Microcaptive insurance arrangements after CIC Services.

• Author: Newkirk, Kaitlin

The CIC Services (1) decision recently handed down by a federal district court in Tennessee has drawn the attention of those involved in microcaptive insurance transactions, other taxpayers engaged in reportable transactions, and administrative law watchers. The business that brought the lawsuit, CIC Services, an adviser and manager of microcaptive insurance transactions, had previously secured a U.S. Supreme Court victory in which the Court held that the company's suit was not precluded by the Anti-Injunction Act. On remand to district court, CIC Services now has another win--this time with the court invalidating Notice 2016-66, which classifies certain microcaptive arrangements as reportable transactions. This article examines the possibly far-reaching implications of the federal district court's March 2022 holding. Before delving into the decision and its broader repercussions, however, it may be helpful to review what microcaptive insurance arrangements are, the IRS's efforts to crack down on their abuse, and the prior developments in the CIC Services litigation.

Microcaptive insurance companies

To protect against certain risks, businesses can create "captive" insurance companies that are typically owned by the business's owners or family members. There are tax advantages to this arrangement because the insured party can deduct the premium payments as a business expense. In addition, under a provision in the Code that benefits small insurers, the insurance company can exclude from taxable income up to $2.45 million of premium payments per year by electing under Sec. 831(b) to be taxed only on its investment income. As a result, the insured party can take a deduction and there is no corresponding tax on the captive insurer. These small insurance companies are referred to as "micro" captives.

If these arrangements are used for real insurance purposes, the Code permits them. However, the arrangements set up by business owners (often on the advice of unscrupulous promoters or advisers), frequently lack the true attributes of insurance, for example, by insuring implausible risks, failing to address genuine business needs, duplicating the business's commercial insurance coverage, or charging excessively high "premiums."

To help curb microcaptive insurance abuses, the IRS issued Notice 2016-66. As background, the Service has authority under the American Jobs Creation Act of 2004 (2) to collect information about potential tax shelters and impose civil and criminal penalties upon taxpayers failing to disclose reportable transactions. Although Congress instructed the IRS to define reportable transactions "under regulations," the IRS began to issue subregulatory guidance via IRS notices. In Notice 2016-66, the Service announced that Sec. 831(b) microcaptive insurance transactions substantially similar to the transaction described in the notice would be classified as transactions of interest that are reportable transactions requiring disclosure under Regs. Sec. 1.6011-4 and Secs. 6011 and 6012.

CIC Services case

CIC Services, a Tennessee-based captive insurance manager and material adviser to taxpayers that participate in microcaptive transactions, challenged Notice 2016-66 in district court. It argued the IRS violated the Administrative Procedure Act (APA) in promulgating the notice and requested that the court hold that the notice is invalid. Specifically, CIC Services argued the notice violated the APA in two ways: (1) It was arbitrary and capricious, and (2) the IRS failed to engage in standard notice-and-comment rulemaking as required by the APA.

Rather than address the APA claims, the IRS initially fought the case by arguing that the suit was blocked by the Anti-Injunction Act (Sec. 7421) --a law originally enacted in 1867 that prevents taxpayers from stopping the IRS from assessing and collecting taxes. The district court for the Eastern District of Tennessee agreed with the IRS that CIC Service's claims were barred by the Anti-Injunction Act and dismissed the case for lack of jurisdiction. (3) A divided Sixth Circuit affirmed the district court's decision. (4)

Supreme Court holding

CIC Services appealed the case to the U.S. Supreme Court. (5) In May 2021, the Court unanimously reversed the Sixth Circuit decision. It held that the Anti-Injunction Act did not prevent CIC Services from filing suit to invalidate Notice 2016-66. The Court offered several reasons for its holding, including that CIC Services should not have to intentionally violate the law--risking criminal liability and ruinous civil penalties--in order to secure its day in Court. The Supreme Court decision, which was discussed in the August 2021 issue of The Tax Adviser, (6) meant that CIC Services could move forward with its lawsuit.

District court decision

Now able to reach the merits of the case, the district court for the Eastern District of Tennessee issued a March 2022 opinion in favor of CIC Services. The court vacated Notice 2016-66 because the IRS had not followed the APA's notice-and-comment procedures in promulgating the notice and the notice was arbitrary and capricious under the APA. This outcome is a major blow to the IRS and its ability to require reporting on Form 8886, Reportable Transaction Disclosure Statement, for Sec. 831(b) microcaptives.

Notice-and-comment procedures; Mann Construction

The IRS argued that it was exempted from complying...