Microcaptives to Find One Tax Penalty Tougher to Beat (1)

Microcaptive insurance companies and their insureds have been in the IRS’ crosshairs for several years. In 2015, the IRS added Section 831(b) captive insurance companies to its annual dirty dozen list and made microcaptives reportable transactions in 2016.

The Tax Court has sided with the government in microcaptive cases since Avrahami v. Commissioner in 2017, holding that insureds aren’t entitled to deduct premiums paid to captives and in some cases that the premiums are taxable to the captive. In Caylor Land Development, Inc. v. Commissioner, the Tax Court upheld the IRS’ assertion of accuracy-related penalties for the first time in a microcaptive insurance case.

The US Court of Appeals for the 10th Circuit joined in by upholding the Tax Court’s decision in Reserve Mechanical Corp. v. Commissioner. Meanwhile, the IRS recently avoided potential taxpayer victories by dropping its cases in Series Protected Cell 76, A Series of Oxford Ins. Co. TN LLC v. Commissioner and Puglisi v. Commissioner.

The victories have emboldened the IRS to continue to disallow premium deductions taken by insureds, tax captives on their premium income, and to assess penalties—most commonly the 40% non-economic substance penalty and 20% accuracy-related penalty. The IRS also sometimes asserts a 40% penalty for failure to report a reportable transaction when the taxpayer doesn’t file a Form 8886.

Section 6707A Penalty

The 40% Section 6707A penalty is for failing to file a timely or complete Form 8886. Notice 2016-66 made most microcaptive transactions “of interest,” requiring the form. CIC Services, a captive manager, challenged this notice by arguing that the IRS violated the Administrative Procedures Act. The case went to the Supreme Court, which ruled that the Anti-Injunction Act doesn’t prevent CIC Services from challenging the notice.

Upon remand, the district court held that the notice is a legislative rule, and that the IRS violated notice and comment requirements. Thus, the notice was invalid, at least according to the US District Court for the Eastern District of Tennessee. Several other courts also have struck down listed transaction notices involving syndicated conservation easements (Notice 2017-10) and certain trust arrangements involving cash value life insurance policies (Notice 2007-83).

The IRS has started to correct its failures. Similar to what the Treasury Department did with syndicated conservation easement transactions, it issued proposed regulations on April 10 that either would make mircrocaptive transactions listed transactions or transactions of interest. The proposed regulations require taxpayers to file disclosure notices not only for future tax years, but also for all prior years their statutes are still open.

What does this mean for microcaptive companies subject to Notice 2016-66? Many practitioners expected the Tax Court to follow Tennessee by invalidating the notice, but the proposed regulations preempt any such action. Although taxpayers briefly enjoyed the upper hand in fighting Section 6707A penalties, the IRS likely will regain the ability to assert such penalties upon promulgation of the final regulations. Taxpayers who didn’t file disclosure statements under Notice 2016-66 will be able to correct failures.

Economic Substance Penalty

The 40% non-economic substance penalty is more common. Codified under Section 7701(o), a transaction must change the taxpayer’s economic position in a meaningful way, and the taxpayer must have a substantial non-tax purpose for entering into the transaction. Without both prongs, the tax benefits are disallowed. Under Section 6662(b)(6) and (i), the IRS imposes a 40% penalty on such nondisclosed transactions.

While the Tax Court hasn’t considered the economic substance doctrine in any microcaptive case, the IRS has used Section 7701(o) to unwind captive transactions and impose a 40% penalty. However, a recent memorandum states that a timely filed Form 8886 will allow a taxpayer to meet disclosure requirements under Section 6662(i).

If a taxpayer timely filed a complete form, even if the transaction lacks economic substance, a 40% economic substance penalty won’t be imposed because the transaction isn’t considered “nondisclosed.” This memorandum is a valuable tool for taxpayers that timely filed Forms 8886, as it provides “a strong argument” that the economic substance penalty shouldn’t apply. While the IRS may not impose a 40% penalty, it can still use the economic substance doctrine to unwind the transaction.

Accuracy Related Penalties

The IRS likely will assess a 20% accuracy-related penalty under Section 6662(b)(1) or (2). In Avrahami, the Tax Court found reasonable cause even in the presence of a potentially abusive transaction. The taxpayers in that case relied on the advice of their estate planning attorney in setting up the captive. The court reasoned that it was a case of first impression regarding Section 831(b) captives and had “previously declined to impose accuracy-related penalties when there is no clear authority to guide taxpayers.”

Because the taxpayer reasonably relied on this advice, the court found reasonable cause, even though the attorney who provided the advice received a fee from the captive manager. The court also waived penalties in Syzygy v. Commissioner because the taxpayers reasonably relied on the advice of their CPA.

In Caylor, however, the court upheld a 20% penalty. The taxpayer in that case was pitched captive insurance as a tax planning solution and was told by his CPA that the captive seemed “too good to be true.” He couldn’t prove that he relied on the professional advice of a tax adviser to demonstrate reasonable cause.

The triumvirate of Avrahami, Syzygy, and Caylor reiterate the fact-specific arguments taxpayers must make when arguing against 20% penalties, which the IRS undoubtedly will continue to impose. For post-Avrahami tax years, taxpayers will lose the ability to argue a lack of guidance on the microcaptive issue. Further, the IRS can try to parallel a taxpayer’s facts with Caylor, a baseline it didn’t previously have.

The IRS likely will continue asserting both the 40% penalty—or in the alternative, the 20% penalty. Taxpayers are now in a better position to fight the 40% non-economic substance penalty and can correct any disclosure failures tied to the Section 6707A penalty. On the other hand, accuracy-related penalties will be harder for taxpayers to beat.

This article does not necessarily reflect the opinion of Bloomberg Industry Group, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.

Author Information

Meeren Amin is an attorney with Fox Rothschild who focuses his practice on assisting businesses and individuals in finding solutions to complex tax controversies.