A showdown for the ages

It’s been a busy 12 months for the micro-captive industry, not least because of the ongoing battle between the Internal Revenue Service (IRS) and CIC Services that played out before the US’ highest court.

In May this year, the US Supreme Court found in favour of CIC—which had challenged the legality of Notice 2016-66 under the Administrative Procedure Act (APA)—clearing the way for the trial court to rule on whether Notice 2016-66 is illegal and whether it should be enjoined.

Notice 2016-66 requires information reporting for certain participants and material advisors of micro-captive transactions.

The unanimous court decision “definitively ended the IRS’s extreme interpretation of tax exceptionalism”, according to Sean King, founding principal and in-house counsel at CIC.

“Under a theory commonly referred to as ‘tax exceptionalism’, the IRS has long insisted that it’s exempt by virtue of the Anti-Injunction Act (AIA) from pre-enforcement legal challenges to its rules and regulations,” says King.

Consequently, the IRS has “historically made shamefully little effort to comply” with the requirements of the Administrative Procedures Act (APA) when issuing rules and regulations, he adds.

Under the AIA “no suit for the purpose of restraining the assessment or collection of any tax shall be maintained in any court by any person”, which effectively meant that courts were prevented from restraining the IRS’ attempts to assess or collect taxes against taxpayers.

King claims that the IRS has often tried to disguise rules and regulations as mere “notices”, and that taxpayers have “long been subjected via threats and intimidation to the systematic enforcement of illegal edicts from the IRS”.

“Prior to our lawsuit, taxpayers generally could not safely avoid complying with illegal rules by asking a court to strike them down,” he adds.

Before the case made its way to the Supreme Court, CIC had challenged the lawfulness of Notice 2016-66 under the APA (which sets out the processes that agencies must follow when promulgating regulations) before a district court. However, the court dismissed the action on the basis that it would be barred by the AIA, which requires those contesting a tax’s validity to pay the tax before filing a legal challenge.

A divided panel of the US Court of Appeals for the Sixth Circuit affirmed the lower court’s decision and denied a request for review, prompting CIC to appeal to the Supreme Court.

The Supreme Court’s decision to side with CIC and find that the AIA didn’t preclude its suit cited the fact that Notice 2016-66 imposed affirmative reporting obligations, which inflicted costs separate and apart from any tax or tax penalty.

“Because the IRS chose to address its concern about micro-captive agreements by imposing a reporting requirement rather than a tax, suits to enjoin that requirement fall outside the AIA’s domain,” the court said.

The case has now been remanded back to the district court for a determination as to whether or not the notice is illegal and whether it should be enjoined.

"We are confident, but of course not certain, of victory at the district court level. We hope to know within 90 days or so,” says King.

He adds: “If we win, we expect that court to enjoin further enforcement of Notice 2016-66. It’s unclear whether such an injunction would forbid the IRS making further use of the data that it has already illegally collected or whether it would simply prohibit future collection under the notice.”

It’s unclear how the IRS might react to the lower court’s decision if it does not go in the agency’s favour.

“What the IRS does, assuming we win, is anyone’s guess. They could seek to retaliate against us in innumerable ways,” warns King. “They could simply re-issue the notice in the form of a valid regulation that follows the requirements of the APA. Or they could simply drop the issue and seek to police captives through ordinary audits.”

The Supreme Court’s green light to challenge the validity of Notice 2016-66 is not the only development to cause a rumble across the micro-captive industry this year.

The key developments involve a mix of issues including substantive and procedural tax law, IRS summons enforcement, as well as civil litigation against captive insurance advisers, says David Slenn, partner at Shumaker, Loop & Kendrick.

At the Supreme Court level, an appeal involving the issue of whether micro-captive participants can sue a captive manager in a class action or be forced to arbitrate separately (as specified by parties’ arbitration clause in the management services agreements) has been denied.

“The US government continues to litigate summons enforcement actions involving micro-captive cases, including one related to micro-captive advisers who also serve as lawyers but who might be considered promoters of abusive micro-captive arrangements,” says Slenn.

He adds that another summons enforcement matter involves records held by a state captive insurance regulatory department. In this case, in mid-July, a US magistrate judge recommended that the summons, which was sent to the Delaware insurance authority and sought information on certifications issued to micro-captive insurers, should be enforceable.

Meanwhile, in the Tax Court, the IRS has won its fourth straight micro-captive case, this time involving a non-risk pool participating micro-captive.

“There are a number of cases percolating through the Tax Court, with some no doubt featuring better facts than the last four reported decisions,” Slenn adds.

King is confident that of the cases presently pending in the tax court, “taxpayers will ultimately win their fair share of them” and, as they do, the rules of the road will become much clearer.

