaction are required to disclose this transaction on their individual income tax return.
Scenario 2: The amount of liabilities incurred by the captive insurance company for losses and claim administrative expenses during the last five years was more than 70 percent of the premiums earned less policy holder dividends paid, but during the last five years the captive insurance company made financing available to A, the dealership or related parties in a way that did not result in taxable income or a gain to the recipient.
The captive insurance company made financing available during the last five years, which is considered a reportable transaction and the participants in this transaction are required to disclose this transaction on their income tax returns.
We anticipate that most dealers that have a captive insurance company that has made the 831(b) election to be taxed as a small insurance company will have some reporting requirements or disclosures on their income tax returns for 2016. Please consult with your captive insurance company administrator to ensure the proper filings are complete and to gather the proper information to disclose on your personal income tax returns if required.
For more information on this topic, or to learn how Baker Tilly tax specialists can help, contact our team.