What 831(b) Captive Owners Need to Know About IRS Notice 2016-66

IRS Notice 2016-66On Tuesday, November 1 the US Internal Revenue Service (IRS) and Treasury Department issued a November surprise to the Captive Insurance industry in the form of Notice 2016-66.

What is Notice 2016-66?

Notice 2016-66 relates to captive insurance companies set up under U.S. code 831(b), also known as micro-captives. Stories of 831(b) captive abuse have been widely reported in recent times and have caught the eye of a number of U.S. agencies and lawmakers. There is a general understanding that there is an element of the micro-captive industry that improperly uses the tax exemption to shield taxable income. The IRS and Department of Treasury acknowledge this practice of tax avoidance and evasion, but as they point out in the early sections of 2016-66, there isn’t enough information currently gathered to properly target the offenders.

To combat this abuse, and to begin to gain a better understanding of the overall scope and use of 831(b)s, the two government agencies have teamed up on 2016-66. This new notice now defines certain 831(b) transactions as “transactions of interest” and now makes them subject to additional reporting of the transaction and imposes penalties for non-compliance.

Who does Notice 2016-66 Impact?

It is important here to understand exactly what the IRS is now terming a transaction of interest. Here is their definition (from IRS website):

  • A, a person, directly or indirectly owns an interest in an entity (or entities) (“Insured”) conducting a trade or business;
  • An entity (or entities) directly or indirectly owned by A, Insured, or persons related to A or Insured (“Captive”) enters into a contract (or contracts) (the “Contracts”) with Insured that Captive and Insured treat as insurance, or reinsures risks that Insured has initially insured with an intermediary, Company C;
  • Captive makes an election under § 831(b) to be taxed only on taxable investment income;
  • A, Insured, or one or more persons related (within the meaning of § 267(b) or 707(b)) to A or Insured directly or indirectly own at least 20 percent of the voting power or value of the outstanding stock of Captive; and
  • One or both of the following apply:
    • the amount of the liabilities incurred by Captive for insured losses and claim administration expenses during the Computation Period (defined in section 2.02 of this notice) is less than 70 percent of the following:
      • premiums earned by Captive during the Computation Period, less
      • policyholder dividends paid by Captive during the Computation Period; or
    • Captive has at any time during the Computation Period directly or indirectly made available as financing or otherwise conveyed or agreed to make available or convey to A, Insured, or a person related (within the meaning of § 267(b) or 707(b)) to A 10 or Insured (collectively, the “Recipient”) in a transaction that did not result in taxable income or gain to Recipient, any portion of the payments under the Contract, such as through a guarantee, a loan, or other transfer of Captive’s capital.

Benefits Exemption:

It should be noted here that any captive arrangement that has secured a Prohibited Transaction Exemption (PTE) from the US Department of Labor (DOL) to provide insurance for employee compensation or benefits covered by ERISA is not considered a Transaction of Interest under these new rules. This may have broad and deep implications on the employee benefit captive industry.

What are the Reporting Requirements?

Reporting of a transaction of interest must be done using Form 8886, which is the Reportable Transaction Disclosure Statement. The Form 8886 filing must describe the transaction in question enough so that the IRS understands how the transaction is structured and who is involved in it. There are additional Form 8886 filing requirements of the taxpayer and captive. These are described in detail here.

What are the Penalties?

Parties that do not comply with this new rule are subject to penalties under U.S. Code 6707A which states:

Subject to the maximum and minimum limits, the amount of the penalty is “75 percent of the decrease in tax shown on the return” as a result of the reportable transaction (or which would have resulted from such transaction if such transaction were respected for federal tax purposes).

  1. The maximum penalty in the case of a listed transaction is $100,000 for a natural person and $200,000 for all other taxpayers. In the case of a non-listed reportable transaction, the maximum penalty is $10,000 for a natural person and $50,000 for all other taxpayers.
  2. The minimum penalty for each reportable transaction (listed or non-listed) is $5,000 for a natural person and $10,000 for all other taxpayers.

It is pointed out in Notice 2016-66 that these rules may be revisited and transactions of interest may be redefined once the IRS and Treasury Department have a better grasp on the situation and better understand the abuse they are looking to eliminate. Further notices from the agencies will likely address this.

So, you own an 831(b) captive; what should you do next???

If you own an 831(b) micro-captive and are unsure of you need to fill out a Form 8886, contact our award-winning team of captive consultants, accountants and attorneys for an unbiased, independent review of your situation.

Alternatively, if you have been looking to write ERISA-covered employee benefits or compensation insurance into a micro-captive, now may be a great time to move forward. There are so many advantages to underwriting employee benefits and this ruling gives us yet another. Spring is the industry leader in employee benefit captive funding solutions and can help you evaluate your current situation and subsequently develop your plan and secure DOL approval. Contact us today!

Image credit: Isaac Bowen via flickr

Regulatory Changes That Have Led to Increased Employee Benefit Captive Funding

Fifteen years ago, captives were not commonly used for financing employee benefits, as regulatory obstacles and reinsurance restrictions limited eligibility to only the largest of captives.

The DOL must approve the placement of ERISA benefits into pure-parent captives. Many well-known organizations have obtained funding approval, including ADM, Alcon Labs, Alcoa, AGL Resources, Astra Zeneca, Banner Health, International Paper, Memorial Sloan-Kettering Cancer Center, Sun Microsystems, and United Technologies.

Many more companies have used captives to fund other non-ERISA employee benefits that do not require DOL approval. Moreover, employer groups and associations are establishing captives to fund employee benefits, thus offering an alternative to the commercial insurance markets and providing an incentive for membership growth.

