Analyzing Proposed Regulations Updating IRS Notice 2016-66
On April 10, 2023, the Internal Revenue Service (IRS) issued proposed regulations addressing micro-captive insurance transactions that must be reported as either a listed transaction or other transaction of interest. The IRS previously issued guidance on this topic (Notice 2016-66), which a Tennessee federal district court recently invalidated for failing to adhere to the notice-and-comment requirements of the Administrative Procedure Act. See CIC Services, LLC v. Internal Revenue Service, 2022 WL 985619 (E.D. Tenn. March 21, 2022). The new proposed regulations attempt to cure the procedural defects found by the courts, and provide some substantive modifications.
The prior guidance identified reportable micro-captive transactions as those involving:
- an 831(b) captive insurance company;
- at least 20 percent of the vote or value of which is owned by the insured or related entities; and
- the micro-captive has made certain financing available or conveyances to related entities that did not result in taxable income or gain to the recipient (i.e., loans, guarantees, or transfer of the micro-captive's capital) (the "financing factor"); or
- the amount of liabilities incurred by the micro-captive with respect to loss payments or claims expenses is less than 70 percent of the premiums earned, less policyholder dividends, as determined over a 5-year computation period.
In addition to addressing the procedural notice-and-comment issues, the new proposed regulations make some substantive changes to those requirements based on comments received and the IRS's experience in litigating micro-captive cases. These include changes to the ownership requirement (addressing indirect ownership through derivatives and other indirect interests in the micro-captive's assets); changes to the implications of the financing factor (raising the reporting level of a transaction to listed transaction, rather than merely a transaction of interest, indicating the IRS's growing suspicion of this factor); and changes to the loss ratio factor (lowering the loss ratio threshold to 65 percent and extending the computation period from 5 to 10 years for the transaction to qualify as a listed transaction and to 9 or fewer years for the transaction to qualify as a transaction of interest).
Finally, the proposed regulations provide exceptions from reporting obligations for certain captives that have prohibited transaction exemptions and for certain consumer coverage (for example, warranties at the point of sale) reinsurance arrangements that would otherwise meet the requirements set forth in the proposed regulations.
The IRS invited written comments on the proposed regulations, to be received by June 12.
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