Tax alert: Avoid penalties. Report participation in micro-captive transaction by May 1

The IRS recently designated certain captive insurance arrangements, defined as ‘micro-captive transactions, as a transaction of interest in Notice 2016-66. This designation means that the IRS believes that these transactions have the potential for abuse. All taxpayers participating in a microcaptive transaction are required to provide this information by May 1, 2017, or could face penalties of up to $50,000 per year. This includes the insurance company, the insured, and any other taxpayer whose tax return reflects the tax consequences of a micro-captive transaction.

What is a micro-captive transaction?

A micro-captive transaction includes an arrangement where an organization enters into an insurance contract with an insurance company that meets each of the following requirements:

1. The organization, an owner of the organization, or a related party of either directly or indirectly owns at least 20% of the insurance company.
   As a result of the 20% related ownership test, a widely-held insurance company is less likely to be involved in a micro-captive transaction.
2. The insurance company has made an 831(b) election only to be taxed on its investment income.
   This election only applies to insurance companies that receive premiums of $1.2 million or less ($2.2 million for 2017 or later years).
3. Over a five-year period ending with the tax year, either (1) the insurance losses and claims administration expenses incurred by the insurance company are less than 70% of the premiums earned or (2) the insurance company has directly or indirectly entered into guarantees, loans or other transfers of capital with the insured, an owner of the organization, or any other related party.

Filing requirements & penalties

Any taxpayer that has participated in a micro-captive transaction must file Form 8886 to report that participation by May 1, 2017 (this due date was originally January 30, 2017, but was subsequently extended to May 1 by Notice 2017-08.) This includes the insurance company, the organization insured by the insurance company, and any other taxpayer whose tax return reflects the tax consequences of a micro-captive transaction. Form 8886 is required to be filed for each year in which a taxpayer participated in a micro-captive transaction to the extent that the statute of limitations was not closed for that tax year as of November 1, 2016.

These requirements may lead to multiple taxpayers having a Form 8886 filing requirement with respect to the same micro-captive transaction. Each of those taxpayers may also have a separate filing requirement for multiple years if the micro-captive transaction has met requirements above with respect to more than one tax year. Reporting may still be required even if a micro-captive transaction existed in a previous tax year but no longer exists today.

The failure to file Form 8886 by the deadline will result in a penalty equal to 75% of the tax benefit generated by the micro-captive transaction, up to $50,000 ($10,000 in the case of an individual taxpayer). The penalty for a failure to report applies even if the micro-captive transaction is ultimately not considered to be abusive.

Many state and local jurisdictions have similar filing requirements and associated penalties.

Action steps

The reporting deadline of May 1, 2017, is a very short deadline, and there are substantial penalties for the failure to timely report. Therefore, it is recommended that all taxpayers that have ever participated in a captive insurance arrangement review that arrangement to determine if it meets the definition of a micro-captive transaction for any year open under the applicable statute of limitations.