Court Invalidates IRS Micro-Captive Transactions Notice: Now What?

On March 21, 2022, a U.S. District Court in Tennessee invalidated IRS Notice 2016-66 (November 2016), which announced the IRS view that certain micro-captive insurance transactions are transactions of interest (essentially tax shelter transactions) and that they are subject to the special reporting regime applicable to so-called reportable transactions. The special reporting requirements in the Notice also applied to promoters and to material advisors in such transactions.

The Notice previously had been criticized by many on substantive grounds as painting micro-captive transactions with too broad a brush. Not all of these transactions are abusive. For example, many automobile dealerships engaged in these transactions for various risk reduction motives and to have more control over insurance costs and claims management.

The District Court vacated the Notice in its entirety because the IRS did not comply with the notice-and-comment requirements of the Administrative Procedures Act (APA), and because the IRS acted in an arbitrary and capricious manner in issuing the Notice (i.e., it didn’t analyze the relevant data and provide a sufficient explanation for its decision). The immediate impact of invalidating the Notice is that the IRS must return all documents and information produced to it as a result of the Notice, not just the ones provided to it by the plaintiff in the case at hand. A logical follow-on is that any penalties asserted against taxpayers for failure to comply with the Notice should no longer apply. For taxpayer’s contesting or litigating one of these cases, it is important to note that the court refused to enjoin government agencies from introducing in future judicial or administrative proceedings any information obtained unlawfully under the Notice. It did that because “the IRS may attempt to promulgate an APA-compliant rule” in the future and it didn’t want to create “future litigation over how and when the IRS received information in its possession.”

Because the District Court that decided the case resides in the Sixth Circuit, the decision applies only to taxpayers in Kentucky, Michigan, Ohio, and Tennessee. The IRS is likely to assert that the Notice continues to apply throughout the rest of the country, until another court holds otherwise, and the IRS may appeal the decision. Importantly, the court’s decision has no impact on the IRS’s technical tax analysis of these transactions, and the IRS is unlikely to slow its enforcement efforts regarding these transactions. Micro-captive insurance transactions are, after all, included in the IRS’s dirty dozen list of tax scams.