The U.S. Treasury Department and Internal Revenue Service (IRS) have issued proposed regulations to identify certain micro-captive transactions as "listed transactions" and "transactions of interest." 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 that must also be reported to the IRS. The implications of these proposed regulations will be on material advisors and participants in the listed transactions and transactions of interests. Material advisors and participants will be required to file disclosures with the IRS and will be subject to penalties for failure to disclose. Tax law generally allows businesses to create “captive” insurance companies to protect against insurance risks. It also provides that some small non-life insurance companies can choose to pay tax solely on their investment income under Internal Revenue Code section 831(b), known as “micro-captives”. In abusive micro-captive structures, promoters, accountants or wealth planners persuade owners of closely held entities to participate in schemes that lack many of the attributes of genuine insurance. This proposal follows the mention of micro-captives in the IRS' 2023 ‘dirty dozen’ list, updated on 5 April. The dirty dozen list is an annually published list of tax scams. It is published by the IRS to remind, identify and help people watch out for various tax scams and schemes. Micro-captives feature every year. Previously, the IRS identified certain micro-captive transactions as transactions of interest in Notice 2016-66. However, recent court decisions in the Sixth Circuit and the US Tax Court have ruled that the IRS lacks authority to identify listed transactions and transactions of interest by notices, such as Notice 2016-66. Instead, the IRS must identify such transactions by following the existing notice and public comment procedures that apply to regulations. The U.S. Treasury and the IRS have disagreed with these court rulings and continue to defend listing notices in litigation except in the Sixth Circuit. The U.S. Treasury and the IRS have stated that they will “no longer take the position that transactions of interest can be identified without complying with notice and public comment procedures.” The IRS has consistently disallowed the tax benefits claimed by taxpayers in abusive micro-captive structures. Three taxpayer court challenges against the IRS position disallowing micro-captive tax benefit have been unsuccessful. Each time, the Tax Court sustained the IRS’ disallowance of claimed tax benefits. The U.S. Treasury and the IRS intend to finalise these proposed considerations after they consider 2023 public comments.