“The time that the IRS can continue to rule by fear, uncertainty and doubt (FUD) rather than by law is short, and it knows it, which is why the service is proceeding as aggressively as it is,” he claims.

For now, the IRS is showing no signs of easing up in its pursuit of fraudulent tax avoidance schemes. In April, the IRS established an office of promoter investigations (OPI) to expand on the work its promoter investigations coordinator began in the summer of 2020.

At the time, IRS Commissioner Chuck Rettig said the office will increase the tax authority’s focus on promoters of abusive tax avoidance transactions.

“This office will coordinate efforts across multiple business divisions to address abusive syndicated conservation easements and abusive micro-captive insurance arrangements, as well as other transactions," said Rettig.

Then, in July, micro-captives returned to the agency’s annual ‘Dirty Dozen’ list of tax scams and schemes. Despite a respite in 2020, micro-captives have been a regular feature on the list since 2014.

Taxpayers were warned that 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 insurance”.

As an example, the IRS says that “coverages may ‘insure’ implausible risks, fail to match genuine business needs or duplicate the taxpayer's commercial coverages” and that the premiums paid under these arrangements are “often excessive and used to skirt tax law”.

Is the IRS overreacting and damaging the attractiveness entire captive insurance industry? It’s a grey area.

Michael Maglaras, founder and principal of Michael Maglaras & Company, explains: “We are the last industry left of any major consequence that self-polices and self-regulates. We went terribly wrong with 831(b)s.

“When you are a self-policed industry, the thing you never do is let the federal government peek under your tent. You hold yourself and your colleagues to the highest standards of conduct because, if you do let the federal government peek, before you know it half their body is under the tent.”

Maglaras sees section 831(b) of the Internal Revenue Code as one of the best examples of a government getting it right.

“The provisions of 831(b) are a beautiful architecture that help smaller and mid-market businesses manage risk,” says Maglaras. “There’s nothing wrong with the code, it’s the abuse of what’s written in the code that is the problem.”

And now that the federal government—with its unlimited budget and unlimited patience—has effectively “peeked under the tent”, dire consequences are sure to follow.

“Unfortunately, I’m predicting that small to medium-sized businesses will directly suffer as a result of the abuses of 831(b)s. Premiums will go up, and businesses will be less likely to form a captive,” says Maglaras. He concludes: “The industry caused this. We have only ourselves to blame.”

In a similar vein, Slenn believes that while the future of certain 831(b)s remains uncertain, what is certain is a “growing uneasiness among business owners to participate in a transaction that requires annual reporting as a ‘transaction of interest’ as well as being associated with a ‘Dirty Dozen’ listing”.

He warns: “The constant pressure and expense imposed on those that wish to defend might effectively terminate certain types of micro-captives, with non-abusive micro-captives continuing forward.”

“While the IRS’s whining over ‘abuse’ within the captive insurance industry is not entirely unfounded it is mainly grandstanding intended to justify its reign of terror,” King contends.

He adds: “The simple fact is that the IRS could end almost all such alleged abuse overnight—not by spreading FUD, not by starting up dozens of new audit teams and not by issuing more burdensome notices like 2016-66, but simply by issuing reasonable, substantive guidance, guidance that the industry has long begged for and that Congress demanded from the IRS nearly five years ago.”

King believes that the industry would conform to such guidance almost overnight and any supposed abuse would largely end, but that this guidance never comes.

“Why?” he asks. “The answer is obvious if you think about it. Imagine a situation where, rather than having a speed limit, the law simply forbids driving at any ‘unsafe speed’ and then leaves it up to individual police officers to arbitrarily determine in their own judgement what is safe for each driver and what is not.”

Imagine that these officers receive praise or are rewarded politically whenever they “protect the public” from “dangerous drivers” by issuing massive fines, he says. Imagine also that the legal fees for a law-abiding citizen to challenge these “arbitrary and inconsistent determinations” of safety (or lack thereof) exceed the cost of the fine itself so that nearly all drivers are highly motivated to settle rather than to contest.

“Such a situation would be a recipe for extortion,” explains King. “Alas, it’s exactly the situation that the captive insurance industry presently faces with the IRS. The IRS believes rightly that so long as it can keep the rules of the road intentionally vague via the spread of FUD and by refusing to issue guidance, it can more easily extort settlements.”

King is confident however that, over the next few years, the courts or Congress will do what the IRS “would have done already were it honest” by providing the industry with meaningful guidance and/or safe harbours.

King ends on an optimistic note: “A few years from now this industry will be booming as the ‘captive wars’ will be long behind us. Our firm is thrilled that we led the charge and won one of the biggest battles in that war with our Supreme Court victory.”