For those of you not following the saga of Internal Revenue Code (IRC) Section 831(b), here is a brief primer. Section 831(b) allows for the formation of so-called small captives, also known as micro-captives.
Section 831(b) captives' claim to fame is that earnings from premiums are not subject to federal income taxes; only interest income is taxed. The maximum annual premium is currently $1.2 million, but this increases to $2.2 million on January 1, 2017.
The primary users of these captives have been small-to-middle market, privately owned companies. The 831(b) captive was created in 1986 as part of that year's tax overhaul. They were originally designed to help small agriculturally focused insurers weather the liability crisis of the mid-1980s and compete effectively with their larger brethren.
The tax advantage provided by Section 831(b) did not long escape the notice of estate and tax planners. For almost 20 years, these firms have used these small captives to shield a portion of their clients' earnings from income tax on the premiums. For over 5 years, the Internal Revenue Service (IRS) has been investigating these transactions and has concluded that many of them may constitute illegal tax shelters. In these cases, the captive promoters appear to follow the rules of captive insurance, but, in reality, these efforts only hide the true nature of their tax shelter strategies.
However, there are a variety of perfectly acceptable reasons for a captive or small insurer to elect to be taxed under Section 831(b). This assumes that taxation is not the primary reason for forming the captive and that the transaction creates economic substance for all parties.
The IRS Change
In Notice 2016–66, the IRS made a transaction of interest announcement. A transaction of interest is one that the IRS suspects may be illegal but doesn't have enough information to make the determination. If its suspicions are confirmed through the collection of certain data, the transaction becomes "listed," meaning that it has been determined to be a prohibited transaction.
There are two requirements compelling promoters and taxpayers to divulge the details of the 831(b) transaction—only one of which must be satisfied. First, if the captive's loss ratio is 70 percent or lower, compliance is required. Second, regardless of the loss ratio, if the captive has provided any type of loan or another sort of financial transfer to its parent company or any other company or individual, compliance is required. Moreover, the disclosures must include data from up to 5 years of captive activity.
The 70 percent loss ratio requirement is somewhat high given the fact that commercial insurers' acceptable loss ratios run between 60 and 65 percent depending on the line of insurance. By design, the vast majority of 831(b) tax shelter captives have extremely low loss ratios, as losses reduce the amount of premiums subject to the tax advantage.
The IRS has given taxpayers 3 months to respond to its questions and data requests.
Those of us who have long opposed the use of Section 831(b) captives as a tax shelter welcome this development. It means that the taxpayers are forced to divulge to the IRS every facet of the transaction, including how the promoters first introduced the transaction to their taxpayer clients.
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