Southern District of Texas partially rules against IRS in new micro captive case
The United States District Court for the Southern District of Texas has ruled against the Internal Revenue Service (IRS) in the latest micro captive legal case.
The case was Drake Plastics versus the IRS, and in its published opinion the Court said that the dispute was about a tax disclosure rule for captive insurers. The IRS justified the rule by the potential for tax evasion that captive-insurance arrangements present.
However, the plaintiffs, Drake Plastics, a related captive insurer, and their tax-advising firm, did not want to make the disclosures and contended that the rule exceeds the IRS’s authority, lacks support in the administrative record, and is arbitrary and capricious. The IRS responded to each argument and submitted the administrative record. The court held a hearing to allow the parties to argue their positions.
The Court announced that: “Based on the cross-motions for summary judgment, the record, the arguments of counsel, and the applicable law, the court grants in part the plaintiffs’ motion for summary judgment and a permanent injunction, (Docket Entry No. 58), and grants in part the IRS’s cross-motion for summary judgment, (Docket Entry No. 63). The court finds that the IRS: (1) appropriately designated micro-captive transactions as transactions of interest through 26 C.F.R. § 1.6011-11; but (2) cannot justify on the current record the designation of micro-captive transactions as listed transactions through 26 C.F.R. § 1.6011-10. The court therefore vacates 26 C.F.R. § 1.6011-10.”
According to Dustin Carlson, president, SRA 831(b) Admin, the court drew an important line. He told Captive International: “There's a difference between requiring disclosure and branding an entire industry as presumptively abusive. The IRS used the listed transaction designation to treat thousands of legitimate captive insurance arrangements as tax shelters without the evidence to support it. The court agreed and vacated that designation. SRA funded this case because the business owners and advisors who depend on captive insurance deserved someone willing to fight for them.
“We've always been willing to work with the IRS to clean up this industry. The taxpayers who have lost in Tax Court lost because of operational failures, and we'd welcome a framework that targets those shortcomings. Unfortunately, the IRS hasn't shown any willingness to engage. The risk environment for American businesses is only getting harder to navigate, and captive insurance is one of the few tools that fills the gap. The IRS should be helping us get this right, not trying to shut it down.”
Matthew Queen, advisor, 831(b) Institute, told Captive International: “SRA 831(b) Admin is the biggest captive industry win against the IRS since the Notice 2016-66 Supreme Court victory. This case creates a schism with the recent industry loss in the matter of CIC Services v IRS, which sets the stage for more disagreements on this front.
“The primary impact of this case is that the IRS’s final rule’s definitions as to what constitutes a listed transaction were deemed arbitrary and capricious. While the portion of the rule defining a transaction of interest stands, the bigger deal is whether a captive arrangement is per se abusive – and that’s the part of the rule that was vacated by the court.
“But the larger issue is that there is now an uncertainty for captive transactions. Taxpayers and captive managers have strong arguments against enforcement of the listed transaction rule in Texas, and probably the rest of the 5th Circuit. However, taxpayers and promoters in Tennessee and the balance of the 6th Circuit probably do have to comply with the listed transaction disclosure requirements. The rest of the country can take a defensible position that noncompliance with the listed transaction portion of the rule is legal, but the IRS can challenge that.
“This decision means that captives meeting the conjunctive test (Relationship Test, Financing Factor, and 30% loss ratio) have no reporting obligation as a listed transaction. Since listed transactions are presumptively tax avoidant, this is a relief for small captive owners and promoters. But the extent to which captives across the country can rely upon this is a grey area. In general, there is an increasing scepticism that district court judges can strike down entire laws without any oversight.
“While the removal of the listed transaction element, even if geographically limited, is a great development, the transaction of interest portion of the rule remains in place. Therefore, the IRS does still possess the authority whether in Tennessee or Texas or anywhere else to demand disclosures for captives triggering the so-called Financing Factor or 60% loss ratio. This basically guarantees the IRS to continue collecting vast amounts of data on the industry which – mysteriously enough – never seem to make it into the administrative record supporting the IRS’s decision-making processes.
“Captive managers and owners will have to advise their clients on how to operate given the 60% loss ratio threshold or the Financing Factor. And if any taxpayers qualify as a listed transaction under the rule but do not live in Texas then they need outside counsel to advise on disclosure.
“Since the opinion was released less than 24 hours ago, there are many avenues to consider for the next steps. The government may appeal its loss in the 5th Circuit. SRA or Drake could appeal the transaction of interest portion of the opinion to the 5th Circuit. But there are conflicting opinions as to whether a vacatur of a rule paired with an order from the court remanding the IRS to rewrite the rule is a “final” ruling that can be properly appealed.
“With that said, if the IRS does appeal and the ruling is upheld by the 5th Circuit then there is a definitive circuit split on a rule promulgated by the IRS. That is one of most common paths for a case to be granted a writ of certiorari and proceed to the US Supreme Court.
“While the dust continues to settle, the captive insurance industry is once again potentially knocking on the doors of the US Supreme Court over a major disagreement regarding the 831(b) portion of the industry. That is shocking. Very few cases go to the Supreme Court and certain industries basically never get reviewed by SCOTUS. For captives to make it once is remarkable – especially given that the business of insurance is state law. But for the industry to be set up twice in a decade underscores just how aggressive the IRS has been with regard to 831(b) captive prosecution.”
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