Experts Question Proposed IRS Micro-Captive Regulations at WRCIC
June 14, 2023
Proposed regulations put forward by the US Department of Treasury and the Internal Revenue Service (IRS) identifying certain micro-captive arrangements as "transactions of interest" or "listed transactions" were the subject of considerable discussion Tuesday at the Western Region Captive Insurance Conference (WRCIC).
The proposed regulations were a key topic of conversation across multiple conference sessions during the day, with speakers questioning the regulations' focus on micro-captives' loss ratios or even whether the regulations were a permissible step for the IRS under the federal McCarran-Ferguson Act.
The proposed regulations, IR2023-74, come after the IRS previously attempted to take a similar step several years ago through its Notice 2016-66. But recent court decisions in the Sixth Circuit and the US Tax Court found that the IRS lacks authority to identify listed transactions and transactions of interest by notices such as Notice 2016-66, and must instead follow notice and public comment procedures applying to regulations in order to identify such transactions.
In a March 2022 ruling in CIC Services, LLC v. Internal Revenue Service, Department of Treasury, and the United States of America, Judge Travis R. McDonough of the United States District Court Eastern District of Tennessee ruled that, in enacting its Notice 2016-66 micro-captive reporting requirement, the IRS violated the federal Administrative Procedure Act (APA). "Notice 2016-66 is a legislative rule that is invalid because the IRS failed to observe notice-and-comment procedures required by the APA," the ruling said.
"It's not surprising that the IRS lost this," Steven T. Miller, partner at ZMFF&J Law, said during a WRCIC session titled "Captive Insurance Taxation—The Latest." "They never thought they were subject to the APA, by the way." Mr. Miller spent 25 years with the IRS, including serving as acting commissioner.
To comply with the court's ruling, the IRS released the proposed regulations, then took public comments on them until this June 12. A public hearing on the regulations is set for July 19.
Despite seeking comments and holding a hearing, the IRS's attitude is "We might have to go out for notice and comment, but this hasn't changed our mind at all," Mr. Miller said.
So-called micro-captives are small captive insurance companies that elect to be taxed under section 831(b) of the Internal Revenue Code, which allows small insurance companies to be taxed only on their investment income. They have been the target of IRS scrutiny in recent years.
In an April statement announcing the proposed regulations, the IRS said that listed transactions are abusive tax transactions that must be reported to the IRS, while transactions of interest are tax transactions that have the potential for tax avoidance or evasion that must also be reported to the IRS.
While Notice 2016-66 established one metric for declaring a micro-captive as a listed transaction as having an average loss ratio of less than 70 percent the previous 5 years, the new proposed regulations lower that threshold to 65 percent.
"Think of the old transaction of interest notice on steroids and you'll have the proposed regulation," Mr. Miller said. "It's an expansion."
A fellow panelist in Mr. Miller's WRCIC session, Charles J. (Chaz) Lavelle, partner at Dentons Bingham Greenebaum LLP, took issue with the IRS's emphasis on loss ratios in determining the legitimacy of an insurance company.
"Losses are evidence of risk," Mr. Lavelle said. "Lack of losses is not evidence of lack of risk." Loss levels can be shaped by luck and loss-control efforts, he noted. The real question should be whether the captive set its premiums correctly.
"So, I think premiums is the answer," Mr. Lavelle said.
In another WRCIC session Tuesday titled "Recent Captive Tax Development: Loss Ratios and McCarran-Ferguson," F. Hale Stewart, risk management attorney and analyst at ZMFF&J Law, said the IRS's focus on loss ratios in the proposed regulations is "confounding to a lot of people in the insurance world."
"The obsession with loss ratios tells me that they believe that insurers should make a little bit of a profit, but you can't make too much of a profit and you can't store up premium for a rainy day," Mr. Stewart said.
Another panelist on that session, Robert J. Walling III, principal and consulting actuary at Pinnacle Actuarial Resources, noted that insurance rates have to be set prospectively. "So, the bottom-line answer on loss ratios is it doesn't matter," Mr. Walling said.
Mr. Walling said that because few captive insurance companies provide loss ratio data to the National Association of Insurance Commissioners (NAIC), it's necessary to look for proxy data in determining the relevance of the 65 percent loss ratio figure in assessing the legitimacy of an insurance company.
One possible proxy is the NAIC Report on Profitability. Looking at 9 years of data from that source from 2012 to 2020, more than half of 444 possible state and coverage line combinations fell below the 65 percent loss ratio standard on average, Mr. Walling said. Using that data, 12 states had 9-year loss and loss adjustment expense ratios below 65 percent for all lines combined, he said.
"There are very, very large insurance segments, insurance companies, insurance lines of business where the 65 percent benchmark just doesn't make sense," Mr. Walling said.
A third member of that panel, Matthew Queen who serves as chief risk officer for Goldner Capital Management and owner of The Queen Firm, LLC, a law firm providing captive insurance consulting services, suggested that the IRS's actions with regard to micro-captives run afoul of the McCarran-Ferguson Act, which gives states the authority to regulate the business of insurance in the United States.
"There is an argument here that states' rights are being infringed on by the IRS," Mr. Queen said. "When the IRS comes in and starts talking about 65 percent loss ratios, the alarm bells should be ringing because the IRS is trying to regulate the business of insurance."
Mr. Queen noted that captive insurance companies are licensed and regulated by states, with that licensure and regulation constituting "the business of insurance."
"Captives are creatures of state law. All captives have a license from the state department of insurance," he said. "The state regulators aren't just willy-nilly handing out licenses of insurance."
By leveraging its power to define "insurance" for tax purposes, the IRS is effectively acting as a de facto federal department of insurance, Mr. Queen said.
"Federalism, the basic tenet of states' rights, is at issue here," Mr. Queen said. He suggested that going forward captives should challenge the IRS on these issues in federal courts rather than the US Tax Court.
"You want a judge who understands what federalism is," Mr. Queen said.
June 14, 2023