For companies with property & casualty captives, certain employee benefits may be “unrelated business,” i.e., insurance business unrelated to the captive’s parent. Adding unrelated business to a single-parent captive can improve the captive’s overall financial efficiency; satisfy the need for third party business allowing the parent to deduct its captive premiums from its U.S. federal income taxes; and create additional cost savings.

Regulatory changes have led to increased employee benefit captive funding. Some of these changes include the following:

  • Internal Revenue Service clarifies risk shifting/distribution and unrelated business requirements

In 1993, the IRS ruled[1] that certain employee benefits insurance written in a pure captive is unrelated business (to the captive’s parent) since it benefits the employee and not the employer.  In 2002, the IRS issued three revenue rulings clarifying the qualification of captives as insurance companies for federal income tax purposes, including discussions of third party business, brother-sister arrangements and group captives.[2]

  • The DOL review process provides a roadmap to funding

If the proposed transaction is subject to ERISA, the DOL has a streamlined process for approval.

  • GASB 45 and FASB 158 requirements raise awareness of post-retirement liabilities

Accounting rules such as GASB 45 and ASC 715 (formerly FAS 87/106 and amended by FAS 158) require that organizations account for retiree medical and pension obligations.  These requirements encourage employers to not only account for the liabilities, but also to seek efficient funding methodologies. In addition, GASB statements 74 and 75 are increasing the required disclosures for public retiree medical obligations.

  • Court rulings clarify the parameters for funding retiree medical programs

In Wells Fargo & Co. v. Commissioner 224 F.3d 874 (8th Cir. 2000), the tax court clarified the amount that can be set aside to fund retiree medical benefits, expanding the potential funding allowed to employers.

  • Revenue Ruling 2014-15 clarifies funding opportunities for retiree medical programs

In 2014, the IRS ruled in Revenue Ruling 2014-15 that Non-cancellable Accident and Health Insurance policies will receive life insurance tax treatment as long as the following facts and circumstances are met:

-The Company maintains a VEBA Trust that satisfies the requirements of 501(c)(9)

-The Company purchases a Non-cancellable Accident and Health policy from an insurance company and reinsures the policy through the captive

-Both the Company and the VEBA retain the right to cancel the retiree health coverage at any time

As a result, insuring non-collectively bargained retiree medical benefits through a captive allows for tax-free growth of reserves without the need for a Private Letter Ruling.

Want to Learn More?

Download our Risk Manager’s Guide to Employee Benefit Captives to find out all you need to know about this increasingly popular funding option.

 

[1] IRS Revenue Ruling 92-93

[2] IRS Revenue Rulings 2002-89, 2002-90 and 2002-91

Cell Captives: The Right Fit for Many Small and Mid-Sized Businesses

Cell Captive StructureWhat is a Cell Captive?

A protected cell company (PCC) is a legal entity, set up by a sponsor, which is divided up into individually protected cells that are rented out by the sponsor to companies or groups who want to use a captive cell to fund various risks. The sponsor establishes the core of a PCC and the overall PCC structure. Once established, the sponsor also manages the PCC’s day-to-day activities, allowing cell owners to avoid a lot of the corporate and administrative resources typically required for a captive insurance or reinsurance company.

With a PCC, you essentially benefit from pooled administration, but not risk. Each cell in a PCC is independent of and insulated from the others and the core in terms of assets and liabilities. Often, PCCs will allow companies to own more than one cell, and typically each cell is still treated individually.

See also: The Benefits of Captives for Small and Mid-Sized Businesses (White Paper)

What are the Benefits to a Cell Captive

There are a number of benefits to insuring your risk using a protected cell company:

  • Easy entry into funding risk – While you still have to clear the typical regulatory hurdles of setting up a captive which vary greatly depending on the risk in question, a great deal of the administrative time and money that you would typically spend is eliminated since we have already set up the shell entity for you.
  • Economies of scale – With a protected cell company, you enjoy continued administrative savings due to economies of scale from potentially pooled administrative costs.
  • Professional captive management – As an owner of a cell, you generally can expect day-to-day management services from professional captive managers.

Is a Protected Cell Captive right for you?

Participation in a protected cell captive is attractive, but not for everyone. Generally speaking, mid-sized companies that are dipping their toes in captive funding are the likeliest participants given the lower barriers to entry and management assistance a PCC offers. That said, there are a number of other reasons why companies of all sizes would strategically use a cell captive to address their risk portfolio. A feasibility study will go a long way in identifying if a company is a good fit for participation in a PCC.

Want to Learn More? Contact us today to discuss a captive feasibility study, which will determine your funding requirements and whether a captive is right for you.

Spring Releases Captive Insurance eBook and Infographic for Risk Managers

Risk Management CaptiveBOSTON, MA, May 30, 2013—Spring Consulting Group announced today the release of a new educational eBook and Infographic about Captive Insurance for risk managers.

The eBook, titled “Funding Employee Benefits: A Risk Manager’s Guide” is aimed at educating risk managers and human resource directors about the pros and cons of funding employee benefits through a captive, the alternative risk transfer technique most commonly associated with managing a company’s property and casualty risks.

The accompanying infographic, titled “4 Advantages to Funding Employee Benefits in Captives,” highlights the pros of benefit captives in a fun and easily digestible way.

“We wanted to create these materials because we are seeing a growing interest among risk managers in funding employee benefits through captives,” commented Spring Managing Partner, Karin Landry. “With the constant rise in the cost of employee benefits, and a great deal of the Affordable Care Act set to take effect next year, businesses are looking to captives as an attractive option for controlling costs beyond just their property and casualty. We want to be sure they have all the information they need to make an informed and profitable decision.”

Fill out the form below for a free download of this helpful guide.