Many businesses have been caught off guard by a recent Internal Revenue Service (IRS) notice that implicates a popular and commonly-used structure to manage risk. The notice employs a broad net and a short deadline, and significant penalties apply to compliance failures. Unfortunately, some companies received inadequate or overly aggressive tax advice because they relied on promoters that stood to gain financially from the companies’ investment in the captive structure.
If a company owns a captive insurance company that has made an election pursuant to Section 831(b) of the Internal Revenue Code (so-called "micro-captive") at any time since November 2, 2006, there is a very high likelihood that the company is subject to the disclosure and reporting obligations described in the notice. Disclosures for tax years prior to 2016 for which the structure was in place must be filed with the IRS before January 30, 2017.
Although the notice’s end-of-year timing and comprehensive coverage of the industry purportedly strikes some as heavy-handed, the IRS has focused on micro-captives as potential vehicles for abuse for over a decade. In 2015, the IRS even took the step of adding micro-captives to the "Dirty Dozen" list of abusive tax structures. In the Dirty Dozen announcement, the IRS categorized micro-captives as "abusive tax shelters," stating that certain aggressive promoters are selling captive structures to clients, emphasizing the tax benefits of the structure while failing to properly form the insurance company and implement the insurance program that was intended, while collecting large annual captive management fees from the client. The new notice, Notice 2016-66, was issued by the Treasury Department and the IRS on November 1, 2016 in order to formally designate the micro-captive transaction a "transaction of interest" -- a category of "reportable transactions" -- effective for micro-captive transactions entered into on or after November 2, 2006.
It is important to keep in mind that Notice 2016-66 represents the ramping up of a long-standing and well-developed IRS enforcement initiative that will be difficult, if not impossible, for companies with Section 831(b) captive structures to avoid. The relevant disclosure document (Form 8886) is akin to a comprehensive, multi-pronged information document request received by a taxpayer in a high stakes IRS examination, and it should be treated as such. Just as is the case with a contested audit, the strategic decisions made as to the content and presentation of the responsive information on Form 8886 must be carefully considered and should be reviewed by a competent tax professional. The Form 8886 disclosure will define the company’s case and thus influence the ultimate resolution of the IRS inquiry. Because the promoters and advisors of these structures have a potential conflict of interest, companies should seek independent tax advice in completing Form 8886 to put their best case forward and thereby mitigate their ultimate exposure.