Captive Transaction Disclosures Remain for Now: Federal Court Rejects Last-Minute Injunction Request and Affirms Anti-Injunction Act Applies to Penalties

On November 1, 2016, the IRS issued Notice 2016-66, designating certain micro-captive insurance arrangements under section 831(b) as “transactions of interest” that, the IRS contends, have “a potential for tax avoidance or evasion.” The designation requires participating taxpayers and their advisers to file disclosures by May 1, 2017.¹

Broadly stated, based on audits to date, the IRS believes that many of these transactions should not qualify as deductible insurance because of the presence of one or more of the following features:

• The insurance coverage involves an implausible risk, does not match a business need or risk of the insured, or is duplicative of other coverage;
• The insured claims deductions for premiums that were not actuarially based;
• The captive does not have defined claims administration procedures and/or insured does not file claims; and
• The captive does not have adequate capital to assume the risks, and/or invests its capital in illiquid or speculative assets, and/or the captive makes loans to insured or other related entities.

The IRS lays out its concerns in section 1 of the Notice, but in section 2, where the IRS actually identifies the applicable “transactions of interest,” the description is not limited to the features identified in section 1. Rather, the “transactions of interest” designation covers all § 831(b) captive insurance arrangements where (1) the captive had combined claims and administration expenses totaling less than 70% of premiums received over a five-year period; or (2) the captive engaged in any loan to the insured or a related person/entity.² Thus, the definition of the “transaction of interest” is not restricted to the micro-captive arrangements that have the abusive features described in section 1.

Designation as a transaction of interest carries reporting obligations for participants, as well as reporting and list maintenance requirements for those considered material advisors.³ If a participant in a transaction of interest fails to properly report the transaction and/or a material advisor fails to properly report the transaction and/or maintain and furnish the required list to the IRS, the individual or entity may be subject to substantial penalties.⁴ Many states, including New York and California, have reporting regimes that follow the federal regime:⁵ designation of a federal transaction of interest therefore can carry additional state consequences.

The plaintiffs quickly moved for a preliminary injunction prohibiting the IRS from enforcing the disclosure requirements in the Notice, which the government naturally opposed. The Court held an expedited hearing on April 19, 2017 at which the plaintiffs offered testimony claiming financial burdens and reputational harm caused by the Notice.Two captive management companies recently sought an injunction in federal court prohibiting the IRS from enforcing the Notice. The case was CIC Services, LLC v. Internal Revenue Service, et al., No. 3:17-cv-110 (E.D. Tenn. March 27, 2017). In the complaint, the management companies challenged Notice 2016-66 on the following procedural grounds: (1) the Notice is a legislative rule and was improperly promulgated without complying with Administrative Procedure Act (APA) notice and comment procedures; (2) the Notice is arbitrary and capricious, containing no reasoned analysis, and therefore violates the APA; and (3) the Notice is invalid because it fails to comply with the Congressional Review of Agency Rule-Making Act requirements.

Shortly thereafter, on April 21, 2017, U.S. District Judge Travis McDonough issued an order denying the plaintiffs’ request for a preliminary injunction.⁶ The Court found the plaintiffs might well suffer irreparable harm due to the compliance costs if an injunction were not issued, but it concluded that the likelihood of success on the merits, which plaintiffs must show to obtain a preliminary injunction, was very low because the Anti-Injunction Act (AIA)⁷ likely barred the type of relief sought, i.e., a permanent injunction.

The Court’s analysis of the AIA adds to recent jurisprudence regarding the AIA’s broad scope, including its applicability to reporting requirements that can lead to penalties. It also highlights the difficulty litigants will face in endeavoring to challenge IRS administrative pronouncements preemptively.

The AIA provides that “no suit for the purpose of restraining the assessment or collection of any tax shall be maintained in any court by any person, whether or not such person is the person against whom such tax was assessed.”⁸ The plaintiffs in CIC Services argued that they were not attempting to restrain the assessment or collection of tax, but rather challenging the reporting regime as being improper under the APA. The plaintiffs argued that the AIA does not prevent injunctive relief merely because persons who fail to comply with the Notice might incidentally be subject to a “penalty” under sections 6707(a), 6707A, or 6708(a). The Court, however, looked to the plain language of the governing statute to conclude that such a penalty is a “tax” for purposes of the AIA. Because section 6671(a) provides that any penalty under Subchapter 68B is assessed and collected in the same manner as taxes, references to “tax” are deemed to also refer to penalties under Subchapter 68B; and since all potential penalties under the Notice are in Subchapter 68B, all penalties must be considered a “tax” for purposes of the AIA.⁹ The Court found further support for this position in the Florida Bankers case,¹⁰ which held that the AIA prevented banks from challenging a regulation that penalized them for not reporting certain interest payments because the penalty was covered by Subchapter 68B.

The plaintiffs attempted to distinguish their claims from Florida Bankers by relying on the 2011 Cohen case,¹¹ which held that the AIA does not prohibit a challenge to IRS procedures even though it bars injunctions relating to tax assessments. The CIC Services Court distinguished Cohen because the Cohen plaintiffs were challenging IRS procedures relating to a refund of taxes already paid, which “cannot affect the assessment or collection of taxes after the fact.”¹² The Court further relied upon Florida Bankers for its conclusion that the AIA cannot be avoided by challenging only a reporting requirement and not the penalties imposed for violating that reporting requirement.¹³

Although the plaintiffs’ injunction claim was rejected, their APA claims appear to remain alive. Predicting how these claims will be resolved is beyond the scope of this article, but if the plaintiffs succeed on their APA claims regarding the applicability of the APA notice and comment procedures to the designation of transactions of interest, the Court would essentially have to invalidate Treas. Reg. § 1.6011-4, relied on by the IRS to issue notices like Notice 2016-66 designating transactions of interest. Such a holding would have enormous ripple effects for listed transactions as well, because the IRS relies on the same regulation to designate listed transactions without notice and comment procedures. Thus, to the extent that the Court holds the regulation invalid and/or that designation of a transaction of interest requires notice and comment procedures, the same would be true for a listed transaction.

Although it is unknown how the plaintiffs’ APA claims will proceed, this case offers some guidance about the broad scope of the AIA. Essentially, this Court’s reading of Florida Bankers and its holding here warns plaintiffs that a refund suit is the only safe venue to seek injunctions challenging IRS pronouncements relating to taxes and penalties, as the AIA will otherwise bar injunctive relief. Flowing from this case and Florida Bankers, litigants appear to lack opportunities to obtain pre-assessment relief with respect to IRS procedures or promulgations. Instead, litigants may have to wait until they have actually paid the tax/penalty to seek an injunction even if the reporting system may be procedurally improper. In this context, for example, the plaintiffs would have to incur a significant penalty in order to be able to challenge the micro-captive Notice. The Court was unpersuaded that there was no adequate remedy at law (which would make the AIA inapplicable¹⁴ ), because a suit for refund is available as a legal matter.¹⁵ The holding effectively means that a pre-compliance injunction will be out of reach for most parties wishing to halt application of the Notice. This case and Florida Bankers suggest that litigants have few options to challenge IRS reporting regimes whenever non-compliance could lead to additional tax or penalties. ■